"MBS" was the first three-letter acronym to become synonymous with bankruptcy and danger, but as the financial crisis has churned three new letters have risen to predict doom and gloom for investors and companies alike: CDS.

The dreaded credit default swap is the latest credit derivative product to be demonized, but before investors begin to scour the books of the major banks left standing for CDS risk, there are some important factors to consider.

The transfer of risk is a major goal of any financial institution, and these swaps allow for the protection against the default of underlying assets by transferring risk to another party. Perhaps no bank is better at this transfer of risk than JPMorgan Chase (NYSE:JPM). Investors catching wind of the looming threat of credit default swaps should take a moment to understand the proficiency of JPMorgan's position in the credit derivatives market. (For a detailed discussion, read Credit Default Swaps: An Introduction.)

JPMorgan bankers invented the credit default swap in the early '90s. The idea is as follows. Making a loan like a mortgage exposes the lender to the risk of a borrower defaulting. Banks have been able to enter into agreements with insurers like AIG (NYSE:AIG) for protection against borrower default. The bank makes a steady stream of payments to the insurer and in return, should the borrower default, the insurer would make the lender whole again.

As evidence of the popularity of this type of credit derivative, investors should note that in 2007 the Comptroller of the Currency Administrator of National Banks (a division of the U.S. Department of Treasury) reported that the notional amount of credit derivatives increased 16% from the prior quarter to $11.8 trillion in the second quarter. These were comprised mostly of CDS, which were the fastest growing product among global derivatives.

The Big Buyers and Sellers
During that time period JPMorgan was the most active and largest buyer and seller of CDS with transactions totaling more than $3 trillion on each side. In second place was Bank of America (NYSE:BAC) with more than $1 trillion in CDS bought followed by Citibank (NYSE:C) with over $1 trillion in transactions on both the buy and sell side.

At the end of the first quarter of 2008 the notional value of credit derivative contracts rose again to $16.4 trillion. The top three participants in CDS remained the same, but the amount of swaps bought and sold by each commercial bank increased. In the case of JPMorgan it bought more than $4 trillion in CDS and sold $3.97 trillion.

Not so Sweet
American Insurance Group was one of the major issuers of CDS. Once the value of the assets AIG was securing fell in value, the insurer was forced to write down billions for its expected losses and post collateral to buyers of the CDS.

Final Thoughts
The market for credit default swaps remains unregulated. While regulators may be pointing their finger at CDS next as the cause for the market's downward cycle, investors should note the correlation between the banks at the top of the credit default swap transaction tables and the banks that are doing the best in today's up and down market.

Related Articles
  1. Stock Analysis

    Will J.C. Penney Come Back in 2016? (JCP)

    J.C. Penney is without a doubt turning itself around, but that doesn't guarantee the stock will respond immediately.
  2. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  3. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  4. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  5. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  6. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  7. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  8. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  9. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  10. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center