Yet another unregulated and bizarre type of financial device about to fall apart.
They are called “credit default swaps”. Reading about this stuff makes my head hurt, but as I understand it, these are “insurance” instruments whereby the buyer, seeking protection, purchases insurance to protect the buyer in case underlying corporate bonds default. Both they buyer and the seller can sell their rights and obligation under the policy, meaning that neither side to the transaction knows who is on the other side at any given time. Meaning also that the buyer has no idea if the seller has the goods to pay up in the event of default. It is apparently, by the way, unnecessary for the buyer to actually own the bonds in question at any time, until an event of default takes place, at which point they must obtain the bonds in order to surrender them to the insuring party, if they can find them:
For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.
Notice something else in there? There are outstanding policies on debt that far exceeds the actual amount of the debt. So in fact, this is not insurance, it’s actually a sophisticated form of gambling in which, of course, you and I will be the biggest losers. There are $45 trillion, that’s right trillion dollars, or credit default swaps out there. That exceeds the value of all the stock in the stock market.
For reasons explained in the linked article, which I fear I can not accurately summarize, this is a potentially big problem. If the losses could be restricted to the schemers that dealt in these instruments it would be a good thing actually, but of course, it never works out that way.
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