Demonization of CDS misstates real role in crisis

NEW YORK (Reuters) - They've been described as evil, acts of Satan and weapons of mass destruction. The fervor around credit derivatives has never been higher.

The $55 trillion credit default swap (CDS) market is almost certain to face regulation as fear and blame surrounds the role it has played in fanning the financial crisis.

New controls may bring many benefits in clamping down some risks and possible abuses of the securities, but behind the fiery rhetoric lie many misunderstandings.

CDSs have been made the fall guy for the collapse of institutions including Lehman Brothers Holdings Inc (LEHMQ.PK: Quote, Profile, Research, Stock Buzz) and bailout of American International Group (AIG.N: Quote, Profile, Research, Stock Buzz).

They've been called the epicenter of the crisis because they played a role in spreading the risks of bad mortgages and other assets globally, threatening systemic consequences from a large counterparty collapse.

"This is nothing more than an insurance contract and we treat it as though it has human qualities. You can't have a good or an evil insurance policy," said Roy Smith, professor of finance at the Stern School of Business at New York University.

"Do we sit around talking about the demon insurance companies who insure the hurricanes?" he asked. "Why not?"

Credit default swaps are used to protect against or speculate on the risk of a company, government or other borrower not paying back their debt. When a borrower fails, the protection buyer is paid the full amount insured.

The contracts have enabled banks and investors to pass on asset risks to other investors, which in some cases may have reduced losses from toxic assets.

Swaps have also encouraged banks and insurers to take on more risk than they could handle, sometimes causing their collapse. But the tool itself is not to blame for lax risk management.

"You could criticize demon rum, or anything that might serve some other purpose that which can be misused," NYU's Smith said. "There are lots of ways to abuse many things."

HOUSE OF CARDS

Take AIG for example. The company sold insurance on portfolios of mortgages and other assets through structured deals called collateralized debt obligations (CDOs).

Because it had a high credit rating, AIG was not required to post much collateral to cover possible losses from the CDS.

AIG earned high premiums from selling CDS insurance. At the end of June, AIG was essentially selling $447 billion in CDS insurance from a subsidiary, via CDOs.