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Credit default swaps are being thrust into the limelight, most especially due to the AIG disaster and hearings going on at Capitol Hill today.

Here is a (hopefully) simple explanation of what a credit default swap is:

Borrower Bill borrows $1,000 dollars from Loaner Jim. Loaner Jim wants to obtain insurance on that debt in the event that Borrower Bill goes bankrupt. Loaner Jim goes to Insurer Ida and asks for insurance on the $1,000 loan. Ida agrees and sets a figure of $50 per year to insure that loan.

Effectively, Insurer Ida is placing a bet that Borrower Bill will make the payments back to Loaner Jim. Insurer Ida even made sure to check Borrower Bill’s credit rating and determined that it was outstanding. What happened here? Insurer Ida wrote a credit default swap, which is an unregulated derivative. This derivative was created by JP Morgan way back in 1995.

Oh, but then some problems occur with Insurer Ida’s business and she isn’t even in a position to pay Loaner Jim the $1,000 in the event that Borrower Bill goes belly-up. Now, the premiums paid have vanished. Soon thereafter, credit agencies discover the problem and tell Insurer Ida to find some new infusion of cash or her credit rating will take a hit. When Insurer Ida can’t do this, her credit rating takes a direct and devastating hit and she goes bankrupt.

Now, Loaner Jim is in big trouble. The debt which was previously insured no longer is. Loaner Jim, as a result, gets downgraded by the credit agencies. Loaner Jim is in such bad shape that he now has to declare bankruptcy. Of course, by this time, Loaner Jim has gotten in on the credit default swap action, having written countless "policies" of his own on many debts owed to his friend, Buddy Bob. When Loaner Jim’s business collapses, pressure then falls on Buddy Bob and, like a snowball rolling down a very long hill, the cumulative effect is devastating.

How is it that things unfolded this way? Well, it would appear that the ratings used to assess each other’s debt-worthiness was farcical. Everyone took a chance, a gamble, an extreme risk and the proverbial chicken is coming home to roost… and not in a good way. Not good at all.

Where does AIG fall into this equation? Well, AIG apparently wrote $78,000,000,000 worth of credit default swaps.

Oh, but it’s not just AIG. Many financial and insurance companies used these derivatives not just to insure against defaults, but to bet on whether or not other companies would fail. These swaps were used to in an effort to make money and not simply as the insurance policy as originally intended.

From the Time Magazine article on March 17th, the scope of the issue is laid out in stark detail:

The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country’s credit crisis.

It cannot be ignored that this was allowed to happen by a government run by politicians whose bank accounts were fattened with the generous donations from big bankers and insurers. They looked the other way.

A default on simply 10% of the above detailed $45,000,000,000,000 would mean certain economic disaster. Even more scary news?  It’s all but certain to take place.

The scariest news of all?  The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars. This was made possible by the fact that these "insurance policies" are unregulated.  So, the reason that all of this betting was permitted to go on was because there was nothing in place to stop them.  No regulation.  No oversight.  No nothing.  Considering that the gross domestic product of all the countries in the world is only about $60-trillion dollars, the potential for an economic disaster of epic proportions is far more likely than anyone cares to admit.

While everyone seems to have their sights set on AIG… the real culprits here are the people in Congress.  Congress made back room changes back in February which allowed the bonuses to be paid by AIG (which were known and permitted by members) despite all of the debate and discussion on Capitol Hill.  Now, everyone is denying responsibility, even those who are chairing the committees responsible for the changes.  The denials and finger-pointing are nauseating and we can only sit back and watch our pockets continue to be picked by all of those responsible for doing what happened and worse - allowing it to happen.

Now more than ever before, radio and television advertising is flooded with ads purporting to resolve your debt and credit issues.  Are these debt settlement firms a panacea or another pitfall?  If you’re not careful, you will find yourself not climbing out of the financial hole you’re in, but digging yourself deeper into debt.

Credit counseling is a good way to get started.  You will find most reputable agencies are working with clients to ensure that your income matches your expenses at a minimum.  Ideally, you want your income to exceed your expenses, but you need to get to break-even before taking the next step.  It starts with curbing your spending.  It moves onto establishing a solid budget in order to get income and expenses into balance.  Moving beyond that - the work begins to initiate meaningful savings plans.

For those in the most serious situations, many firms now offer a fee-based debt management system to help the client restructure and repay their obligations.  These are most often offered on a percentage basis or a monthly fee basis with you, the client, paying money to the debt management firm.  From that, they pay your obligations and take their cut.

So what’s the pitfall?   Too many people are still using their credit cards.  They’re not budgeting for anything.  They throwing good money after bad, bridging the gap on one end of the equation with the "help" of the debt management company while still supplementing their income with credit card spending.  Not good.

The lure of an attractive advertising campaign can be strong.  The television or radio extends its imaginary hand, promising to "eliminate your debt."  It’s hard, when you’re drowning in a financial morass, not to reach out and grab hold of that helping hand.  Truth be told… anyone claiming to be able to "eliminate your debt" is highly unlikely to back up that promise.  Negotiate new terms on your behalf?  Probably.  Consolidate your debt into "one manageable monthly payment?"  Sure, if you stop increasing your debt load.

Never forget, you can always go to your Better Business Bureau in order to ascertain the quality of the firm you are intending to use.  You will see the firms’ ratings with regard to overall level of service and customer complaints and are awarded a letter grade of A+ (being the best) to F (for failure).  You must use due diligence!

