"Credit-default swaps (CDS) worldwide expanded to cover $62.2 trillion of debt in 2007 as investors rushed to protect against losses triggered by the collapse of the U.S. subprime mortgage market." so reports the the New York-based International Swaps and Derivatives Association as reported in Bloomberg. The market has grown from $34.5 Trillion in 2006.
The CDS swamps the subprime market in size 6-fold. The entire U.S. mortgage market is $11 Trillion and the subrime is only $1 Trillion. Some are worried that 10% of the CDS market or $6 Trillion could go bad, dwarfing the subprime problem.
Credit-default swaps, traded by banks and securities firms including JPMorgan Chase & Co. and Goldman Sachs Group Inc., are the fastest-growing part of the $454.5 trillion market for over- the-counter derivatives, financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan.The second party to the loan, the one covering the credit risk is the "Counter-Party".
What happens if your loan goes bad, but the counter-party is overwhelmed with losses and can't make good on the insurance? Since everyone is trying to manage risk with derivatives and the biggest risk is the counter-party risk, expect to see some kind of hedge used in conjunction with CDS to manage that risk. It's just junk piled upon junk!
