You have been reading and hearing a lot about problems in the credit markets – in particular about credit default swaps and collateral debt obligations. Here is a primer on them. Credit Default Swaps (CDSs) are securities based on a relationship between 2 parties. One party commits to insuring the other party in the event of a bond default. In return for accepting the risk, the first party receives an insurance premium from the second party (not unlike the premium one receives when one sells a stock option).  The volume of CDS business is staggering. CDSs are now in the range of $65T.

                 

In the past few years, institutional investor interest in holding individual bonds has shifted towards holding CDSs. The invention of CDSs has increased liquidity in credit markets and even allowed investors to short positions in bonds (bet on the face value of the bond going down). Some suggest that the CDS is so useful that it will become a core staple of bond holder portfolios in much the same manner as S&P500 index funds are a core equity holding.

 

Here’s the downside with CDSs. Think Bear Stearns. CDSs are two-party instruments – a buyer & a seller. What if the party that insures your bond default cannot pay when needed (& agreed to)?  Despite the Bear Stearns fiasco, the CDS business continues to flourish.

 

Collateralized Debt Obligations (CDOs) are funds consisting of bonds (any debt instruments). These funds are then partitioned into groups with similar risk (called tranches). The riskiest tranche receives the highest interest rate but is the first group to suffer a loss when debtors fail to repay their debt. The CDO market is much smaller than the CDS market. The first quarter of 2007 saw $185B in CDO business. Because of the credit crisis, the CDO market has gone through a dramatic downsizing- $11B in the first quarter of 2008.