credit default swaps-the unspoken danger

As alluded to in the previous post, credit default swaps (CDS) are being held up as the great insurance policy against loss in the credit markets. CDS liquidity and standardization have made them the trading vehicle of choice for hedge funds wanting to increase or decrease their exposure to the credit market, a particular segment of that market or to an individual company. Basically, CDS allows the investor to insure against default of a company's bonds (or loans, but that is another market) or a group of companies' bonds for a particular period of time (usually in increments of $10 million for periods of one to ten years). Think of it like term insurance. Like insurance, the ability to collect on a claim is only as good as the insurance company's ability to pay. CDS markets are so intertwined that, in a period of stress, the idea is that the market is akin to a chain-link fence; if a few links break, the whole system won't collapse. The problem is that the system hasn't been under stress yet as it is relatively young. Securities firms and banks are regulated by various agencies. Their financial status is generally ascertainable. Many of the counterparties in CDS are unregulated hedge funds, whose financial status and ability to pay can't always be determined and may fluctuate radically, giver their use of leverage. As we push through the third quarter and into the fourth (rarely does anything good happen in October) keep your ears open to the happenings in CDS.

Next post: Why a CDS default could spark a bond rally.