There's so much information available on some of these financial topics, and so much of it is laden with technical jargon, that I decided to write a basic FAQ on one of them, the credit default swap. I do not pretend to be an expert; rather, like a journalist, I'm going to attempt to put in simple language what they are and what they aren't. My job revolves around explaining the world of finance to laypersons, and I've been answering this question for weeks now. For some of you this will be too basic, and I apologize in advance. OTOH, I see way too many comments that exhibit a lack of understanding, so I hope this is helpful. There will be no judgments here about the value (financially or ethically) of CDSs; nor will I be discussing the Government's actions. Just the facts, Ma'am/Sir; and quibbling with my understanding of the facts is welcome, particularly from better-versed Kossacks.
Here goes:
Q. What is a credit default swap?
A. Let's start by defining the financial category CDSs are in, and that is derivatives. Derivatives are not direct investments in something (a stock, a bond, gold, etc.) but rather are derived from a direct investment. Essentially, two parties agree on a contract, that one will pay the other a sum if a certain investment performs (or fails to perform) in a certain way, for a fee. Credit default swaps are derivative contracts on the performance of credit: a package of mortgages, or of credit card debt, or the debt of a country.
Q. Isn't that just a bet?
A. In two words, not necessarily. Originally, derivatives were designed to reduce risk, not create it. Let's suppose you own a stock for which you paid $20 a share. You are currently worried that it will lose value (and who would blame you?). If you can find someone who, for that fee, will pay you what you lose if it drops to $15, you can reduce the cost of a loss. This is a hedge; it's actually a pretty conservative thing to do -- you'd actually be taking a greater risk without the hedge. Stock derivatives, as a commenter noted, are regulated; CDSs are not, and some of the problems start right there.
Q. What if you don't own the stock? Isn't it a bet then?
A. Again, not necessarily. Here's an example. You own a business in a town where the major employer is General Motors. You extend credit to your customers. You're worried about their ability to pay if GM stock falls (hopefully, you started worrying about this some time ago). One way to reduce your risk would be to buy a derivative that would pay if GM stock drops to a certain level. You don't actually own any GM stock yourself; but you do have a vested interest in its performance.
Q. Who would sell you such a thing?
A. Now it starts to get complicated. Let's posit that someone else sees this differently. He thinks that GM will go up, and thinks that he'll get to keep your fee because his analysis indicates that GM won't go as low as you think it will. You might argue that he's betting, and he might be. OTOH, he might have better information than you do. Or he may have purchased another derivative elsewhere that matches yours (so he's protected if he's wrong) at a lower fee than he's charging you. Or -- and this is critical to understanding what just happened -- he may have executed many such contracts and believes that, taken together, he has managed his risk successfully.
Q. So it's that last investor who is causing the problem, right?
A. Exactly. That last investor -- let's call him AIG -- built models that told him that he could sell a lot of these and make money if he managed his risk well. Remember, it takes two to tango, though; somebody had to buy these. Remember, also, that AIG could be on either side of the equation; on any given CDS, he -- they -- could be a winner or a loser.
Q. What, then, did AIG do wrong?
A. When you strip away all the murky technical language, AIG ran this as an insurance operation; that is, they figured that if they created enough CDSs in enough variations they would balance the risk. What they failed to account for, though, is one of the fundamentals of insurance. Your risks can not be inter-related. If all the houses you insure are on the same block in the same city, you're taking on extraordinary risk. If you have houses insured in all 50 states, you've spread out the risk. The loss of any one house won't affect the chance of loss of any other house. What AIG ignored is the instruments they issued CDSs on are all part of the global economy: If the system started to falter, all of their CDSs were in jeopardy.
Q. Why doesn't the Government just get the money back?
A. It's pretty hard to do that. Buyers include foreign governments; they include corporations who legitimately were trying to reduce their risks; they include speculators; they include parties who bought things they didn't understand from salespeople who probably didn't understand them either. It will not be easy to determine who should be winners and who should be losers, nor can it be done quickly.
Q. What are the CDSs worth?
A. That's the most fascinating question. No one has any idea; and the reason they don't is that it's a moving target. I'm a long-suffering Phillies fan. Imagine you and I had made a bet on whether or not they'd win the World Series this year (I win!). Now imagine that I had to sell our bet in mid-August... or at the end of September... or after the League Championship. It's not hard to believe that I would have gotten a better offer as time went on, and we got closer to the possibility. There are tools for calculating the value of derivatives, but they all have flaws, particularly when the whole system is tottering. Note, also, that CDSs can go both ways; they can assume that credit markets will rise or fall, so it's quite likely that the true size of the CDS market is not yet known, let along the value of any individual CDS.
Q. Should we get rid of credit default swaps, or, indeed, all derivatives?
A. The answer to the latter is no. Derivatives, used properly, are a valuable tool for reducing risk. Credit default swaps, again used properly, can serve the same purpose. Imagine if Countrywide Home Mortgage had bought CDSs on its entire portfolio of mortgages (and that their mortgages had been a lot less risky in the first place). That would been a logical -- and prudent -- use of a CDS.
Here we are very close to deciding what should be done, and better minds than mine will have to sort that out.