What are credit default swaps?

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.

If the subprime securities market crisis that stalled the U.S. economy in 2008 was a threat, the CDS market posed a potential death sentence. Enormous, seemingly untouchable financial institutions, heavily invested in mortgage-backed securities, began to crumble. And many of these failing institutions owned credit default swaps on their subprime securities. Swaps that didn't pay out forced institutions to lower their asset values, causing them to fail even further, freezing the exchange of money (the so-called credit crunch) and, by extension, the entire economy.

What sets the mortgage crisis apart from any potential CDS crisis is that if you follow a mortgage far enough down the line, you eventually come to a house. If a borrower defaults on a loan, the bank can still recoup some of its money by taking possession of the house and selling it. This isn't the case with CDSs; they're based on an action (like a bank failing), not a thing (like a house). And because of their intangible nature, finding a source of capital to cover CDS payouts is less exact. Even more difficult than getting blood from a stone is getting money from thin air.

And the potential losses from the credit default swaps market dwarf those seen from losses associated with subprime mortgage-backed securities. In 2007, the global credit default swaps market was valued at $62 trillion [source: ISDA]. The U.S. mortgage securities market had a value of about $7 trillion [source: New York Times].

To put the CDS situation into even further perspective, the gross domestic product (GDP) of the United States in 2007 -- the total value of all the goods and services generated in the country that year -- was $13.84 trillion [source: CIA]. In the third quarter of that same year, the top 25 banks in the United States held $14 trillion in credit default swaps [source: New York Times]. ­ So even if the United States could liquidate its entire GDP for the year at once, it still wouldn't cover U.S. CDS losses should a series of credit events -- those triggers for CDS payouts -- occur.

A clear picture of the precarious state of the economy balanced on the CDS market was drawn in 2008. In September, insurance giant AIG was saved from collapse by an $85 billion infusion of government cash. The bailout also saved those holding the bag on credit default swaps on the company's bonds; a credit event was averted by government intervention. This wasn't the case when mortgage holding corporations Fannie Mae and Freddie Mac were taken over by the federal government that same month. The action was considered a credit event; investors holding CDSs on bonds (shares) in the two corporations were eligible to submit claims on their policies.

Between the two, Mae and Mac have issued $1.5 billion in bonds to generate capital [source: SMH]. It's hard to tell what the total value of the CDSs taken out on this debt amounts to, but it's most likely much more than the $1.5 billion in actual bonds. Just as a life insurance policy can pay out much more than the deceased party's annual salary, so too can credit default swaps be structured to cover more than the actual losses.

Ironically, the government action may have actually averted widespread CDS claims filed on bonds issued by the mortgage giants; government intervention actually caused the corporation's values to rise slightly. The precarious balance was maintained. For how long, such a disaster could be averted -- or even if it could be -- no one could say.