I thought the first rule of investment was, "If you can't understand what it is, don't buy it!"

Credit default swap. From Wikipedia, the free encyclopedia

A credit default swap (CDS) is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDSs contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan. The European Parliament has approved a ban on naked CDSs, since 1st December 2011, but the ban only applies to debt for sovereign nations.

Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion [ !!! ], falling to $26.3 trillion by mid-year 2010.

Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs. CDSs have many variations. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.

CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systemic risk to the economy.

Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency. In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators greater access to its credit default swaps database.

A number of financial professionals, regulators, and the media have begun using credit default swap pricing as a gauge of the riskiness of corporate and sovereign borrowers, and U.S. Courts may soon be following suit.

For more punishment, go to http://en.wikipedia.org/wiki/Credit_default_swap