A great primer on Derivatives from Sepetmber 30

Fortune magazine via money.cnn.com via Elaine Supkis:

The $55 trillion dollar question

The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster?

By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter

Last Updated: September 30, 2008: 12:28 PM ET

(Fortune Magazine) -- As Congress wrestles with another bailout bill to try to contain the financial contagion, there's a potential killer bug out there whose next movement can't be predicted: the Credit Default Swap.

In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG (AIG, Fortune 500), whose calamitous descent itself was triggered by losses on its CDS contracts (see "Hank's Last Stand").

And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation.

"The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe."

***

AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.

Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract.

And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)

You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.

Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.

The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.

***

ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.

"It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."

***

THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."

This is not an academic concern. Wachovia (WB, Fortune 500) and Citigroup (C, Fortune 500) are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some CDOs. The specifics of the spat aren't important. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?

That's one element of what's known as "counterparty risk." Here's another: In many cases, you don't even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties. Investment firms assert that transfers are well documented (a claim that, like most in the world of CDS, is impossible to verify). But even if that's true, you're still left with the fact that a given company's risks are being dispersed in ways that they may not know about and can't control.

It doesn't help that CDS trading is a haphazard process. Most contracts are bought and sold over the phone or by instant message and settled manually. Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks. Pushed by New York Fed president Timothy Geithner, the players have been improving the process. But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that "there were $1 trillion worth of swaps that were unsettled among counterparties."

Trade settlement is not the only anachronistic aspect of CDS trading. Consider what will happen with CDS contracts relating to Fannie Mae and Freddie Mac. The two were placed in conservatorship on Sept. 7. But the value of many contracts won't be determined till Oct. 6, when an auction will set a cash price for Fannie and Freddie bonds. We'll spare you the technical reasons, but suffice it to ask: Can you imagine any other major market that would need a month to resolve something like this?

***

WITH WASHINGTON SUDDENLY in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. "The market is here to stay," asserts Cawley. The question is simply: What sorts of changes are in store? As this article was going to press, SEC chairman Christopher Cox asked the Senate to allow his agency to begin regulating CDS - mostly, it should be said, to rein in short-selling. And the SEC separately announced that it was expanding its investigation of market manipulation, which initially targeted the short-sellers, to CDS investors.

Under other circumstances, Cox's request might have been met with polite silence. But the convulsions over the mortgage bailout are so dramatic that they are reminiscent of the moment, soon after the Enron scandal, when Congress drafted the Sarbanes-Oxley legislation. The desire to blame short-sellers may actually result in powers for Cox that, until very recently, he showed no signs of wanting. Should legislators wade into this issue, the measures most widely seen as necessary are straightforward: some form of centralized trading or clearing and some form of capital or reserve requirements. Meanwhile, New York State's insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some (but not all) CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law - requirements that would probably drive many participants from the market. Whether CDS players will find a way to challenge the rules remains to be seen. (ISDA, the industry's trade group, has already gone on record in opposition to Cox's proposal.) If nothing else, the New York law may provide additional impetus for the feds to take action.

For now, the biggest impact could come from the Financial Accounting Standards Board. It is implementing a new rule in November that will require sellers of CDS and other credit derivatives to report detailed information, including their maximum payouts and reasons for entering the contracts, as well as assets that might allow them to offset any payouts. Anybody who has tried to parse CEO compensation in recent years knows that more disclosure doesn't guarantee clarity, but any increase in information in the CDS realm will be a benefit. Perhaps that would limit the baleful effect of CDS on (must we consider it?) the next disaster - or even help us prevent it.

First Published: September 30, 2008: 11:34 AM ET

Elaine Supkis has some good news for banks

...and some frightening news about the relationship between China and the US.

(Elaine's blog has become the first blog I check every day.)

Elaine Meinel Supkis in Money Matters:

Last month, Vohs wrote:

The yield difference between 10-year treasury notes and 30-year conventional mortgages is closing in on the 22 year high reached in March. This means that conventional mortgages have not been this profitable since 1986. Naturally, this reflects the distressed state of the housing market, but it also reflects the reward that can be reaped by well financed and prudent lenders. I still believe that the greatest returns for the remainder of this year can be found in the banking sector. Every excess dollar that does not go into consumption and therefore go to Asian economies, will stay in the country and will be used to pay off debt. The great unwind will benefit the banks.

The destruction of the Derivatives Beast and its feeders and enablers will definitely benefit NORMAL banks. Traditional banks run the less-profitable, old-fashioned way will be back and stronger than ever. They do have to fear everyone pulling all money out of all banks. I see people online shrieking that we all should pull our money out of all banks. This will definitely destroy the system. But we must not panic. For the people involved in this mess are very specific and easy to arrest. They are sitting in the offices of all the top investment banks listed at the MarkIt site. Some of them took their golden parachutes and jumped out of the magical flying piggy bank. But we know where their palaces are and they, too, can be arrested. If offshore, we can use our navy and air force to run them to ground.

