Unregulated Credit Default Swaps Led to Weakness

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It's a fair guess that a couple of months ago, few people outside the financial world had even heard the words "credit default swaps." But now the obscure and unregulated financial instruments are shouldering much of the blame for destabilizing the global financial system.

Here's how it works. Let's say there's a guy named Frank and he has a life insurance policy. When he dies, the beneficiary gets a million dollars. Now imagine a whole bunch of other people saying, "I want a million dollars if he dies, too." And so they take out life insurance policies on Frank. Now imagine Frank dies, and all those people bought their policies from the same company. That company, more or less, was AIG.

But the fact that the biggest insurance company in the world was brought down by these unregulated securities might not even be the scariest part. Usually, people who traded credit default swaps did something different from what AIG did — something that was supposed to make them safer, but might possibly have made the whole system more dangerous. They did something called "netting", in which every trade was matched on the other side with another trade, was much more common. The hedge fund would sell protection to Morgan Stanley, say, and buy it from Goldman Sachs. Goldman Sachs, in turn, would sell protection to a hedge fund, which in turn would buy from another hedge fund, and so on down the line.

"If the chain breaks down anywhere where one party does not actually honor their contracts, then the losses multiply rapidly," he says. "It links everybody together in this unholy chain and so what happens is if one party has a problem, then everybody else has a problem."

It's a fair guess that a couple of months ago, few people outside the financial world had even heard the words "credit default swaps." But now the obscure and unregulated financial instruments are shouldering much of the blame for destabilizing the global financial system.

Here's how it works. Let's say there's a guy named Frank and he has a life insurance policy. When he dies, the beneficiary gets a million dollars. Now imagine a whole bunch of other people saying, "I want a million dollars if he dies, too." And so they take out life insurance policies on Frank. Now imagine Frank dies, and all those people bought their policies from the same company. That company, more or less, was AIG.

But the fact that the biggest insurance company in the world was brought down by these unregulated securities might not even be the scariest part. Usually, people who traded credit default swaps did something different from what AIG did — something that was supposed to make them safer, but might possibly have made the whole system more dangerous. They did something called "netting", in which every trade was matched on the other side with another trade, was much more common. The hedge fund would sell protection to Morgan Stanley, say, and buy it from Goldman Sachs. Goldman Sachs, in turn, would sell protection to a hedge fund, which in turn would buy from another hedge fund, and so on down the line.

"If the chain breaks down anywhere where one party does not actually honor their contracts, then the losses multiply rapidly," he says. "It links everybody together in this unholy chain and so what happens is if one party has a problem, then everybody else has a problem."

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