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I know vaguely that they are some kind of insurance that the investment banks buy on mortgages that they buy from the mortgage lenders.

They bundle these individual mortgages and sell them as collateralized debt obligations (CDOs) to other investors wanting to invest in the US.

What I don’t understand now is that why would investment banks try to get insurance on these collateralized debt obligations?

Is it because of the risks involved in them- the homeowners might default on their mortgages and not pay their interests anymore?

Or is it because it is easier for them then to get higher ratings from the Credit Rating Agencies (CRAs)?

In any case guys, do let me know.

Chao.

1 Thought on What is credit default swaps (CDS)?
  1. Reply
    greatinvestideas
    July 8, 2011 at 1:21 am

    You are in the right ballpark, but mixing up your ideas.

    A Credit Default Swap is a contract that pays out if there is a credit event on a bond from a particular issuer. An investor in the bond may want to take on interest rate risk, but not worry about the risk of the bond actually defaulting, so they give up some return and “buy insurance’ in the form of a CDS. They can exist for any bond, but became famous with AIG and the mortgage crisis.

    In the case of the Mortgage Backed Securities, the homeowners started to fail to pay on a large scale, so the people who put together and issued the MBS were unable to pay investors. Lucky for the investors, they had purchased CDS from AIG. Well it turns out that AIG was wrong in their models and never expected such a grand level of defaults all at once. They went crying to Uncle Sam, who decided to take care of them.

    What should have happened is that AIG should have paid out the first in line to make claims, then gone bankrupt, leaving the other claimaints (The MBS investors who wanted to transfer this risk) to fight it out over scraps in court.

    Lesson learned – If you buy any form of insurance, make sure you believe in the creditworthiness of the insurance company.

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