CDSs & Counterparty Risk; What Every Investor Should Know

Credit Default Swaps (CDSs) are making headlines these days, and not for good reasons. CDSs are essentially insurance contracts on debts - investors buy them to protect their income streams and principal investments in debentures should the issuing party default on their obligations. Most notable of these almost-defaults, of course, has been Bear Stearns and CDSs have been in the headlines ever since.

Why do you care? Well, would you believet that CDSs are unregulated and that there's no public record of the sellers solvency should they actually have to deliver on the contracts they sell. As an investor, this should scare you to death. Think about it this way: imagine you paid into your insurance policy, for your car, your home or even  your life, and when the worst actually happened, the insurance company just disappeared; this is the situation that may very well still happen. Yes, still; we're not out of the woods by any extent.

George Soros has been one of the most outspoken investors on the subject of how "unacceptable" it is to have a market such as this develop in an unregulated fashion. Now representing as much as $62 trillion in contracts, the collapse of such a market could mean worldwide financial fallout. This is no joke folks.

How's this for a revelation. JPMorgan is not only the investor of these types of contracts, but is also one of its biggest issuing firms (i.e. counterparties). Unlike traditional insurance companies, there is no agency that monitors the sellers of swap contracts. What makes things even more interesting, you don't even have to own the asset that you want to protect when you buy the swaps. Yes, that's like buying a life insurance policy on someone else - could you imagine if that were possible and what sort of practices that would condone?