Credit Derivatives Disinfectant: First Rays Of Sunshine Credit derivatives have certainly made life interesting in the last year. Perhaps the most common credit derivative is the credit default swap. They’re over-the-counter derivatives that are essentially a bet on the creditworthiness of another party. They’re not very different from an insurance relationship: one party guarantees the performance of another, for a fee.
Where credit default swaps become problematic for the entire economy: how creditworthy are the firms making the bets - the counterparties? There isn’t much public reporting of the prices of the swaps themselves, and no central clearinghouse for trades. Credit derivatives are often employed or written by non-public players like hedge funds or sovereign entities, so there isn’t much visibility into their activities. Even at the level of publicly-traded companies taking on financial responsibilities tied to these instruments, there’s an informational drought. That’s patently unfair to investors: while they might be satisfied with the liquidity and cash-generating ability of a firm in which they’ve invested, they could still be blindsided by said firm’s obligation to pay for an entirely different firm’s failure to meet its obligations. Without disclosure of such obligations, an investor would never know about such potential.
The least heavy-handed kind of regulation may be on the way: sunshine, the best disinfectant. The FASB has proposed a welter of disclosures to be effective in financial statements beginning in fiscal years ending after November 15, 2008. If the proposal goes through as planned, there could be a lot of panicky dispatching of credit derivatives in the second half of 2008 by players afraid of showing too much exposure.