Cribbed from the NYT

I may be the only one whose head spins when I try to explain to the kids why we are in such an enormous financial mess. Trying to understand more than the basics leads me through the looking glass into fantasy-which is where apparently many bankers were spending their time and our dollars.

"Credit default swaps (invented in the last decade!) is a term that comes up again and again. I'm sticking it up here for my own good as well as for my reader's education. The banks, and other lenders were insuring each others bad loans.

The cynicism of that is remarkable.


Credit default swaps, which were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default -- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised.
In essence, it is a form of insurance. Its purpose is to make it easier for banks to issue complex debt securities by reducing the risk to purchasers, just like the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture.
Here is a more detailed, but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:
"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss.
Read More...
"The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.
"As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."
The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated.
When the mortgage-backed securities that many swaps were supporting began to lose value in 2007, investors began to fear that the swaps, originally meant as a hedge against risk, could suddenly become huge liabilities.
The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety. Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge in late 2007.
Credit default swaps also played an integral role in the federal government's decision to bail out the American International Group, one of the world's largest insurers, in September 2008. The Federal Reserve concluded that if A.I.G. failed and defaulted on its swaps, throwing the liability for the insured securities onto the swaps' counterparties, the result could be a daisy chain of failures across the international financial system.
Hide