Let's think a little bit about why
credit default swaps, or famously
referred to by Warren Buffett as financial weapons
of mass destruction.
At the center of it-- and there's
not just one credit default swap writer,
but I'll put one in the middle because each of them
are writing many, many credit default swaps.
AIG is the most famous.
But you have some writer here.
They're given some good credit rating.
Maybe in the past that credit rating
was actually earned by a credit rating agency.
And then frankly, the credit rating agency
got a little sloppy and really wasn't willing to downgrade
them given all of the credit default
swaps, all of the obligations they are taking on.
And as you could tell, I kind of view these guys and these guys
as the main culprits, and maybe a little bit
of the regulatory agencies saying, hey, look,
these guys are writing insurance.
Maybe we should actually regulate them.
But with that said, you have companies over here.
I'll do the companies in this pink color.
And they want to borrow money from other parties,
let's say, investors.
I'll do the investors in this orange color.
So the investors are lending them money.
The companies give them interest.
So investors lending money, giving interest, lending money,
giving interest, lending money, giving interest.
And then these investors-- it seems pretty reasonable--
say, hey, look, there's a guy over here with a double A
rating.
The people that we're lending to don't have a double A rating.
Maybe this guy has a B, maybe this guy has a double B,
maybe this guy only has a single A. And so he says, look,
I want to be completely safe here
so I'm going to pay a little bit of a premium
to AIG or to the writer, whoever the writer is,
and in exchange I will get insurance on this debt.
And it seems pretty reasonable except for the fact
that this player right over here did not put out any money aside
or did not put the appropriate amount of money
aside to properly account for all of these liabilities, all
of this risk that its taking on.
And also, all of these risks are correlated.
You can imagine a situation where the economy goes bad.
Now, all of a sudden this company defaults
on its debt and this company defaults on its debt.
In fact, when the economy's good,
it's likely that very few of these companies
are going to default and when the economy goes bad,
it's likely that many of them will default.
But the real problem is is as soon as these defaults start
happening, then the credit default swap writer
is going to have to actually start paying for the defaults.
They'll get the bad debt and in exchange they'll
make the other side of the credit default
swap, the holder of it, they will pay to make them whole.
And so this could take them out of business.
And all of a sudden, the people over here
who thought that they had insurance no longer do.
And they might actually say, wait,
I can only hold double A debt and they might actually
have to dump this debt on to the market.
Even worse, you have all of the people over here
who didn't lend any money to anybody,
but they really just wanted to make side bets.
Either the side bets might have been pure directional bets
on the state of the economy saying,
hey, I think a bunch of companies
or I think this company in particular
is going to default on its debt, and they too
could get credit default swaps really as just side bets.
So just for maybe this right here is $1 billion in debt,
maybe all of these parties took side bets on this guy.
So even though there's only $1 billion of debt here,
there might be $4 or $5 or $10 billion
worth of insurance on that $1 billion bet.
So if all of a sudden this one company
can't pay its $1 billion, now AIG is on the line
not for $1 billion, but for $4 or $5 or $6 billion,
however much it insured it for.
So it allows people to insure for things
that they don't have the offsetting liability for.
And so you can imagine, some of these people--
if this guy fails will just take a loss and that's bad and all
of the rest because they were expecting that they
wouldn't-- but some of these players might have had
offsetting hedges.
The only reason why they might have felt comfortable
taking on some other liability is
they said, look, if the economy goes really bad,
I have this insurance over here.
And they did that transaction with another third party.
Now all of a sudden, if the economy goes bad
and these guys say, hey, look, I'm in a lot of trouble.
Good thing I have this credit default swap,
but then it turns out that they don't because the counterparty
here fails, the credit default swap writer,
now all of a sudden this guy becomes insolvent.
But this guy was dependent on this guy paying
and he thought he was good because he even looked
at this guy's books and said this guy had offsetting hedges,
and now this guy might fail.
And so you could have this entire cascade
through the entire financial system.