On December 31st I wrote a post titled “CDSs: What Everybody Will Be Talking About In 2008”.
As I explained in that post, a CDS is essentially an insurance policy against the default of a bond. An investor might buy a CDS in order to insure against a bond he owns or to speculate on default. Another party might sell a CDS to reap the premium because it believes that the risk of default is less than the premium it will take in.
Well, the big story today is insurance giant AIG’s (AIG) announcement in an SEC filing that it underestimated the losses on the CDS it wrote on CDOs (bear with me people!). Based on market prices and a bunch of other things they use in their models, their liability is likely greater than they previously disclosed and so will their 4th quarter writedown (AIG Feb 11 8-K).
AIG’s stock is being torched, down 12% on heavier volume than any other day in the last 5 years.
This raises the whole issue of “counterparty risk”. That is, who else out there wrote all these CDS that are now looking decidedly dicey and will all of them be able to cover their liabilities?
UPDATE (Tue 2/12, 10:20am PST): On AIG’s writedown also see today’s Wall Street Journal article “AIG Is Forced To Write Down Mortgage Links” (subscription required).
UPDATE (Thu 2/14, 12:20pm PST): The best article I’ve read so far in explaining what is going on in AIG’s attempt to estimate writedowns on the CDSs it wrote is yesterday’s Wall Street Journal article “Is AIG On Slippery Slope?” (subscription required).