Credit Default Swaps

Credit-default swaps are complex financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. Their value falls as investor confidence increases. Recently, many credit-default swaps collapsed along with the market for mortgage backed securities. This is what prompted the government fearful that the entire credit-default market would unravel to lend $85 billion to insurer American International Group, one of the world's biggest insurers of the bonds.

Example ABC Inc.

1) Investor buys a bond from ABC Inc.

2) The investor gets insurance for the bond by paying a bank a fee, usually as a percentage of the value of the bond.

3) Bank insures the bond for the investor and agrees to pay the investor the value of the bond if


ABC Inc. defaults.

Among the risks:

The bank may not have the assets on hand to pay the investor if ABC Inc. defaults

The investor may be speculating that ABC Inc. will default and use the transaction to make a profit

The credit-default swaps on ABC's debt in the market may exceed the value of ABC's bonds many times over.