In an interesting article by Adam Davidson on Reuters explains in simple terms why AIG’s trouble is something that is important for us. 

In a turbulent week in the financial markets and at a time when the rest of us are feeling the pinch with increases in fuel and food prices, the idea that CDS’s (Credit default swaps) written by AIG could bring the global economy to something of a standstill is a bit of a worry.

So what is a CDS?

At first glance, a credit default swap seems like a perfectly sensible financial tool. It is, basically, insurance on bonds.

Imagine a large bank buys some bonds issued by General Electric. The bank expects to receive a steady stream of payments from GE over the years. That’s how bonds work: The issuer pays the bondholder some money every six months. But the bank figures there’s a chance that GE might go bankrupt. It’s a small chance, but not zero, and if it happens, the bank doesn’t get any more of those payments.

The bank might decide to buy a CDS, a sort of insurance policy. If GE never goes bankrupt, the bank is out whatever premium it paid for the CDS. If GE goes bankrupt and stops paying its bondholders, the bank gets money from whoever sold the CDS.

The market has exploded in the last few years and CDS’s have helped transform bond trading into a highly leveraged, high-velocity business.  Adam Davidson explains that

Banks and hedge funds found that it was much easier and quicker to just buy and sell CDS contracts rather than buy and sell actual bonds. As of the end of 2007, they had grown to roughly $60 trillion in global business.

The reality is that most banks bought and sold these instruments, but AIG was only on one side of this deal.  Selling CDS’s.  Many CDS’s were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis that we have become familiar with.  AIG wrote cover for more than $440 billion in bonds, but this week we discovered that they do not have the funds to cover the CDS payout.  The world waits to see what it going to happen.  For a better view of this go to Adam’s article here.