Help.. credit default swap

[kanjoh321]

I encounter this phrase a lot.. What is a credit default swap?



Jessie

[kanjoh]

Here's the answer to your question Jessie:

A credit default swap is a financial insurance contract where the seller collects premium in return for insurance against the default of credit. This credit default can be for real estate, corporate debt, or any other outstanding loans. The problem is that these instruments were supposed to be used for hedging, and instead they were used for speculation.


Regards

[TheColonel]

Credit default swaps are the reason why AIG almost went bankrupt. The credit default swaps were used to insure subprime mortgage loans against default. The defaults began and AIG had to start paying.

[elessar78]

Below is a link to a good podcast that describes credit default swaps and how they were instrumental in our economy in recent history.

This American Life

But if you don't want to listen to it... basically say you have a company which we'll call "Microsoft." Microsoft issues bonds to raise capital (basically debt) so they go to a financial services company like Lehman Brothers who has a credit default swap (CDS) "desk" and take out a CDS on the debt. The CDS is essentially insurance in the event that Microsoft can't make good on their outstanding debt the CDS will pay out the amount agreed upon.

What made CDS good products for financial services firms was because there was a very low probability of default from a company say like Microsoft. Essentially money in the bank. Microsoft would pay, say, $1 Million for $10 Billion worth of "insurance" and the mathematical models said that there was essentially a zero chance that Lehman Bros would ever have to pay out.

So like kanjoh said above other companies started speculating on Microsoft and taking out CDS on their debt too. Which is weird because they had nothing to gain or lose, they just had money to burn. Think about it in terms of a lottery where you had to just pay $1 for a chance to win $1000. Ninety-nine percent of us would probably do it in a heartbeat. But being as the math said that there was essentially a zero chance of these big huge companies failing, Lehman Bros and similar institutions still took these "bets".

Then the unthinkable happened. The once in a lifetime event where big companies that "would never fail" did just that and couldn't honor their outstanding debts so the CDS kicked in. All of sudden the financial services firms that took the "bets" were on the hook for more money than they could pay out.

Since so much of the entire system's money was tied up in these big financial service firms they were deemed "too big to fail". Some argue that it was necessary to save capitalism. Maybe a bit of over-dramatization but I think things would really really suck right now had we not. But that's a matter of opinion.

Anyway, that's my take on credit default swaps that I've culled from reading The Economist and Financial Times. I could be wrong in some/many aspects, I'm only a graphic designer with a passing interest in economics and finance.