(By Jason Simpkins
) Credit default swaps (CDS) gained infamy in the early stages of the financial crisis as the murky derivatives that helped drive the likes of Lehman Bros and Bear Stearns into bankruptcy.
Now, they're back, inspiring panic in the bond market and making it harder for Greece to borrow money. Already struggling to rein in its out-of-control deficit, credit default swaps could be enough to push the debt-ridden nation into default.
Credit default swaps are credit derivative contracts that let banks and hedge funds place bets on whether or not a company, or in this case a country, will default. The CDS buyer makes periodic payments to the seller, and in return receives a payoff if the underlying financial instrument defaults.
Think of it like this: If Institutional Investor "A" has a $10 million loan to Megacorp, Institutional Investor "B" can agree to cover the credit in that loan. In other words, if Megacorp defaults, "B" has to cover the debt. But "B" collects a small insurance premium for agreeing to cover the loan - a premium it gets to pocket as income.
However, one of the biggest problems with CDS contracts is that their holders have an incentive to push companies into bankruptcy.
"It's like buying fire insurance on your neighbor's house
- you create an incentive to burn down the house," Philip Gisdakis, head of credit strategy at UniCredit in Munich, told the New York Times
Some analysts have argued that short-sellers and CDS players helped drive Lehman Bros. into bankruptcy by driving out the company's investors in a wave of panic and then collecting on their bets. And now they say the same thing is happening with Greece.
The Markit Group of London last year introduced the iTraxx SovX Western Europe index - an index based on CDS that let traders gamble on Greece shortly before the crisis. Critics contend that traders and speculators focus on the index's daily gyrations, and as banks and others rush into these swaps, the cost of insuring Greece's debt rises.
Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow.
The end-goal of course would be to drive the nation into a full-scale default and collect.