Good and Bad CDS

Just a relatively few years ago when you saw CD on the financial pages you knew it referred to a certificate of deposit, a deal made between you and your bank whereby you would keep at least a certain amount of money on deposit for a certain period and the bank would pay you a higher rate of interest.

Now when you see CD you look for another letter, an 'O' for a Collateral Debt Obligation or an 'S' for a Credit Default Swap. We've seen the disasters that have befallen the CDO. Now it looks like we're in for the same with the CDS. These seem to be as arcane - perhaps more so - than the CDO. But, like the CDO, you don't really know who the eventual payee might be in the event of default.

The CDS is an attempt to mitigate losses on corporate bonds (usually). A bond investor finds an insurer (not necessarily an insurance company) to guarantee that the bond will be paid, no matter what happens to the company that issued the bond. In exchange for this guarantee, the investor makes periodic payments to the insurer.

While the investor may know the insurer, this is not always the case. Even if it is so, very often the insurer sells the paper you've signed to another 'insurer' who may repeat the process. Eventually, should the bond issuer default, you will likely have a hard time finding out who is obligated to pay you. And, you may be in for a shock that this company cannot pay you.

The possible loss of your investment is not the only glitch in this type of an investment. The insurer also has total discretion as to the value he places on this swap when it reaches his balance sheet, as there is no exchange where these instruments trade. For example AIG had overstated its swaps by $3.6 billion in the eyes of its auditors.

This market has grown phenomenally. It is now at $45.5 trillion, double the stock market and ten times the treasury market. Of course, the International Swaps and Derivatives Association says 'trust us'.