Credit Default Swaps (CDS) and Greece-Italy-Portugal & Spain

defines Credit Default Swaps as an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults.

In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan.

Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010.

In my understanding these are simliar Private Mortgage Insurance, which is popular in American on home mortgages, that the buyer is not putting a significant downpayment on the property. The bank or mortgage hold is protected by PMI, so if the owner defaults, the mortgage holder does not lose, the bank is paid off by the insurance and the insurance company then is the owner of the rights to the property. Although it gets a lot more complicated then this in the world of finance and risk, as you can have insurance on only certain parts of the debt or only on a certain level of default or only on particular types of non payments.

One of the main problems with the Greek settlement is what will trigger this insurance. The question then comes, if a bond holder has CDS coverage, why would they settle for anything less then the full face value and what happens if they do?

If the bond holder settles for a negotiated settlement, will the insurance kick in. The who should the Greek government be negotiating with the holder of the bond or the CDS.

The other important question is what is a default and how is a default determined. The EU has done everything they can to distance a negotiation with credits from a default. In technical terms it is a default anytime you do not repay the full value of the debt, but what the definition is in legal terms, insurance terms and banking terms could be entirely different.

The European debt crisis is getting ever more serious, and will soon move away from Greece to one of the biggest – and potentially most explosive – economies in the world: Italy

US institutions have been snapping up credit default swaps (CDSs), insurance against credit losses. The value of guarantees provided by US lenders on government, bank and corporate debt in troubled eurozone countries rose by $80.7bn to $518bn in the first half of this year, according to the Bank of International Settlements. If Italy goes down in a disorderly default it will shake the roots of the financial and economic world, estimate put the money needed over the next three years to be  around €650bn

Today cost of insuring Portuguese government debt against nonpayment soared. Reaching a  record on fears the country may be forced to follow Greece in seeking a restructuring of its debt. The spread on five-year Portuguese CDS widened to 1,310 basis points from 1,279 basis points earlier this week. That means it would now cost $1.31 million annually to insure $10 million of Portuguese debt against default for five years.

Yesterday, S&P stated that if Greece goes into default it does not need to be a domino effect, this is true, except countries like Spain, Italy and Portugal, are already in line.

the inforgraph comes from the Economic Time, but does not list an designer.