What is CDS or credit-default swaps (Video)

Simply stated a credit-default swap, or CDS, is a way for the owner of an asset like a bond to buy an insurance policy to protect themselves in the event the issuer of that bond defaults.

But, because the CDS market is unregulated, there is $60 trillion of so in these instruments that are not only purchased by actual owners of the debt, but by speculators betting that the issuing entity will indeed go out of business.

When the economy was “good” and there was little incidence of company’s defaulting, banks sold and took in the premiums with what seemed to be very limited risk. Limited risk because the chance that the company or country issuing the debt would go under was somewhat remote.

The banks would therefore take in premiums and for the most part not have to pay out “claims” on the defaulted paper that they had insured through CDS. Premiums, as the chart below the video shows, are commensurate to the perceived risk that the debt issuer may actually default.

The financial crisis of course proved this idea of low risk of default to be wrong. Now with companies andcountry’s like Greece potentially facing the fate of default, the CDS sellers are once again facing huge exposure. This exposure to CDS has crippled many financial institutions.

CDS explained and a chart of country or sovereign debt with the current cost to insure

Without getting into the technical aspects of CDS, the chart shows the exorbitant cost to insure the debt of Greece because it is considered to be extremely close to a default.

On the other hand, the cost to insure U.S. treasury bonds is about 1/38 the cost of Greece sovereign debt. The more perceived risk, the higher cost to insure