Thursday, September 18, 2008

Credit Default Swaps?

If you follow Daily Sprawl, you've probably seen the above term pop up in a variety of different articles. And, quite possibly, you've wondered what the heck it is and why is everyone talking about it?

Basically, a credit default swap is a form of insurance. The buyer of a financial debt instrument purchases the instrument to make money off of it as an investment (for instance, off the interest that the instrument pays or yields).

But, sometimes bonds or mortgages or other debt instruments go into default and lose their value. The result is that the investment is lost.


If the buyer of the debt instrument also purchased credit default insurance (that's a more accurate term than "swap"). If that happened, then the insurer against the default (e.g. the company that issued the credit default insurance) pays the buyer (e.g. the investor for whom the original debt investment became worthless).

The problem arises when the insurer sells more credit default insurance than it has the ability to pay. That's the problem these days.

This NYT column explains this important problem in more detail.