JP Morgan loss: what is a credit default swap?

http://www.guardian.co.uk/business/2012/may/14/jp-morgan-loss-credit-default-swap

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Credit default swaps (CDSs) are a form of insurance on bonds issued by companies and countries that investors can buy and sell. If it looks like an issuer may have trouble paying – such as Greece, for example – the CDS price rises because the bond is more risky and it will cost more to insure.

CDSs were dreamed up in the late 1990s and became very popular, very quickly. In 2000, the market was worth $900bn (£560bn). By 2008, it was more than $30 trillion.

They can be used by bond investors – as a hedge against potential defaults – or traded separately when they are called naked CDSs.

The case against CDS contracts is usually explained using house insurance as an example: it is not possible to take out an insurance policy on someone else's house – because you would then have a financial interest in burning it down. Investors with no interest in the underlying bond can buy and sell CDSs – and profit from its demise. Greece has blamed speculators trading in CDS contracts on Greek bonds for pushing up government fundraising costs.

Regulators have blamed speculators and their trades in naked CDSs for exacerbating the problems faced by Greece and increasing its borrowing costs. The European commission president, José Manuel Barroso, believes speculative CDS trading has been an "aggravating factor" in the Greek debt crisis.

They also have been blamed for triggering the 2008 financial crisis. In 2003 Warren Buffett called them "weapons of mass destruction".

CDS trades also reportedly led to the $2bn loss at JP Morgan.