Credit Default Swap Problems

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Back in November 2006, I wrote a long-ish piece about credit default swaps. These financial instruments, known for short as CDSs, basically function as insurance policies against borrowers defaulting on loans. In (very) brief, the premise of the article was that some CDS issuers, which we can think of as insurers, probably didn't have enough money to cover the losses once homeowners started defaulting en masse. Once this came to light, I wrote at the time, it could cause a tightening of credit for San Diego's leverage-happy homebuying public.

I never really followed up because the credit tightening ended up being triggered by problems with a different type of credit derivative, the collateralized debt obligation.

Now, though, the originally predicted CDS counterparty problems -- insurers not being able to pay their claims, to put it in plain English -- have arrived, per recent articles in the Wall Street Journal and New York Times. However, they aren't happening as much among hedge funds as I had postulated they might, but they are instead plaguing bona fide bond insurance companies.

The NY Times piece goes into more detail on the ramifications, but the net effect is that a lot of lenders who thought they were insured against defaults are not actually insured after all. This is likely to make them even less eager to lend into the already-tight mortgage and credit markets.

-- RICH TOSCANO