guardian.co.uk,
Rupert Neate, Monday 14 May 2012
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| In 2003 Warren Buffet called credit defaults swaps a 'weapon of mass destruction' Photograph: Thomas Lohnes/AFP/Getty Images |
Credit
default swaps (CDSs) are a form of insurance on bonds issued by companies and
countries that investors can buy and sell. If it looks like an issuer may have
trouble paying – such as Greece, for example – the CDS price rises because the
bond is more risky and it will cost more to insure.
CDSs were
dreamed up in the late 1990s and became very popular, very quickly. In 2000,
the market was worth $900bn (£560bn). By 2008, it was more than $30 trillion.
They can be
used by bond investors – as a hedge against potential defaults – or traded
separately when they are called naked CDSs.
The case
against CDS contracts is usually explained using house insurance as an example:
it is not possible to take out an insurance policy on someone else's house –
because you would then have a financial interest in burning it down. Investors
with no interest in the underlying bond can buy and sell CDSs – and profit from
its demise. Greece has blamed speculators trading in CDS contracts on Greek
bonds for pushing up government fundraising costs.
Regulators
have blamed speculators and their trades in naked CDSs for exacerbating the
problems faced by Greece and increasing its borrowing costs. The European
commission president, José Manuel Barroso, believes speculative CDS trading has
been an "aggravating factor" in the Greek debt crisis.
They also have been blamed for triggering the 2008 financial crisis. In 2003
Warren Buffett called them "weapons of mass destruction".
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