Investments, tenth edition

1.2 

  Credit Default Swaps 

 In parallel to the CDO market, the market in  credit default swaps  also exploded in this 

period. A credit default swap, or CDS, is in essence an insurance contract against the 

default of one or more borrowers. (We will describe these in more detail in Chapter 14.) 

The purchaser of the swap pays an annual premium (like an insurance premium) for protec-

tion from credit risk. Credit default swaps became an alternative method of credit enhance-

ment, seemingly allowing investors to buy subprime loans and insure their safety. But in 

practice, some swap issuers ramped up their exposure to credit risk to unsupportable lev-

els, without sufficient capital to back those obligations. For example, the large insurance 

company AIG alone sold more than $400 billion of CDS contracts on subprime mortgages.