Understanding Credit Default Swaps (CDS)

I recently watched Michael Moore’s “Capitalism: A Love Story”. In one scene, Moore asks a seasoned finance professional to explain credit default swaps and he had a difficult time doing so. At that moment, I realized that it was hard for me to explain as well. Thus, I thought I’d write this article.

A credit default swap is a credit derivative contract between two parties. It is classified as a derivative because the value of the contract is linked to an underlying asset – typically a bond.

The buyer of a CDS contract is essentially buying insurance on a credit instrument (a bond, for example). If the firm that issued the bond defaults, the CDS buyer receives a payout from the CDS seller.

Credit default swaps came into use in the 1990′s as a way for banks to shift default risk to a third party. However, as the market grew, CDS contracts were used increasingly by “investors” betting whether companies would go into financial distress (speculative purposes) rather than for hedging purposes.

Credit default swaps played significant roles in the collapses of Bear Stearns, Lehman Brothers and AIG.

The video below explains how credit default swaps work and the role that CDS contracts played in digging AIG deeper into financial trouble.

Featured Video:

When the analysts and experts talk about the current financial crisis, they often refer to credit default swaps. So, what exactly is a credit default swap? Marketplace Senior Editor Paddy Hirsch goes to the whiteboard for this explanation.

Video Source:

http://marketplace.publicradio.org/