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Untangling credit default swaps

When the analysts and experts talk about the current financial crisis, they often refer to "credit default swaps." So, what exactly is a credit default swap? Marketplace Senior Editor Paddy Hirsch goes to the whiteboard for this explanation.

About the author

Paddy Hirsch is a Senior Editor at Marketplace and the creator and host of the Marketplace Whiteboard. Follow Paddy on Twitter @paddyhirsch and on facebook at www.facebook.com/paddyhirsch101
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Hi Paddy, Thank you for such an excellent explanation. I just had a question about 2 million dollar Jim has to pay Sam, if GM Bonds goes down in value. How did you find 2 million dollar? Is is 2 million plus 2 million in collateral and rest from selling the bonds? One more question Paddy, I just got my undergrad in Finance and looking for a job. I am very nervous about the interviews? Are the interviewers going to expect us to know about CDS, OPTIONS, FUTURES and all about other financial instrument and Market? I am an international student here in US and just started reading wall street and there are so many things I still don't get. Will I gradually learn working in a financial setting or am I not able to work without all this knowledge? Please advice. Thank You Sabita Agrawal

Credit default swaps explained clearly in Paddy's Wbiteboard presentation. But one question that I've never seen answered in this and other explanations is the BET. The seller of the CDO and the buyer insuring bonds are often equal in knowledge--so why would one party think they could predict the future better than another party? A small gamble, okay. But $ trillions? I don't understand.

I fully understand insuring something you own. I can insure my house against loss. The credit default swaps are like allowing anyone else to insure my house - make a bet that my house will suffer loss. I can understand taxpayer money being used to honor legitimate insurance. But is taxpayer money being used to make good on the bets? Do we bail out bookies?

I can not believe that credit default swaps are illegal.. it's legalized gambling, and why would AIG give these "sams" collateral.. it is foolish....
I'm sure this is not going to be solved very easily...

Excellent explanations of very complex situations. I am not a businesswoman or an economist. I have tried to find explanations of the terms being thrown about in this economic crisis, but this is the first time I have found any that made sense! Please continue with these white board sessions. Better yet, how 'bout an online class? Many thanks.

i heard about this video on npr this morning during the interview with paddy hirsch. i've been trying to learn more about "swaps" because i'm following the jefferson county alabama sewer crisis which is being attributed to the county commission's use of credit default swaps related to auction notes. this is a good introduction to the process. although the term insurance contracts is a useful descriptor it may be helpful to readers to point out that these contracts are not considered formal insurance programs. in addition to pooling risks mentioned by a previous commentator formal insurance is regulated by states and insurers generally must meet solvency requirements through reserves.

Why on earth would Jim (the insurance salesman) offer collateral to Sam for buying investment insurance? No other insurance (like health insurance, car insurance, flood insurance, earthquake insurance) offers collateral to the buyer of insurance; the buyer of insurance justs hopes/risks that the insurance company will remain solvent. I don't understand why any insurance company (AIG) would offer collateral in order to induce someone to buy insurance. That makes absolutely no sense. What were the people working at these insurance companies smoking? And if there is some legitimate reason for the insurance company to offer collateral just for buying investment insurance, then why don't they offer collateral for all other types of insurance like health insurance or flood insurance?

Absolutely wonderful "ground level" explanation of a variety of current subjects, displayed in such manner as to be quite useful for all levels of the investment public. Highly recommended viewing.

Much thanks for the straight forward presentation, a couple questions though:

Why would Sam bet on GM's failure?, would seem about as beneficial as smashing up his Ferrari just to get... a Ferrari?

If organizations like AIG are in this much trouble just from having their credit downgraded prior to the recent market crash then how bad does it get when Sam finds out his GM bonds are worthless??? Did the 150+ Billion for AIG just kept the lights on and the real problems haven't even started yet?

Nice presentation, but apart from collateral calls, there is another difference between a car insurance and a credit default swap:

Insurance companies play with probabilities. If they insure 100 cars and 10 of those crash, then they still make enough money from the 90 others to pay for these, and one crash does not the probabilities of the others to crash.

Compare that with an insurance against crashing stock: If the GM stock of one investor crashes, then the GM stock of all the other investors crash, and the company has big trouble. My guess: their mathematicians had one drink too much.

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