credit default swap

(finance) financial instrument in which buyer is someone who needs insurance against the possibility that a borrower will default on a loan. in that case, the counterparty is whoever receives the cds premiums, and pays out in the event of default.

why it’s bad
loans are usually made by either commercial banks (in which a loan officer is supposed to make a professional -ssessment of risk of default before handing over the money), or by investment banks (which underwrite securities like bonds). if the borrower has a high risk of default, then the loan should not be made–period.

credit default swaps were a stupid method of supposedly turning a bad loan into a “risky” (and potentially high-yield) “investment”; they were in reality a strategy for fraud. since portfolio managers knew they were bundling securitized loans that contained mostly cr-p, they would arrange credit default swaps and cash in when the borrowers defaulted.
what the bankers h-t on was a sort of insurance policy: a third party would -ssume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. jpmorgan would then get to remove the risk from its books and free up the reserves. the scheme was called a “credit default swap,” and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.

{newsweek, “the monster that ate wall street,” 27 sep 2008}