A Credit Default Swap (CDS) is a financial instrument where the buyer of the CDS pays a premium to the seller for insuring against a debt default. If the debt is defaulted (or there is a "credit event"), the buyer of the CDS receives a lump sum payment to make good his loss. The seller of the CDS receives monthly payments (similar to premiums) from the buyer; if the debt defaults, the seller has to pay the agreed amount to the buyer.

Here is an example: ABC Insurance Co. holds a bond from Risky Mortgage Co. XYZ Hedge Funds buys a CDS in this bond from ABC Insurance Co. For our example, let's say they pay 5 percent or $5,000 over time. If Risky Mortgage Co. pays back the loan, ABC Insurance Co. makes a profit because they got the premiums from XYZ Hedge Fund and didn't have to pay XYZ Hedge Fund anything. If Risky Mortgage Co. defaults on the bond, then ABC Insurance Co. has to pay the remaining amount of the bond principal to XYZ Hedge Fund.

Why would XYZ Hedge Fund buy a CDS like this? If it held bonds from Risky Mortgage Co., it might be worried about losing its investment. To hedge against the risk of default on the bond, XYZ Hedge Fund could buy a CDS from ABC Insurance Co.. If Risky Mortgage Co. defaults on the bond, XYZ Hedge Fund will lose its investment; but it will receive a payoff from ABC Insurance Co. to compensate. If Risky Mortgage Co. doesn't default, then the Hedge Fund doesn't lose its investment and will have paid a premium to ABC Insurance Co. to protect themselves.

ABC Insurance Co. treats selling CDS like any other insurance line. They figure they will collect lots of premiums and only have to pay a few claims. But when there are too many losses caused by too many defaults, the ABC Insurance Co. can't pay all the claims; and they become insolvent. This is what happened to AIG and why the government bailed them out.

In our example, XYZ Hedge Fund actually owned a bond from Risky Mortgage Co. However, unlike insurance, you don't have to own the underlying asset in order to buy a CDS on it. You can buy insurance against the risk that the house you own burns down, but you can't buy insurance against the risk that your neighbor's house burns down. You have no "insurable interest" in your neighbor's house. To buy a CDS you need no "insurable interest." Trillions of dollars of CDS are sold to people and organizations who don't own the underlying bonds. This is pure speculation. In the words of Dirk van Dijk, "This ability to buy insurance on things that you have no insurable interest in transformed this market into a huge casino."

There is nothing to prevent an investor from insuring losses on Risky Mortgage Co. bonds multiple times. Even though the investor my "lose" 50 percent on an investment and have that made up to them by the insurer, the investor can cash in on multiple policies. Let's say a $2 million bond defaults and pays 50 percent. The investor can collect the lost $1 million from the seller of the CDS. And if he bought 10 CDS — he can collect that $1 million 10 times.

This is the reason that even the slightest drop in asset values covered by these CDS sets off a chain reaction. The loss in the value of the asset is multiplied across the firms that have covered the loss through CDS. A $1 million default is transformed via these CDS into a loss 10 or 20 times that.

The CDS themselves are then bought and sold — they are seldom held to maturity. The market is completely unregulated. Who owes what to whom is almost impossible to determine. There is often uncertainty about who actually owns the CDS and whether or not the seller can actually pay in the event of a default. Unlike a true insurance product, there are no regulations that require the seller to maintain sufficient reserves to pay claims.

Today the CDS market is estimated to be a $70 trillion business. (Yes, that's a "T".) The Office of the Comptroller of the Currency estimates that major financial institutions hold about 40 percent of these instruments. It could take years of litigation to figure out who owes whom what. The fear is that once the system starts failing, there will be "cascading defaults" and because the CDS market is so huge, its failure threatens the whole global economy.

Maybe we should call it the Credit Default Swamp.

E-mail: Patti@spencerlawfirm.com