Credit Default Swap

Definition: Insurance for municipal bonds, corporate debt, and mortgage securities. These insurance contracts can be swapped from buyer to buyer, with no guarantee that the buyer can actually cover default losses.

CDS allowed banks and hedge funds to lend billions of dollars without tying up their reserves to cover such loans. The CDS market, which is not regulated by the government, emerged in the 1990s and has since ballooned to more than $45 trillion in mid-2007 — roughly twice the size of the U.S. stock market.

Usage: [Insurance company] AIG was on one side of these trades only: They sold CDS. They never bought. Once bonds started defaulting, they had to pay out and nobody was paying them. AIG seems to have thought CDS were just an extension of the insurance business. But they're not. When you insure homes or cars or lives, you can expect steady, actuarially predictable trends....

My death doesn't, generally, hasten your death. My house burning down doesn't increase the likelihood of your house burning down. Not so with bonds. Once some bonds start defaulting, other bonds are more likely to default. The risk increases exponentially. (Reuters, Sept. 18, 2008)