Credit Default Swap

What Is Credit Default Swap?

A credit default swap (CDS) is a financial contract that works much like an insurance policy on debt. One party pays regular premiums to another, who agrees to compensate it if a specific bond, loan, or security defaults. Buyers can use swaps to hedge against losses on debt they hold, or to speculate on the creditworthiness of borrowers they have no direct stake in. Because these contracts traded largely outside traditional regulation, the total risk built up in them was hard to see. The insurance giant AIG sold credit default swaps heavily against mortgage-related securities, and mounting claims on those contracts drove it toward collapse in September 2008.

Why It Matters

Credit default swaps matter because they concentrated and hid enormous risk during the 2008 crisis. AIG had effectively promised to cover losses on securities across the financial system without holding enough capital to pay if many failed at once. When mortgage securities soured, the potential payouts threatened AIG's survival and, through it, the many banks counting on its guarantees, prompting a federal rescue that eventually reached about $182 billion. The episode exposed how lightly regulated derivatives in the shadow banking system could magnify systemic risk. It became a major target of the 2010 Dodd-Frank Act, which pushed much swap trading toward central clearing and greater transparency.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• What insurance giant received an $85 billion emergency federal bailout in September 2008 (later expanded), due to its exposure to credit default swaps?
  AIG (American International Group)
• What financial instruments, resembling insurance contracts on debt securities, did AIG sell heavily and which contributed to its near-collapse?
  Credit default swaps