Farrell: AIG's Problem with Credit Default Swaps

A quick overview on what credit default swaps are. The biggest issue at this moment (early in the morning) is AIG and can they get by the need for capital.

A credit default swap is like an insurance policy. In fact, it is an insurance policy. Suppose you own bonds issued by XYZ Corporation and you want to hedge against the possibility of a default. The credit default swap market has developed over the years to allow you to do that. You would enter into a contract with say an insurance company that would sell you a "policy" that would make you whole if XYZ defaulted. The contracts usually run for five years and you pay an annual premium for the coverage. AIG is a big insurance company and they issued a lot of these contracts. They allowed their customers to "swap" to them the risk of XYZ defaulting.

If XYZ's situation worsened, be it real or imagined, a new credit default swap would cost more to enter into and the value of the existing one would change. The issuing company has to mark the value of the existing contract to the current market and that is one of the reasons why AIG has taken such huge markdowns the past few quarters.

(See the video for a further discussion of the financial sectors problems).

And these markdowns are just that, markdowns. If XYZ doesn't default during the life of the insurance policy, then the markdown will be marked back up. AIG has said that the economic risk they see is much smaller than the markdowns they have taken. That may be but I don't know they have any more insight into the fortunes of a GM, Lehman, Merrill or Washington Mutual than the rest of us ( I don't know if AIG has written contracts on these companies. Using them as examples only.) This was probably a poor business decision to enter this business. There really isn't a bad risk in the insurance business. There is bad pricing of that risk.

This stuff is so confusing. Even if you feel you understand the basic concepts I doubt many of us would want to debate the relative merits of either side. The markets are saying it's not understandable and the markets are punishing those stocks involved. When in doubt- sell. What we need is for Goldman and Morgan Stanley , both of whom report this week, to show an understandable quarter with little in the way of new writedowns (although Goldman has avoided most of this mess.) Stay tuned.