A credit default swap, CDS, is a form of insurance against a loan default. The seller of the credit default swap insures the buyer of the swap that he or she will be compensated for the face value of the loan or a percentage of it if the loan defaults.
The problem is that there are even CDS’s which are not backed by any collateral on a loan and are truly high risk swaps on intangible assets which may be paper assets only. Effectively a loan on nothing or a fraudulent piece of paper.
A financial institution can create a counterfeit phony bond loan with an interest rate return which may be paid for a few years just to make it seem legitimate, sell it to a buyer who in turn insures it with a CDS given by a private investor or other financial institution which is left holding the bag when the loan defaults with no collateral backing it. A real Ponzi scheme with the issuer or seller of the CDS left with a total loss when the loan defaults as it inevitably will.
In 2007 CDS’s were at 62 trillion dollars and have fallen to 25 trillion dollars in 2012. CDS’s are high risk gambling and are another potential area which can cause a liquidity crisis if massive loan defaults occur.
Lack of transparency or not having all the necessary information is the real problem where humans make investments based on trust of a financial institution and not knowing whether the loan is truly legitimate or not.
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