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, on Monday, the big story was insurance giant AIG’s (NYSE:AIG) announcement in an SEC filing that, it underestimated the losses on the CDSs it wrote on CDOs (bear with me people!). Based on market prices, and a bunch of other things that the company uses in its models, its liability is likely greater than the company previously disclosed. As a result, its 4th quarter writedown (AIG Feb 11 8-K) will be much larger than previously expected.
AIG’s stock was torched on Monday, and was 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 of these CDOs that are now looking decidedly dicey, and will all of them be able to cover their liabilities?