AIG sold $500 billion in credit default swaps without posting collateral. When the housing market collapsed, it nearly took the global financial system with it. Here's how CDS work and what they're used for today.
Educational content only — not personalized financial, legal, or tax advice.
A credit default swap (CDS) is a bilateral contract in which the protection seller agrees to compensate the protection buyer if a specified borrower (reference entity) defaults on its debt. The buyer pays a periodic premium (the CDS spread, expressed in basis points per year); the seller pays the face value of the defaulted debt minus recovery value if a credit event occurs.
A CDS functions like insurance on a bond — but with a critical difference: you don't need to own the underlying bond to buy protection on it. This 'naked CDS' feature allowed speculators to bet on corporate or sovereign defaults without holding any underlying exposure, creating the potential for notional CDS outstanding to far exceed the face value of the underlying debt.
At their pre-crisis peak in 2007, total CDS notional outstanding was approximately $62 trillion — more than the entire global GDP. The market has since contracted to approximately $8-10 trillion.
This connects to Parametric Insurance and to Climate Adaptation Finance).
Hedging: A bank that has lent $500 million to a single corporate borrower buys CDS protection on that borrower to reduce concentrated credit exposure without selling the loan (which might damage the relationship). This is the legitimate hedging use.
Speculation: A hedge fund that believes a company's credit quality is deteriorating buys CDS protection as a directional bet. If the CDS spread widens (deteriorating credit) or the company defaults, the fund profits. This is economically similar to short-selling the company's equity.
Relative value: Traders go long/short CDS across related credits (e.g., long protection on a weaker competitor, short protection on a stronger one) to express views on relative credit quality.
Synthetic CDOs: As described in the MBS article, CDS on MBS tranches were used to create synthetic exposure to the housing market far exceeding the actual mortgage market size.
AIG Financial Products (AIGFP), a relatively small unit of the insurance giant, became the world's largest seller of CDS protection on mortgage-backed securities and CDOs. By 2007, AIGFP had sold approximately $500 billion in CDS protection.
The critical mistake: AIGFP's CDS contracts included collateral posting requirements if the referenced securities were downgraded or if AIGFP's own credit rating fell. AIGFP didn't hedge these positions or reserve sufficient capital against them — management believed that AAA-rated CDO tranches backed by diversified mortgage pools couldn't all fail simultaneously.
When housing prices declined and CDO values fell, counterparties (Goldman Sachs, Deutsche Bank, Société Générale, and others) made collateral calls totaling tens of billions. AIG couldn't meet the calls. The U.S. government provided an $85 billion emergency credit facility in September 2008 (ultimately growing to $182 billion) to prevent AIG's collapse — which would have triggered default on hundreds of billions in CDS contracts held by financial institutions globally.
Dodd-Frank's Title VII mandated:
Central clearing eliminates bilateral counterparty risk — the clearinghouse becomes the counterparty to both sides, collecting margin from both and mutualizing default risk among clearing members. The bilateral AIG-style exposure that created systemic risk is significantly constrained in the post-Dodd-Frank regime.