Credit Default Swaps

1. What is a Credit-Default Swap?
I am going to make my life easy today. I have found a WSJ blog explaining exactly what I had planned to write about: bond insurance. The blog posting is titled “The Vicious Circle” . I would like to emphasize the paragraph to the left of the graph:
“The credit-default swaps, a measure of protection against default, have exploded. Today it costs $1.2 million, along with $500,000 annually, to protect $10 million in bonds against default, compared with $680,000 on Thursday, according to Phoenix Partners Group.”
A credit swap is a put on a bond. The trigger is a default event. Let me give you an example using the numbers in the above paragraph: Suppose I hold $10 million AIG bonds and wish to protect myself against this bond defaulting. I can buy such insurance by: paying $1.2 million upfront plus an annual premium of $500,000.
The question is why is that contract called a swap? The answer is that if default occurs, the insured can swap the bond with the insurer for its face value of $10 million.
Note: this swap has very little in common with interest rate or currency or equity swaps.

2. Why Are Credit-Default Swaps So Important?
When two counterparties enter a credit default agreement, they do not have to report this agreement to anybody. According to some estimates, credit-default swaps have been written on bonds with more that $60 trillion. This amount is a multiple of the amount of actual bonds outstanding in the U.S. (Government and private). It is reasonable to assume that many of these swaps have been entered for speculative purposes (if you bought such swap on AIG last week you could sell it this year at a huge profit).
Now, several financial institutions hold bonds that lost a lot of their market value but have not, as yet, defaulted. These bonds appear on their books at 100% of face value because, on the face of it, they are insured, or rather, “insured”. Nobody knows if the insurer (who can be AIG or a hedge funs or a bank) will be capable of making its commitment whole in case of default.