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What are credit default swaps?

        Money | Money & Ethics

How Credit Default Swaps Work
CDSs are sold over the counter, not in a formal venue like the New York Stock Exchange (shown above in September 2008, as markets tanked, thanks in part to failed CDSs).
CDSs are sold over the counter, not in a formal venue like the New York Stock Exchange (shown above in September 2008, as markets tanked, thanks in part to failed CDSs).
Spencer Platt/Getty Images

Credit default swaps (CDSs) are essentially insurance policies issued by banks (sellers) and taken out by investors (buyers) to protect against failure among their investments. The distinct difference between the health insurance scenario on the last page and credit default swaps is that the health insurance industry is heavily regulated. Insurers are forced to open their books to regulators to show that they have the collateral to pay out on every one of their policies. The credit default swap market is not regulated by anyone -- at all.

Credit default swaps are derivatives -- any kind of financial instrument whose value is based on the value of another financial instrument [source: Risk Glossary]. The value of credit default swaps is derived from whether or not a company goes south. They can be valuable if it doesn't through premium payments, or they can be valuable as insurance if the company goes under. Think of it in terms of loans. When you invest in a company, you essentially give it a loan. It repays the loan in dividends, increased share prices or both. If a company goes bankrupt and its shares become worthless, then it's defaulted on the loan you gave it. Bankruptcy is one of several credit events -- triggers that allow a credit default swap buyer to call in the coverage it took out on its investment.

This type of swap was initially created in the late 1990s to protect against defaults on extremely safe investments like municipal bonds (loans made to cities to finance projects). Monthly premium payments made these swaps a steady source of extra cash flow for the issuers. As a result, they became increasingly popular among the huge issuing banks and the investors who realized they could be traded as bets on the health of a company. Anyone confident about a company's health can purchase seller swaps and rake in premiums from swap buyers. Those who doubt a company's health can purchase buyer swaps, make premium payments on the swaps and cash them in when the company goes under. It's much like speculators buying and selling insurance policies based on the chances of Jimmy's legs being crushed.

Unregulated financial instruments like derivatives can be sold over the counter (OTC), meaning they can be purchased outside of the formal exchange markets, like the New York Stock Exchange. Since no regulation exists on the derivatives, they can be traded from one party to another. There's also no requirement that purchasers of the policies prove they had the cash available to pay out on the policy, should it be called in. A purchaser of a CDS or any OTC instrument can buy it from anyone who owns one. They can also be sold by the policy's issuer or the purchaser, and either can sell their end of the policy without notifying the other. This can make it difficult to track down the person holding the seller swap in a credit event.

Even worse, if the CDSs protecting a company's investments turn out to be worthless, the company is forced to rewrite their balance sheet to reflect the losses, since the failed investment wasn't covered by the swaps. Heavy losses can cause the value of an institution to plummet. If this happens to many institutions at the same time -- and the CDSs each institution took out can't be paid out -- then the situation can become dire for entire markets in a chain reaction.

This is the situation world markets faced in 2008.