What are Credit Default Swaps and Why Should We Care?

In its most basic terms, a credit default swap is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, corporate bond investors buy credit default swaps for protection against a default by the issuer of the corporate bond

Credit derivatives are financial instruments that “derive” their value from the bond market. They can cover any bonds that are not issued by governments—that is, where investors face the risk that the borrower may not repay...Derivatives separate this last factor—credit risk—from the other two.

This allows investors to insure themselves against the risk of
default or, alternatively, to speculate that a default will occur. The
instrument that does this is a credit-default swap or CDS (see jargon guide). Hence A agrees to pay a series of premiums to B; who agrees to compensate A if the bond defaults.

This allows investors to speculate on default without owning the
bond itself. Those who buy protection could make substantial profits if
the company gets into trouble, since the value of the swap will rise
sharply. Plenty of speculation occurs and CDS positions are sometimes much larger than the bonds outstanding.

To date, the insurers have tended to do better than the speculators.
This partly reflects today's benign economic conditions (few companies
have gone bust), but also relates to the second quirk in the market.
The highest-rated bonds (known as investment grade) tend to have
delivered better returns than were necessary to compensate investors
for the risk of default. In other words, someone who insured such bonds
against default would have, on average, made money (conventional
insurance companies, which insure against fire or theft, have not
always done so well).

As discussed above, during the quarter a net mark-to-market loss amounting to ($5,211.0) million was recorded related to contracts executed in credit default format, primarily in our collateralized debt obligation exposures. The negative mark-to-market is driven by dramatically lower prices in certain structured finance asset classes particularly with respect to CDOs of ABS with subprime RMBS exposure. The lower prices were driven by poor collateral performance, rating agencies downgrades and uncertainty regarding the ultimate outcome of subprime residential mortgage-backed securities losses. Reduced demand for such securities, a lack of liquidity in the markets and forced selling by structured and/or leveraged investment vehicles, all combined to exacerbate pricing declines across the structured debt capital markets.