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What are credit default swaps?

What are credit default swaps? Why are they such a big deal? What is the deal with AIG and credit default swaps?

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Credit Default Swaps

Posted by: Mr_Blue on 2008 12 05

Credit default swaps (CDS) are financial instruments called financial derivatives. The purpose of CDS is to protect against the risk of default on a debt instrument such as mortgage backed securities (MBS) or corporate bonds. A buyer of a CDS pays a premium to a seller/writer of CDS. If MBS/bonds default a purchaser of CDS receives a lump sum payment - kind of like insurance. This sounds reasonable right?

Well, financial institutions realized that these CDS can be traded. A huge market was created with these CDS - some analysts have said the CDS market is worth $60 trillion. Keep me mind you don’t have to own MBS/bonds to buy/sell CDS. Speculators jumped in the market - if they thought default risk of a bond was underpriced they bought a CDS - they sold/wrote CDS if they thought default risk was overpriced. CDS is unregulated so that means there are no margin or net capital requirements that are in say the option and futures markets.

Lehman Brothers was said to have sold/written a ton of CDS. AIG was heavily into selling CDS - some estimate hundreds of billions of dollars worth. That meant when the MBS market became riskier with a few defaults - AIGs portfolio of CDS became worthless but it was sitting on hundreds of billions of dollars of obligations it would have to pay if MBS or bonds began to default.

AIG

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What are credit default swaps?

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