The Credit Suisse crisis

To understand the Credit Suisse problem, we first have to understand what is CDS (credit default swap) so let’s understand

Just like government issues bonds there are even private companies that issue bonds. So let’s assume Adani needs a capital of $1 million and because they have such a brand value in market and can get money easily they will float bond and borrow money from common people but one person will not give Adani $1 million, so what will Adani do they will divide $1 million bonds into small denominations and over the period Adani will payback investor interest so while people buy bonds they are essentially lending Adani $1 Million collectively and at the maturity Adani will repay the principal amount and this is how bonds works. let’s take an example that in tomorrow’s news Headlines are UK and USA both could face recession and because of this panic in market now the bondholders have assumed that the company will not be able to pay them principal amount back and this is were Insurance company come into role they will tell Bond holders that the Insurance company will Insure this bond and will safeguard them from the risk if they just pay some particular percentage of interest or fee to them and if investors pay some amount to this insurance company then tomorrow if Adani is not able to pay back the principal amount to Bondholders then insurance company will pay them back and this is called as CDS ( Credit Default Swap) where an Insurance Company will take risks on behalf of investors.

So lets say there are home buyers wanting a loan of xx$ each so the bank would lend xx$ at 6% interest now bank instead of giving out there own money the bank would get the money from rich investor and then they will distribute the loan to home buyers at 6% Interest and in return they will agree to give rich investor a return of 3% and remaining 3% they will make profit and this is what you call as mortgage bank security whereby a bank takes a group of loans and Pays them by investor such that the investor get returns and bank gets profit without investing their own capital, the borrowers are happy because banks are quickly disbursing loans and bank is happy because without investing there capital they are getting profit, but as more and more loans got disbursed the bank executive got scared so just like bondholders go to insurance company bank goes to insurance company they can get insured the loan insured by paying some fee. So, tomorrow if this homebuyers are not able to payback loans the insurance company have to pay the amount back to Bank this is what happened in 2008

One of the important matrix that indicated this danger was the fee they were charging to bank and this is what you call as CDS spread and the more this percentage the more the risk of insuring the credit (100 basis point making 1%) and vice versa. Now if we look at Lehman brothers CDS spread after a certain point touches 250 basis points in march 2008 and immediately after that the US economy collapsed and now the same is happening with Credit Suisse CDS spread of credit Suisse stood at 278 basis point as in 2.78% which means just like 2008 several business and investors took loan from bank and these units were insured by Credit Suisse so when this CDS spread is seen going up it says that the risk of insurance Company has increased by large extant and just like Lehman bother share got down its bottom with its increasing CDS spread credit Suisse has lost 60% of its market cap in this year itself.

Well experts says that even the smartest people on Earth cannot predict Recession. Therefore, it is important to compare the past to the present and keep a tap on the market.

Thank you.

Regards,

Shreya Mehta,

Kautilya,

IBS Mumbai.