Critics of credit default swaps argue that they are a nefarious tool used by short-sellers to bring down companies. “Naked” credit default swaps, those purchased by investors who don’t own the underlying debt, have come in for heavily criticism lately. Some would even ban them.
But the truth is that credit insurance is an important market tool that arguably has kept the credit markets alive and liquid during the crisis and provided banks with additional liquidity at a time when it was badly needed. Yes, even naked credit default swaps are helping. If you think things are bad now, just imagine how much worse they’d be if banks and investors couldn’t hedge their exposure to the risks of their counter-parties.
Let’s take one example of how credit default swaps are propping up ailing institutions: hedging prime brokerage exposure. Say you are primed at Morgan Stanley. Now, of course, you are nervous about whether Morgan Stanley is going to stay alive through this crisis. So you buy protection on Morgan Stanley from UBS, Goldman, JP Morgan and Barclays. (Probably a good idea to diversify those CDS both between firms and across geographic regions.) This way, Morgan Stanley goes bankrupt, those counterparties owe you cash within the next six months that will mitigate part of the resulting asset freeze.
In no way is this a perfect hedge. But it is a settlement risk mitigator. If you couldn’t buy credit default swaps on your prime brokerage without taking on even more exposure by purchasing the underllying debt, you might have to pull your business out of any firm where you perceive a bankruptcy risk. In short, “naked” credit default swaps are arguably keeping firms afloat and mitigating those post-modern “flight of the creditors” bank runs.