A credit default swap (CDS) is a credit derivative contract between two counter parties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults.CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur.
Credit default swaps are sort of like insurance against default on a financial vehicle, namely now mortgage backed securities, however it is very important to uderstand that in fact it is NOT insurance. There are several important differences between the two however here is the most important.
The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event
In other words, if you are holding onto a bunch of mortgage backed securities, you may want to buy some credit default swaps to insure yourself against loss. Yet, you don't have to own any to buy a credit default swap. A credit default swap is a bet for or against the defaulting on any particular asset, in this case again mortgage backed securities.
Why is AIG going under? That's because they made some really bad bets. They don't merely owe some that wanted to hedge against their own MBS, but rather, they owe everyone. For every one Dollar of MBS, there could be one, two, ten, or even one hundred Dollars of credit default swaps. How many bad contracts is AIG holding onto? Of course, no one knows except for the obvious answer which is a lot.
What is clear is that the kind of money that it would take to save them is enormous. It is like in the trillions. Worse than that, as the mortgage market continues to weaken, they will hold onto more and more bad contracts. In other words, their situation will go from bad to worse with no end in sight.
As such, what should be clear to everyone, mostly those in charge, is that giving them $30, $40, and $50 billion at a time is a total waste of money. This company probably needs us to add at least one of not two zeros to our bailouts. Of course, there is another layer of problems. AIG is deemed too big to fail. That's why they are getting so much in bailout money. One of the main reasons that they are too big to fail is that they owe so much to so many that if they failed that might start a domino among its creditors that are debtors to others. Though, of course, no one knows for sure because we can't see their books.
The thought of course is that not only would bankruptcy cause irreperable damage to the company, but it would cripple its creditors. That's why the government continues to bailout AIG. Yet, before another penny is given, they must open up their books entirely so everyone can see just how bad it is. This black hole must stop.