This is not the end, and maybe in even the end of the beginning....
As Bear Stearns careened toward its eventual fire sale to JPMorgan Chase last weekend, the cost of protecting its debt, through an instrument called a credit default swap, began to rise rapidly as investors feared that Bear would not be good for the money it promised on its bonds. Not familiar with credit default swaps? Well, we didn't know much about collateralized debt obligations (CDOs) either — until they began to undermine the economy. Credit default swaps, once an obscure financial instrument for banks and bondholders, could soon become the eye of the credit hurricane. Fun, huh?
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.
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