What exactly is a CDS? How does it work? Why are they dragging us deeper into an economic recession?

What exactly is a CDS?
Contract between a buyer and a seller referencing the creditworthiness of a 3rd party called a reference entity. This 'reference entity' applies to a corporation or a government and thus CDS applies to municipal bonds, corporate debt, and mortgage securities.

How it works...
The 'protection' buyer will pay a periodic fee (called 'premium') to the protection seller and in return, the seller will give them a payment only if something happens to the 'reference entity' (the corporation or government). This premium is paid so the buyer has a sense of security knowing that if a default does occur, his losses will be covered. This premium is essentially the spread of a CDS. It is expressed as a percentage of the theoretical (or 'notional' as it is called) price. For example (example taken from Wikipedia), if the CDS spread of AIG is 50 basis points (or 0.5%), then an investor buying $10 million worth of protection from CITI bank must pay the bank $50,000 per year.

The events will influence the payment that the protection seller pays to the protection buyer:
1. bankruptcy of the corporation or government
2. Failure to pay a covered obligation (such as a bond or loan)
An obligation is accelerated (After a default, the bond demands that it be payed immediately- not a good sign for the company or government)
A delay in the payment of obligations or debts (usually occurs when a company is under commercial stress of a government is under political stress and they need to delay debt payments to its creditors)
Restructuring of a company or government (usually occurs to companies when they are taken over by another company and they need to reorganize themselves in order to be more profitable for the future). *This type is what applies to the ‘buyouts’ that we hear about today.

If any of the above happens, the protection seller will provide public information to the protection buyer saying that this even did occur and then the buyer will be forced to make his payment.

You can think of them like insurance. When a default happens to a bank or government, the losses are covered. However, you can view CDS like bets between the protection buyer and protection seller. They are betting on whether these events will or will not occur to the reference entity (the corporation or government).

How they are used
Speculation
Hedging
Arbitrage

What do they apply to?
- Municipal Bonds
- Corporate Debt
- Mortgage Securities

Who are they sold by?
- Hedge funds
- Banks

How much of the market they stand
The CDS market has been valued at over $45 trillion in mid- 2007 (twice the size of the $22 trillion U.D stock market).

Credit default swaps represent over 30% of the credit derivatives market.

Problem with CDS:
At first they seem okay; they are like buying insurance after all. However, these contracts can be traded (or swapped) between investors (it can be bought and sold at both ends- the insurer and the insured) without an overseer of the trade. This is dangerous because no one can ensure that the buyer has enough money to cover the losses if the CDS does default. The volume of trading for CDS (number of people involved in this type of trading) is so heavy because it seems like guaranteed cash, and there is too much secrecy surrounding these trades. This is a huge problem, especially when the whole market eventually collapses (now). Harvey Miller, senior partner at Weil, Gotshal & Manges explains that “An original CDS can go through 15 or 20 trades. So when a default occurs, the so-called insured party or hedged party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default." This is part of the reason why Obama calls for regulation. With CDS, there is “no standard contract, no capital requirements, and no standard way of valuating securities in these transactions” explains Prakash Shimpi, managing principal of Towers Perrin.

Problem with CDS at this time:
Here are 2 reasons why I think CDS are dragging the economy down.
1. As the economy started to decline and the sub-prime credit crunch began, people who invested in CDS got worried because they didn’t know whether the parties holding the CDS insurance would have the money to pay them back. Therefore, they kept selling them and the market liquidity started to decrease. Of course, bad market liquidity means it gets harder for people to get in and get out of the CDS market, causing a stifle in the whole market. The worried investors who sold their CDS insurance quickly were right; this is exactly what happened to AIG. They, being the ‘protection sellers,’  were forced to write down $11 billion because of their CDS portfolios.
2. Banks are already being bothered with write-downs and mortgage-related securities at this time. Now, they have to value the insurance contracts and the securities of the swaps, meaning more losses due to CDSs.

Why they were so popular back then
Commercial banks thought they were easy money. The economy was doing great and CDS just seemed like a way to collect premiums and earn some extra income for the company.

Most affected institutions:
Commercial Banks (top 25 banks held more than #13 trillion in CDS)
Top four: JP Morgan Chase, Citibank, Bank of America, Wachovia