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Wednesday, January 6, 2010

Credit Default Swaps: Frequently Asked Questions

Edward V. Murphy
Specialist in Financial Economics

Rena S. Miller
Analyst in Financial Economics

Credit default swaps (CDS) are contracts that provide protection against default by third parties, similar to insurance. These financial derivatives are often used by banks and other financial institutions to manage risk.

The near-collapse of AIG and subsequent firm-specific government assistance in September 2008, largely as a result of an AIG unit’s extensive issuance of credit default swaps, drew attention to the unregulated nature of these instruments. Government assistance to AIG—which has totaled roughly $180 billion—came against a backdrop of rapid growth of the derivatives market, rising credit defaults on mortgages and related mortgage-backed securities, and operational problems in the over-the-counter (OTC) market where credit default swaps are traded. The failure of Lehman Brothers in September 2008 also raised systemic risk concerns due to Lehman’s heavy involvement in the credit default swaps market, both as a major seller of credit default protection, and as an actively traded underlying entity on which such credit protection was written.
The lack of any record-keeping or reporting requirements in the CDS market further aggravated problems regulators faced in gauging the potential systemic impact these companies’ failures could have on the economy as a whole. This state of affairs led a number of policymakers to inquire whether credit default swaps pose a danger to the financial system and the economy.

This report defines credit default swaps, explains their use by banks for risk management, and discusses how they may have contributed to systemic risk. It also examines legislative proposals to address risks from credit default swaps. Among the bills to regulate credit default swaps and other derivatives is H.R. 4173, in its Title III section on over-the-counter derivatives, which passed the House of Representatives with various amendments on December 11, 2009. In the Senate, the Committee on Banking, Housing and Urban Affairs has released a committee print draft of a comprehensive financial reform bill that includes legislation to reform OTC derivatives. Senator Jack Reed, who chairs the Senate Banking Subcommittee on Securities, Insurance, and Investment has introduced S. 1691 to regulate the OTC derivatives markets, including CDS. Senator Blanche Lincoln, the chair of the Senate Agriculture Committee, which shares jurisdiction over derivatives with the Senate Committee on Banking, Housing and Urban Affairs, has also indicated an intention to introduce legislation reforming regulation of OTC derivatives. For broader background on reform of the OTC derivatives market as a whole, please see CRS Report R40965, Key Issues in Derivatives Reform, and CRS Report R40646, Derivatives Regulation in the 111th Congress, Derivatives Regulation in the 111th Congress. This report will be updated as conditions warrant.

Date of Report: December 22, 2009
Number of Pages: 11
Order Number: RL22932
Price: $29.95

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