Credit Default Swaps

A lot of people have been talking about credit default swaps (CDS) these days. What exactly is a CDS? Well, suppose we compare your relationship to an investment in a fixed income security, such as a bond. This is a pretty steady relationship, but there's always a possibility that everything you've invested could go to waste. To avoid this unfortunate scenario where you lose your entire investment, you might consider investing in a CDS, also known as a rebound boyfriend/girlfriend. This person is someone who you've maintained a reasonably close relationship with, and who could immediately provide the benefits of a relationship to minimize the hurt and loss felt after a breakup.

Ideally this person has had a crush on you for a long time, and requires little attention in order to keep their hopes up of potentially hooking up with you. However, the amount you should invest in a swap or rebound depends on the riskiness of your current relationship and the degree to which you need them to replace the flow of benefits. Different swaps promise different gaurantees against default. The great thing about swaps is that they can be traded on the secondary market. If the cost of your swap doesn't make sense given the riskiness of your relationship, you can always trade for a different one.

In reality, a credit default swap is basically an insurance policy against the possibility that your fixed income investment will default. For example, Goldman Sachs owned billions of dollars worth of mortgaged backed securities (MBS), which are essentially investment products comprised of thousands of home mortgages all packaged together. When people started failing to make their mortgage payments, a lot of these investments went sour. But Goldman, along with many other banks, had purchased credit default swaps from AIG to hedge their investment. So when the credit crisis hit, AIG owed billions of dollars on the swaps they issued, which contributed to their rapid downfall. This was one of the major controversies surrounding the bailout, because most of taxpayer money was used to pay off AIG's obligations to banks who owned the swaps.