The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country's credit crisis.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the e...

The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country's credit crisis.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

The fundamental difference between credit default swaps and insurance is what gives them the potential to create losses on a massive scale. Insurance requires an insurable interest. i.e. you have to be owed the money to insure against it's loss. The amount of underlying debt would therfore limit the size of the market if these derivatives wre insurance contracts. That is in the real world.

In the parallel world of derivatives trading they are all really just bets. A Bank or hedge fund , via its traders, can accept bets from other banks and hedge funds. These are really just bets placed with bookmaker. The main difference is that the bookmaker accepts bets on a variety of runners so...

The fundamental difference between credit default swaps and insurance is what gives them the potential to create losses on a massive scale. Insurance requires an insurable interest. i.e. you have to be owed the money to insure against it's loss. The amount of underlying debt would therfore limit the size of the market if these derivatives wre insurance contracts. That is in the real world.

In the parallel world of derivatives trading they are all really just bets. A Bank or hedge fund , via its traders, can accept bets from other banks and hedge funds. These are really just bets placed with bookmaker. The main difference is that the bookmaker accepts bets on a variety of runners so that any horse can win and he will still make a profit. He may also lay off the risk by placing bets himself.

Whilst the CDS risk could be laid off, there are a number of problems in doing so:-

1. There is little or no appetite for such risk in the current market.
2. There is a lack of confidence in each other by banks. They wont lay off risk with each other.
3. The price of laying off the risk is much higher than it was a year ago so they will have to write down a loss against it.

The situation is of concern because it is unregulated trade and therefore there was nothing to prevent a bank from taking far too much risk and therefore premium up front. When the number of defaults starts to increase someone could be left with alot to pay out and potentially be unable to settle the bets. Such a collapse would trigger that bank's insolvency and all of its bonds would be worthless and bets placed on it's default would then be due to pay out.

The numbers quoted of $ 60 trillion sound frightening. Typical default ratios in peacetime are alot less than 1% or $ 600 billlion. Which is actually smaller than Hank Paulson's current bank assistance program. It is a less likely event than the Sub Prime CDO crisis and the FED would find it easier to contain.