A: They do so through credit-default swaps, which are exotic insurance-like financial instruments that signal how investors view the risk of any particular country's debt. As part of prudent management of the risks they're assuming, big investors that buy a country's bonds also buy these swaps as protection against default. Investors with no underlying stake in the bonds, however, can also buy swaps and bet against a country.
If investors think a country is financially weak, the cost of insuring the purchase of its bonds goes up, and this also influences the return investors will demand in exchange for assuming the risk of buying a country's bonds.
Q: Why do these swaps sound familiar?
A: They're the same instruments that helped amplify the near-meltdown of the U.S. financial system in September 2008. Investors bet against the bonds of investment banks Bear Stearns and Lehman Brothers, the insurer American International Group and others. In good times, swaps help manage risk. In bad times they seem to increase fear and panic.
Q: What's the big deal if swaps go bad?
A: Before swaps became so popular, a country defaulted on a bond, then negotiated with its creditors what's called a "haircut." They'd agree to repay say 70 cents on the dollar and issue new bonds with a higher interest rate for anyone willing to invest anew.
Swaps add a new wrinkle. The swaps market, worth trillions of dollars, isn't regulated, and there aren't clear settlement mechanisms or exchanges on which these instruments trade. Today's fear is the same as the worries in the turbulent fall of 2008 — that a default could trigger disorderly settlement of these bets and financial chaos could ensue."
The beast is back! Remember that CDS was the primary factor that brought AIG down. It is pretty much a bet against bankruptcy of a company or a country. And guess what? Apparently there are literally gazillion of CDS being traded against European countries such as Greece or Spain.
If Greece default on their loans, it will trigger massive CDS repayment - I am not sure whether it is as big as AIG but the market of CDS are huge.