Something I have not spoken about, because I considered it tangential to the root cause of the current problems with the financial system, is the role of Credit Default Swaps. Although the real problem is that people essentially counterfeited money, credit default swaps were sometimes used as part of this process.
A credit default swap is a bet on some outcome. It can be legitimately used as a form of insurance against a negative outcome. For example, it was possible to buy a credit default swap as insurance against a piece of debt defaulting. In other words, “I’ll pay you a premium now, and if that debt over there becomes bad, you pay me the money I would otherwise have lost”.
Unscrupulous dealers bought credit default swaps on risky debt, so that they might sell that debt to other people as “good” debt. Unscrupulous insurers sold the insurance on the debt, thinking that they would simply refuse to pay if too much debt went bad. Some honest insurers sold legitimate swaps, but they we not aware of how risky the debt was that they insured.
Regardless of how honest people were when the transactions were made, when enough debt defaults, it is simply not possible for the insurers to pay without going bankrupt. And, everyone insured everyone else. So, in the end, the swaps neatly tied together a large number of companies in a net that insured that if enough parts of the net went down, the rest of the net would be dragged down with them.
In the context of the current crisis, the real problem with credit default swaps is that they tie all the dominoes together in a non-obvious way. Dominoes no longer need to be next to each other for a collapse to spread through the system.
For more context and background, this article is pretty good: http://www.newsweek.com/id/161199
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