Credit Default Swap - CDS

You’re most likely here because a professor assigned you a report on the 2008 Financial Crisis. You found yourself reading about the credit crisis, and ended up clicking on credit default swaps for any clue on what the heck these things actually are. It was bound to happen.

So...let’s try to keep it simple.

You loan $1,000 to a guy you met at a bar (maybe not a 100% sober decision) with a high interest rate. Now you’re regretting the decision. So you tell the bartender that you’re willing to pay him $20 a month to guarantee the loan in the event that the person defaults. You'll pay $20 a month for a specified period of time, and he will pay off the loan to you in the event that the barfly defaults.

That's the basis of a credit default swap. It’s a form of insurance.

During the financial crisis, companies that bundled mortgages purchased credit default swaps from companies to insure those loans. There was just one problem. One company, AIG, insured an overwhelming amount of these swaps in order to collect the premiums. When the entire housing market sunk and millions of Americans failed to pay their loans, an incredible number of mortgages went into default. As a result, all of the financial companies that had purchased insurance in the form of CDS were making claims all at the same time. This resulted in a $182 billion bailout from the U.S. government for the insurance company.