Credit Default Swaps: A Simple Explanation of CDS

The Wall Street Journal today has an interesting story about how AIG got into hot water by writing a lot of credit default swaps.  So I thought it was a good time for a simple explanation of what a CDS is.

We start with a simple loan: a lender passes money to a borrower, receiving an IOU in return.

(In the real world, the IOU is a corporate bond, or possibly a collection of debts called a Collateralized Debt Obligation.)

Len is taking some risk, because Barb may not be able to repay the loan.  Len shells out some money for a guarantee from his buddy Sid:

Sid says to Len, "If Barb doesn't pay your money back, I'll step up and pay you the money Barb owes."  Sid is like a co-signer, except he isn't Barb's uncle.  Sid is doing this as a for-profit business.  He hopes to collect the CDS fee without ever having to make good on the loan.

To some folks, it sounds like gambling on Barb's finances.  I've heard people say that shouldn't be allowed.  (They probably don't like craps, either.)  Here's the benefit: Len can be more liberal in his lending because of Sid's guarantee.  Len does not have to study Barb's finances in detail.  If Barb is borrowing from many different guys, it might be more efficient for only the one person, Sid, to check her credit quality.

That's the simple explanation.  Next up:  what went wrong with CDS.