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Sure. The short answer is..... You(party A) and party B have a contract. You want to eliminate the risk that Party B goes bankrupt and can no longer pay you.

Sure. The short answer is..... You(party A) and party B have a contract. You want to eliminate the risk that Party B goes bankrupt and can no longer pay you. You go to party C who will take small payments from you each month/quarter and in return they will pay you if party B goes bankrupt. Now the important things to note are: 1) The amount you pay party C is based on how you and party C analyze the bankruptcy risk of party B. 2) The amount that party C pays you when the CDS is triggered doesn't necessarily have to have any relation to your original contract with party B. ie party B might be making a one time payment of $1 million to you but nothing stops you from taking out $10 million in CDS protection on party B. 3) The trigger for a CDS may not necessarily be the failure of party B to pay, ikt might be related to their credit rating, ownership changes, or really any term you can negotiate. 4) you can write a CDS when you aren't even involved in the original party A to party B transaction. This is what happened in teh big short where Michael Burry had no involvement in the Mortgage back securities, but had several banks writhe him a CDS that payed out if the original mortgage backed security had a certain percentage of its mortgages fail. This is where things really went off the rails as companies like AIG wrote the CDS protection for a whole lot more MBS(Mortgage backed securities) than they could possibly ever cover, because their models predicted that there really wasn't any way they could fail in the manner they did. Suddenly a single MBS could have 100x its value in CDS default protection written on it. This leverage is how the 2008 bailout got so big.

ThrustVectoring 10y ago
The 100x is more because companies weren't really able to sell these contracts. Instead, they'd make another one with the opposite position to mitigate their risk. In case of default, there'd be a lot of offsetting payments.
- mcnees287 10y ago
  I think the comment is referring to the fact that one can write CDS on top of an underlying instrument. So, if I have $100 million in MBS, other parties, or even myself, can write CDS contracts that reference my $100 million MBS. What I have just done is to create more exposure than the underlying MBS. The MBS is still only $100 million, but the total outstanding contracts on the pool (MBS + CDS) is now much larger. What you are talking about is related to offsetting contracts, which is different. AIG was left holding the bag for most of these. They are one of the few who did not offset like you are saying.
  - deleted 10y ago
    [deleted]
  - erichocean 10y ago
    > They are one of the few who did not offset like you are saying. Which just goes to show important the offsets actually are in practice.
rsync 10y ago
You're missing the very best part ... in many cases, the C parties allowed customers to assemble their own CDS specifically containing the very worst segments of the contracts between parties A and B (to stretch your analogy).
- infinite8s 10y ago
  It's not an analogy - you are confusing the difference between CDS (which is what chollida1 described) and MBS (a type of collateralized debt obligation the is pooled together and various buckets of risk are tranched and securitized, which is the aspect you describe).
mjevans 10y ago
Why is that type of betting (gambling) allowed? That's just plain insanity.
- erichocean 10y ago
  It's not betting (gambling), it's insurance. Is insurance insane?
  - jdmichal 10y ago
    How could you call it insurance when you have no interest in the original security? What are you insurance against?
    - jkimmel 10y ago
      You don't need to be a direct party in a contract to be affected by it. You can insure against possible negative outcomes of someone else's contracts. e.g.) Party A and Party B sign a contract that Party B will pay Party A $X by some date. Party A has seperately agreed to pay you $0.9X shortly afterward. You are a savvy businessperson and realize that Party A will not have $0.9X to pay you if the Party B fails to make their payment. Party B is on the rocks after a nasty reorg, and you think the probability they fail to pay is significantly greater than 0. You want to protect your business against this event. To do so, you purchase a Credit Default Swap from Party C for $0.05X that ensures the full $0.9X payment. While Michael Barry was "speculating" using CDS's, you could also argue that he was "insuring" his firm against a housing crash, which did tank most investment vehicles.
      - iofj 10y ago
        Why are these parties allowed to make contracts like that without putting up collateral ? I can pay a bum on the street 10 dollars to sign his name on a contract like that (that he'd take over these payments in the case of bankruptcy). He would not pay up if it does happen. Apparently the situation is the same with these banks. Isn't this fraud ? They're signing insurance contracts they know they might not be able to pay up. Why don't we demand that they put the money into a locked account like every landlord on the planet does with tenants ? If you don't have that guarantee on a locked account, not used for anything else, then why is that contract accepted as hedged risk ?

ThrustVectoring 10y ago

The 100x is more because companies weren't really able to sell these contracts. Instead, they'd make another one with the opposite position to mitigate their risk. In case of default, there'd be a lot of offsetting payments.

mcnees287 10y ago
I think the comment is referring to the fact that one can write CDS on top of an underlying instrument. So, if I have $100 million in MBS, other parties, or even myself, can write CDS contracts that reference my $100 million MBS. What I have just done is to create more exposure than the underlying MBS. The MBS is still only $100 million, but the total outstanding contracts on the pool (MBS + CDS) is now much larger. What you are talking about is related to offsetting contracts, which is different. AIG was left holding the bag for most of these. They are one of the few who did not offset like you are saying.
- deleted 10y ago
  [deleted]
- erichocean 10y ago
  > They are one of the few who did not offset like you are saying. Which just goes to show important the offsets actually are in practice.

rsync 10y ago

You're missing the very best part ... in many cases, the C parties allowed customers to assemble their own CDS specifically containing the very worst segments of the contracts between parties A and B (to stretch your analogy).

infinite8s 10y ago
It's not an analogy - you are confusing the difference between CDS (which is what chollida1 described) and MBS (a type of collateralized debt obligation the is pooled together and various buckets of risk are tranched and securitized, which is the aspect you describe).

mjevans 10y ago

Why is that type of betting (gambling) allowed? That's just plain insanity.

erichocean 10y ago
It's not betting (gambling), it's insurance. Is insurance insane?
- jdmichal 10y ago
  How could you call it insurance when you have no interest in the original security? What are you insurance against?
  - jkimmel 10y ago
    You don't need to be a direct party in a contract to be affected by it. You can insure against possible negative outcomes of someone else's contracts. e.g.) Party A and Party B sign a contract that Party B will pay Party A $X by some date. Party A has seperately agreed to pay you $0.9X shortly afterward. You are a savvy businessperson and realize that Party A will not have $0.9X to pay you if the Party B fails to make their payment. Party B is on the rocks after a nasty reorg, and you think the probability they fail to pay is significantly greater than 0. You want to protect your business against this event. To do so, you purchase a Credit Default Swap from Party C for $0.05X that ensures the full $0.9X payment. While Michael Barry was "speculating" using CDS's, you could also argue that he was "insuring" his firm against a housing crash, which did tank most investment vehicles.
    - iofj 10y ago
      Why are these parties allowed to make contracts like that without putting up collateral ? I can pay a bum on the street 10 dollars to sign his name on a contract like that (that he'd take over these payments in the case of bankruptcy). He would not pay up if it does happen. Apparently the situation is the same with these banks. Isn't this fraud ? They're signing insurance contracts they know they might not be able to pay up. Why don't we demand that they put the money into a locked account like every landlord on the planet does with tenants ? If you don't have that guarantee on a locked account, not used for anything else, then why is that contract accepted as hedged risk ?