The mechanics
Suppose you own £10 million of Lehman Brothers bonds and are worried about Lehman defaulting. You buy CDS protection — paying, say, 150 basis points per year (1.5% of £10m = £150,000 annually) to an insurance seller. If Lehman defaults, the protection seller pays you £10 million (the face value) and takes delivery of the defaulted bonds at their distressed market price. You have effectively insured your credit exposure. The CDS spread (the annual premium) moves inversely with perceived creditworthiness: as Lehman deteriorated in 2008, its CDS spread widened from 150bps to thousands of bps, signalling the market’s assessment of near-certain default.
Naked CDS and systemic risk
The crucial distinction is between covered CDS (the buyer holds the underlying bond) and naked CDS (the buyer does not hold the bond). Naked CDS are pure credit speculation — betting on whether a company will default without owning the underlying exposure. This is analogous to buying fire insurance on your neighbour’s house: you profit if they burn down. By 2007, the total notional amount of CDS outstanding was estimated at over $60 trillion — far exceeding the total outstanding bonds of the underlying reference entities. This created concentrated, opaque webs of counterparty risk: if one large seller defaulted (as nearly happened with AIG), the shock would cascade through the entire system.
AIG and the 2008 crisis
AIG’s Financial Products division sold approximately $440 billion of CDS protection on mortgage-backed securities (MBS), treating them like insurance products — but without the capital reserves required by regulated insurers. When MBS deteriorated in 2007–2008, AIG faced escalating collateral calls it could not meet. The Federal Reserve and US Treasury ultimately provided an $85bn bailout (later expanded to $182bn) to prevent AIG’s failure from triggering a cascade of unmet CDS claims across the global financial system. This episode illustrated the most fundamental problem with OTC derivatives: counterparty risk is invisible to the market until it is too late.
“Credit default swaps are the financial equivalent of selling flood insurance on the Mississippi Delta — the premiums are attractive until the flood comes.”
What this means for you
Post-2008 reforms — principally Dodd-Frank in the US and EMIR in the EU — pushed CDS toward central clearing through CCPs (central counterparty clearinghouses), which dramatically reduced bilateral counterparty risk. CDS spreads remain one of the most useful real-time signals of credit market stress: the spread on a country’s sovereign CDS, or a company’s single-name CDS, often predicts distress before rating agencies act. For credit analysts and fixed income investors, monitoring CDS spreads alongside bond yields provides a richer picture of perceived credit risk than either metric alone.