What is a credit default swap?

I would recommend reading the article "The Price of Greed" in the Sept 29 issue of Time magazine. CDS's are derivatives, sold by AIG, designed to protect investors from failures of other companies. Time calls them "pixie-dust" securities that supposedly offer insurance against a company defaulting on its obligations. They are collaterized, which is where AIG got into trouble when their credit rating was downgraded. The required additional collaterial was nowhere to be found. A CDS is essentially an insurance policy for credit derivatives. It's not technically insurance for quite a few reasons, chief among them being that, as derivatives, the sellers aren't regulated nor are they required to maintain reserves enabling them to pay off the buyers if the underlying securities default, and the buyer of a CDS doesn't need to own the derivative he's insuring. These are the "naked CDS." I have written extensively on the evil that is the naked CDS, usually comparing it to naked fire insurance. If they sold that product, very little would prevent the naked fire insurance holder from going over to his neighbor's house and setting it on fire so he could collect. AIG was the leader in the naked CDS and a very large player in clothed CDS, In ten years, when the dust has settled, we'll all look back and think, "who thought THIS was a good idea?" Until then the naked CDS stands as prima facie evidence that deregulating the derivatives market was a really stupid idea.

A credit default swap (CDS) is a credit derivative contract between two counter parties, whereby the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or credit event in respect of a third party or reference entity.

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or on the occurrence of a specified credit event (for example bankruptcy). Credit Default Swaps can be bought by any investor; it is not necessary for the buyer to own the underlying credit instrument.

A CDS is like a Health insurance policy that we may take to cover up for the cash requirements if we get any health problems. We pay a premium to the insurance company and if we get any health problems, the insurer would pay for the medical treatment. Here are the differences between credit default swaps and "traditional" insurance, according to Wikipedia: * the seller need not be a regulated entity; * the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements; * insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets; * in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract; * Hedge Accounting may not be available under US GAAP unless the requirements of FAS 133 are met; in practice this rarely happens; * The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.[2][3][4] By contrast, to purchase insurance the insured is generally expected to have an insurable interest such as owning a debt. The last one is the most important here. Think of fire insurance. They don't allow people to purchase fire insurance on other people's buildings for the obvious reason: people would insure the worst firetraps in town, then go around burning them down to collect the insurance settlements. OTOH, you can buy CDS contracts on derivatives you don't own and never will--essentially betting that the underlying derivative is going to fail. Here's an example: You are the CEO of the biggest factory in the state, and you're getting ready to move your operations to Vietnam--which is going to put a few thousand people out of work. You could use your contacts in business to find out where your employees' mortgages are tranched (read up on structured financing), and buy naked CDS on those tranches. If you're the only one in town that pays decently, a lot of your employees are going to lose their homes, and you'll be in fat city when it happens. Right now you should be thinking, my but that would be a vicious thing to do. Yes it would, but so would closing your factory because you can get kitchen utensils made in China for two percent less than you're making them in the US, and that happens all the damn time.