Tuesday, October 21, 2008

Credit Default Swaps

A credit default swap is a contract, generally between banks, that acts as insurance on debt. Under the contract, the seller, for a fee, agrees to make a payment to the buyer if something bad happens to the debt the buyer has insured with the swaps.

For instance, a bank that holds another bank's bonds could insure those bonds against loss by buying swaps. If a bond held by an investor lost so much value that it was worth only 8¢ on the dollar, the holder of that investor's credit default swap would owe him 92¢ for each dollar covered by the swaps.

The chairman of the Securities and Exchange Commission has estimated there are $55 trillion in credit default swaps outstanding.

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