DKos: Evolution of a Credit Default Swap

[deminks]

http://www.dailykos.com/storyonly/2008/11/16/1002/9542/629/660423

(snip)

Stage 1 (Perturbo mutans)
You have just made a loan to someone, and now you're nervous that this scoundrel might not pay. What to do, what to do? Ah, but you need not worry! I happen to have assets on hand that can easily cover your petty loan. What's more, for a small monthly fee, I'll be happy to provide you with insurance of a sort. Should the person to whom you've extended a loan prove unreliable, I'll shoulder the burden -- so long as you keep up the payments. Let's call this insurance a... credit default swap.

In 1999, these credit default swaps already existed, but they were a niche product. Only a fraction of banks employed them and then only on a fraction of loans. Without some knock to the system, swaps would probably have remained a relatively small player.

Stage 2 (Perturbo furtiva)
Knock, knock. In 2000 Republican economic hero, Phil Gramm, with the assistance of a small legion of lobbyists, created the Commodity Futures Modernization Act. Along with ushering in the Enron disaster, this bill provided the one thing that credit default swaps needed to grow and mutate -- invisibility. Thanks to the CFMA, not only were credit default swaps unregulated, they were impossible to observe directly. Like black holes in deep space, you could only spot swaps by looking at how other things acted nearby.

So, now you've made a loan to someone, and you're worried about it. I want to offer you a credit default swap so I can collect the fee. Trouble is, I don't have the assets to cover your loan. So how can I... hold on, credit default swaps are so unregulated that no one says I actually have to be able to deliver on my promise. Hey, over here! Have I got a swap for you, and it's a bargain.

So now the CDS is a means of moving the risk, but the risk is still as high (or higher, since the original lender might have been better able to cover the loss). In fact, credit default swaps have gone from being a risk mitigator, to a risk magnifier.

(end snip)

More stages at the link. A very good description of a CDS and how they truly came about, not the rethuglican rewrite blaming Carter 30 years ago. This is just the CDS, it doesn't delve into the side bets and shorts.

[Morning Dew]

1. good article - thanks!

nm

[wellst0nev0ter]

2. I Laughed And Cried.

I thought we left the Underpants Gnomes Unified Theory of Out-Of-Ass Profit Making in the dustbins of the dot-com boom. But no.

[safeinOhio]

3. I've printed out a bunch of "credit swap" articles

just waiting for the first freeper to cross my path. Hello Rush, dittos, know anything about these swaps?

[Agony]

4. Don't worry, be happy. Cover your ass with the VIX or a LEAP!

Options to the rescue!
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http://www.cboe.com/micro/vix/faq.aspx
1. What exactly is the VIX?
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from wikiP
In finance, short selling or "shorting" is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. Short selling or "going short" is contrasted with the more conventional practice of "going long" which occurs when an investment is purchased with the expectation that its price will rise.
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