Other typical pitfalls and issues to avoid:

• Companies that offer you a document that claims to absolve you of all of your debt.
• Companies that charge fees "up-front" or fees that are unreasonable steep.
• Lenders can still sue you even though you’re hoping to settle.
• The process can take several years to accomplish, with the industry average being about 36-months.
• This will negatively impact your credit and debt interest will continue to accrue during the process.
• Companies that advise you to stop communicating with your lenders or stop making payments to your lenders.

Tips and information for you:

• Always communicate with your lenders.  The worst thing you can do is cut them off.
• Find a firm that is certified with the National Foundation for Credit Counseling.
• Lenders would rather get something instead of nothing.
• You will probably have to pay income tax on the amount of the forgiven debt.
• Do not sign any contracts or agreements until you’ve read and understood them completely.
• Check the laws in your state - some, for instance, prohibit the collection of fees earlier than "half-way" through the process.

Most importantly, client beware. As with any industry, there are plenty of bad apples out there who will make your situation potentially far worse.  Emails and websites tout a way to consolidate bills into one monthly payment without borrowing; stop credit harassment, foreclosures, repossessions, tax levies and garnishments; wipe out your debts; or rid bad credit. These offers often involve bankruptcy proceedings , but they rarely say so.

Proceed with caution.

A mathematical formula is used by the three different credit bureaus located in the United States of America in order to help determine an individual’s worthiness when it comes to credit. This is, in turn, used in order to determine how much money an individual might receive when it comes to a loan or whether or not they are worthy of receiving something such as a rental apartment or home in which to live. The newest way to measure credit is using the FICO system. Using this system, an individual can have a credit score that falls within the range of 350-850. In your credit report, your previous actions are calculated in order to make up specific percentages which make up your total credit score.

Credit Inquiries: 10% - This does not include your personal inquiries of your own credit report.

Types of Credit Used: 10%

Credit History Length: 15%

Debt to Income Ratio: 30%

Payment History: 35%

All of the loans, debt, credit cards and billing accounts that you have should be included on your credit report. You can get a feel for how good or bad your credit score is by looking at you credit inquiries, credit used (typically either revolving or installment), length of time that you have been building up your credit, your debt ratio (which looks at how much money you are bringing in as an income and how much money you are spending as debt) and the history of the payments that you have made/are making.

Not all things stay on your credit report forever. While these old factors can often be accessed, most of the time companies or individuals who are making inquiries about your credit are not going to look that far back, beyond the current credit page. Bankruptcies, in the United States, are on an individual’s credit report for seven years. Typically, after this time, the bankruptcies will not be easily visible any more. Even though these things may not be on a person’s credit report seven years later, there is the chance that the information will be factored into their overall credit score.

There are a number of ways to get your credit report. One of the easiest and most affordable ways to do so would be to go to www.AnnualCreditReport.com. By using this site, which is backed by the Federal Government of the United States of America, individuals can get a free report from each one of the three credit bureaus, once every twelve months. However, once you get the report it can be slightly confusing. It’s not just a simple number like they show on television. Here are some hints for decoding your report:

There are negative credit indicators and positive credit indicators. On your report, you will see how many potentially negative indicators you have on your credit report and how many accounts you have that are positive or in good standing.

There are a number of codes that are made up of a letter and a number. These codes are made up of R1, R2, R3, R4, R5, R6, R7, R8, R9, I1, I2, I3, I4, I5, I6, I7, I8 and I9. R stands for revolving credit and I stands for installment credit.

The numbers indicate the payment schedule. 1 means the payment was never late, 2 means the payment has been 30 days late, 3 means the payment has been 60 days late. The numbers continue to go up and the corresponding increments are 90 days, 120 days, that payments are being made under the wage earner plan, repossession and charge off.

In recent years, additional numbers and letters may be found. The letter O is the code for ‘Open’. The number zero (0) is code for approved, and 1 is paid as agreed. In this version, the FICO version, the numbers 2-8 correspond to the numbers stated for 1-8 in the previously created code.

In the FICO version, the number 9 corresponds to being charged off because of bad debt. J stands for Joint, I for Individual, U for Undesignated, A for Authorized User, T for Terminated, M for Maker, C for Co-Signer, B for on the Behalf of another Individual and S for Shared. This version is quickly becoming the more popular way to code credit reports.

You may be initially nervous about writing a credit dispute letter. Of course, you want it to sound professional, but you do not want it to come off as pretentious. By using plain language and being honest, you can easily and quickly whip up a respectable and effective credit dispute letter.

Get the Address for the Complaint Department:

In order to make sure that your letter does not get passed around from department to department, address the letter to the complaint department within the credit bureau that you are contacting. This is a quick and easy way to speed up the process of your letter and your complaint getting addressed by the credit company.

Know the Format for a Business Letter:

There is a formal way to write a business letter. This includes your contact information and date on the upper right hand portion of the letter, the company’s information on the left hand side underneath the lines used for your contact information and the body of the letter following the common phrase “To Whom it May Concern:”. In order to help with this, there are a number of business letter templates online you can locate using your favorite search engine and the phrase “business letter template” or “credit dispute letter template”. Try looking at Microsoft’s® community sample letter at http://office.microsoft.com/en-us/templates/TC300005241033.aspx.

Include a Copy:

Make sure to add a copy of your credit report to your letter packet. Do not include the original credit report because if the mail gets lost, you may not get it back. This will also make sure that the complaint department can see what you are concerned about in the report.

In the Body…:

Don’t be vague in your letter. Make sure that you include the specific concerns that you have. In your packet to the complaint department, make sure to include a copy (NOT THE ORIGINAL) of your credit report. Highlight, circle or otherwise mark the concern that you have on the copy of your credit report so that the complaint department can easily identify and locate your concern on your credit report.