CDSs: What Everybody Will Be Talking About In 2008

“… defaults of a different kind could be the big issue of 2008.  If you want to mug up on jargon for the year ahead, then the business of insuring against bond defaults known as credit default swaps, or CDSs, would probably be the best place to start.”

– “Markets In 2008”, The Economist, December 29 (Hat Tip The Float)

The financial term of 2007 has to be CDO for Collateralized Debt Obligation (for a funny take see, “Broker Joe’s CDO”).

The term for 2008 just might be CDS for Credit Default Swap.  A credit default swap (CDS) is essentially an insurance policy against the default of a specific bond or an index of bonds. 

But one doesn’t have to own the bond to buy insurance on it.  If one wanted to bet against the bond one could just buy the insurance which would increase in value as the perception of the likelihood of default increased. 

A lot of bets have been placed on both sides with CDSs.  If the economy slips into recession and companies with little margin for debt coverage start to struggle we’ll be hearing a lot about CDSs in 2008.