You have probably heard that credit default swaps helped bring down AIG, and that they work like insurance on a bond. The first part is right. The second is a picture that falls apart as soon as you read the contract, because the buyer need not own the bond and need not lose anything to collect. Here is what the contract says, who decides when it pays, and how the payout gets calculated.
What You Are Actually Buying
A credit default swap is a private contract between two parties about the debt of a third party, called the reference entity. You pay a fixed premium at set intervals. The seller owes you a payment if that reference entity suffers a credit event, which is a defined list of bad outcomes ending in default. Nobody at the reference company signs anything or is told the trade happened.
Say you buy $10 million of five-year protection on a corporate borrower. Since ISDA's 2009 standardization, North American corporate contracts carry a fixed coupon of 100 basis points a year for investment grade names and 500 for high yield, which makes contracts on the same name interchangeable. At 100 basis points you owe $100,000 a year, paid quarterly on the 20th of March, June, September and December. Where the market price of the credit differs from that coupon, an upfront payment on day one settles the gap. Five quiet years cost you $500,000 and return nothing, which is the outcome a hedger is paying for.
Why It Looks Like Insurance and Is Not
Buy fire insurance and you must own the house. That requirement is called insurable interest, and it exists so nobody has a financial reason to want your house to burn. A credit default swap has no such requirement. You can buy protection on debt you have never held.
The payout is also not linked to any loss you can document. An insurer reimburses damage it inspects. A CDS seller pays a formula: your notional amount (the contract size, $10 million above) multiplied by par minus whatever the debt turns out to be worth. New York's insurance regulator reached this conclusion in a 2000 opinion, finding that these contracts were not insurance precisely because payment did not depend on the buyer having suffered a loss. That reading is much of why the market grew up outside insurance law, with no required reserves and no supervisor checking that sellers could pay a claim.
Naked Positions and What They Turn a CDS Into
Protection bought without owning the underlying debt is called a naked position. It is the practical way to bet against a company's creditworthiness, since bonds are hard to borrow and short. Buying naked protection is a wager that the credit deteriorates. Selling protection is the mirror wager, and it gives you an exposure close to owning the bond with borrowed money.
This is why the amount of protection outstanding on a name can exceed the bonds that exist. The contract references the debt, it does not consume it, so any number of traders can write contracts on the same bonds. The European Union decided the sovereign version of this was destabilizing, and Regulation 236/2012 has banned uncovered sovereign CDS positions across the EU since November 2012. Corporate names carry no such restriction in Europe or the United States.
What Counts as a Credit Event
Three triggers do most of the work. Bankruptcy. Failure to pay, meaning a missed payment that survives its grace period. Restructuring, meaning terms rewritten to lenders' disadvantage, such as a cut coupon, a stretched maturity or a reduced principal.
Sovereign contracts add repudiation or moratorium, and obligation acceleration. Contracts on banks and insurers, under the 2014 ISDA definitions, add governmental intervention, which covers a regulator forcing losses onto bondholders in a bail-in. It was written because Europe's bank rescues imposed real bondholder losses the older wording did not clearly capture.
Restructuring is the trigger that generates arguments. Bankruptcy is a court filing and a missed payment is a fact, but whether a negotiated change of terms counts as restructuring is a judgment call with millions riding on it.
Who Decides, and Why That Has Been Fought Over
No payout starts because you assert one. The question goes to an ISDA Credit Derivatives Determinations Committee: ten dealer members and five buy-side members, all firms that trade these contracts. An 80% supermajority, twelve of fifteen, decides the question. Short of that it goes to external review by independent legal experts. The ruling binds every contract on that name at once.
Greece in 2012 shows why this matters. In early March the committee found that the voluntary bond exchange was not a credit event. On 9 March, after Greece invoked collective action clauses to impose the deal on holdouts, the same committee ruled unanimously that a restructuring credit event had occurred. Billions turned on a legal distinction, decided by a vote.
Then there is the manufactured default. In 2018 Blackstone's GSO Capital Partners lent to homebuilder Hovnanian below market rates, on condition that Hovnanian deliberately skip an interest payment on notes held by its own subsidiary. A default costing the borrower nothing would still trigger the swaps GSO had bought. The trade was unwound after litigation. In June 2019 the CFTC, SEC and FCA jointly warned that such strategies threatened the market's integrity, and ISDA amended its definitions that year to exclude narrowly tailored credit events. The process for deciding these questions has been reviewed and reformed more than once, each time after a disputed case exposed a gap in it.
The Auction That Sets the Recovery Rate
The original settlement method was physical. You handed the seller defaulted bonds and received par. That works only while contracts are scarcer than bonds, and by 2008 they were not, which turned a default into a scramble for deliverable paper.
Cash settlement replaced it, with one auction setting a single recovery price for everyone. Creditex and Markit run it in two stages. First, dealers post two-way quotes and submit physical settlement requests; discarding the quotes that cross gives an initial market midpoint and a net open interest, the bonds still to change hands. Second, anyone may submit limit orders, and the price that clears that open interest becomes the final price.
Lehman's auction on 10 October 2008 set a final price of 8.625 cents on the dollar, so protection sellers paid 91.375. Estimates of the gross notional referencing Lehman ran to around $400 billion, and it produced about $5.2 billion of actual cash movement, because most positions offset each other. Greece's March 2012 auction set 21.5.
Why the Seller's Health Is Part of the Product
Protection is worth what the seller can pay, and no more. AIG Financial Products had written roughly $527 billion of notional credit protection by the end of 2007, much of it on senior tranches assumed never to lose money.
What broke AIG first was not claims. It was collateral. These contracts require you to post cash as the position moves against you, and by 12 September 2008 counterparties had called about $23.4 billion. AIG could not fund it. The Federal Reserve lent $85 billion on 16 September, and the total government commitment eventually exceeded $182 billion.
The reforms that followed changed the plumbing rather than the product. Standardized index CDS must now clear through a clearing house, which stands between the two sides and collects margin from both daily; the CFTC's first clearing determination covered the main CDX and iTraxx indices, phased in through 2013. Contracts that stay bilateral, which includes most single-name CDS, fall under margin rules requiring both sides to post.
Reading a Spread as a Probability
The pricing intuition fits on one line. The annual spread is approximately the annual default probability multiplied by the loss given default, which is one minus the recovery rate. Practitioners call it the credit triangle.
Run it backwards. A five-year spread of 200 basis points is 2% a year. Using the market's conventional 40% recovery assumption, the implied annual default probability is 0.02 divided by 0.60, about 3.3%, which compounds to roughly 15% over five years. Two caveats. That is a risk-neutral probability, so it includes the compensation sellers demand for bearing risk and runs above the historical default rate. And the recovery rate is assumed until an auction proves it.
The everyday reading needs none of that arithmetic. A spread is a price that moves every day; a letter rating is an opinion revised when a committee meets. The major agencies still had Lehman Brothers at an A grade days before it filed for bankruptcy, while its swaps were already priced for severe distress. When the two disagree, they are answering the same question at different speeds.
