Credit Default Swaps (CDS) – What Are They?

I thought I knew the meaning of these three words, when taken individually. But when they are put together in this sequence, they convey something I never knew even existed. Some have called them financial weapons of mass destruction. What? Three innocent looking words as weapons of mass destruction? Then I took a look at my 401K and knew right there and then that I, like many others, have been hit by these nasty weapons. In a matter of days $1.6 trillion worth of savings evaporated into thin air. Baby boomers: welcome to the golden years.

Of course, I don’t pretend to understand why and how credit default swaps, all of a sudden, froze the entire global market and drove world leaders into a panic reaction. But the little I know makes me wonder, why some of the things that were allowed to go on were even legal. CDS can be used to ensure a bond you own against loss, which is good. But credit default swaps were also used to allow people to buy insurance for assets they don’t even own. So, if I were the gambling type, I would look for an asset that I believe is on the verge of failure, and buy insurance against it. If that asset fails, as many solid looking institutions suddenly did, I stand to collect the full value of the insurance.

As experts estimate, companies like AIG collected about a trillion dollars in CDS fees while leaving themselves exposed to an estimated sixty trillion worth of liabilities. They saw this kind of insurance as easy money because they assumed the assets people were buying the insurance for would never fail. Well, they failed and they did so in a big way. As bad as it has been so far though, there could be more nasty surprises down the road. Supposedly, it is very difficutlt to quantify the extent of the damage because Credit Default Swaps were sold and re-sold many times over as private transactions. You just don't know until claims are made by people down the chain, only to find out the insurer one level up has no money to cover the claim, and so on and so on.

CDS – weapons of mass destruction indeed. And I have one sorry retirement account to prove it. In "free" market economies, regulation is a bad word associated with "socialism". Now that the lack of reasonable oversight has caused this enormous crash, governements around the world are forced to buy equity in "market driven" businesses - back to socialism. Boy, am I confused?Governments are now rescuing the very people who caused this mess in the first place. The smart but unethical guys have successfully "privatized profits and socialized debt", as concisely put by others. They cash in big when capitalism works in their favor and cash in again when "socialism" kicks in to bail them out with public money. Hey, with no risk to their personal wealth, any amount of risk can be taken with abandon. And that they did.