Default Insurance/CDS Question
Hey guys,
Horribly simple question but haven't got a good answer yet so here you go:
Lenders purchase default insurance in case a borrower stops making payments, but can a borrower buy default insurance on himself? Basically buying a CDS on yourself as a hedge if the market tanks.
Now just to add another layer of financial engineering; could you pull out your equity in the deal assuming you bought default insurance, so in theory all the credit risk would of been transferred to a 3rd party.
Not trying to get cost of capital discussion now etc. But in theory would a structure like that exist and would a counter party agree to the swap?
My initial thought is this isn't likely to work. I mean from the protection provider's viewpoint, why would I agree to insure somebody against themselves? I am basically giving them an incentive to default.
I don't see why a structure like that couldn't exist in theory, but as a practical matter, the moral hazard / adverse selection problems you'd have would drive premium rates up too high for it to be feasible.
By the way - it's "(c/sh/w)ould have", not "of".
@CorpFinHopeful: I disagree, its not an incentive. If the swap is triggered you would at best break even with your initial investment.
@Angus Macgyver: Providers sell all kinds of products that induce moral hazard. Life insurance, art insurance, home insurance. Seems to work. Why not a default insurance?
And couldn't companies buy CDS on themselves in the secondary market?
Isn't this an effective instance of "reinsurance"? Moreover, for institutions that have outstanding debt, DVA achieves a similar purpose to what you describe.
In general, other than the conflict of interest issue, I don't see why this can't be done...
Limited under Permitted Investment clauses usually.
A company buying CDS protection on itself out of the blue would no doubt set off alarms in the market....Not sure it is even legal however.
There is nothing illegal about a company (e.g. a bank) buying its own CDS.
You can insure the deal and synthetically offload your exposure to a third party.
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