Markets Indicate Growing Concern of Potential Bankruptcy By Some States

The credit default swaps of 5 states are now trading at over 100.

Michigan 192
California 165
Nevada 164
New Jersey 150
Ohio 104

These are not total panic levels, but they are very high. It shows increasing concern about holding paper from these states.

Credit default swaps are often used to manage the credit risk (ie the risk of default) which arises from holding debt. Typically, the holder of, for example, a government bond may hedge his exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond.

For example, a pension fund owns $10 million of a five-year bond issued by Country X. In order to manage the risk of losing money if Country X defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 100 basis points (100 basis points = 1.00 percent). In return for this credit protection, the pension fund pays 1% of 10 million ($100,000) per annum in quarterly installments of $25,000 to Derivative Bank.