Here is an anonymous but very astute take on all this from China:

How China could wreck the US economy

The recent bailout package being approved in the US Congress needs to be viewed in the context of the spurt in the accumulation of forex reserves of China by about $500 billion in the last six months to about $2 trillion in aggregate.

This gargantuan build-up of forex reserves by China has strangely received very little attention of economists, policy analysts, currency traders and, of course, geo-strategists around the world.

Why is China engaged in this exercise? What could be its implications on the on going global financial crisis? Could China trip the bailout package announced by the US last week? Crucially what are the implications for the existing global order?

What is intriguing in the Chinese forex reserve build-up is that both trade surplus and foreign direct investment account only for a part of this gargantuan pile. After adjusting for all known sources of reserve accretion, experts conclude that approximately an excess of $200 billion could have flown into China as 'hot money' -- read inexplicable flow of funds -- in this period.

The Economist -- in one of its issue in recent months -- quotes Michael Pettis, an economist working in China, who explains how and why hot money flows into China. According to Pettis, hot money comes into China when companies overstate FDI and over-invoice exports.
*snip*
What is worrying the Americans is that China accounts for about one-fourth of the global forex surpluses and are the counterparts of the US current account deficit. Put simply, while China accumulates forex reserves, the US accumulates a corresponding debt. And the Americans are aware that it is the Chinese are the biggest accumulators of the US treasury bonds.

What is indeed intriguing is that a country -- the US -- that prides on being 'independent' of other countries, especially in security affairs, is now caught in a quagmire as it has to be constantly in the good books of the Chinese government if it wants to avoid a sudden shock.

Countries that hold large US dollar denominated forex reserves have a powerful tool in their arsenal -- they could wreck American financial markets at a mere click of a mouse by selling their dollar holdings. Imagine China with a holding nearly $2 trillion worth of treasury bonds seceding to sell the same overnight.
*snip*
All this is not pure economics as it is made out to be. Rather, it was and remains a well-planned economic, political and military strategy of the Chinese

Sounds like this guy knows me! Heh. And yes, this is a very well-planned strategy of the Chinese communist leadership! They hatched it long ago and I witnessed the egg laying. I warned the State Department, I tried to get this talked about on TV since 1986 and I am totally locked out of the system because the guys who are busy destroying our nation for the Chinese don't want to hear this. They want to believe they are NOT traitors but great patriots who just happen to be lining their own pockets.

Which was part of the Chinese plan. Alas, I must have talked too bitterly about how easy it is to bribe US negotiators, politicians and officials! Well, we walked into this trap, ourselves. We can't blame the Chinese for taking advantage of our own moral failings. Time for us to grow up and behave.

After we kill the Derivatives Beast and arrest all the bankers who created this monster.

Elaine Supkis explains why Insurance can promote Recklessness amongst the Reckless

Elaine Supkis at Money Matters:

Ron Paul: Buying bad debt is the wrong solution

(CNN) -- Paul: Well, we need to do a lot, but a lot differently. We have to recognize how we got into this problem. We have too much debt. We have too much malinvestment.

Roberts: OK, OK. So we recognize all of the things that got us here. But, right now, today, what would you do, if not this bill?

Paul: You have to liquidate those mistakes. Those mistakes were made due to monetary policy. So you have to allow the market to adjust prices downward. And that's what we're not allowing to do.

If there are too many houses and the prices are too high, the sooner we get the prices down to the market level, as soon as we quit trying to encourage more housing -- this is what we're doing. They're trying to stimulate houses and keep prices high. It's exactly opposite of what we should do.

So, we should get out of the way and not buy up bad debt. There's illiquid assets, but most of those are probably worthless. They're mostly derivatives. And we're sticking those with the taxpayer. So we have to recognize that the liquidation of debt is crucial. And if we did that, we would have tough times, there's no doubt about it, for a year. But if we keep propping a system up that's not viable, we're going to have a problem for decades, just like we did in the Depression. That's what we're on the verge of doing.

[. . .]

Roberts: So what do you then think of this idea of raising the limit on [FDIC] insurance to $250,000, from its current cap of $100,000?

Paul: Well, on the short run it will calm the markets. People will feel better. I might even personally feel better for a week or two.

But I know that long term, it's the wrong thing to do. I opposed this in the early '80s when they went from 30 [thousand dollars] to 100 [thousand dollars], saying it would lead to more problems like this with malinvestment. It would cover over the mistakes. And the same thing will happen.

But if we raise it to 250 [thousand dollars], people are going to feel better, then it will keep the bubble going for a little while longer and putting more pressure on the dollar. If the dollar lasts longer, then finally the world will give up on the dollar -- and then we will have a big problem that nobody has even really begun to think about.

Roberts: A lot of people might hope that you're wrong with your projection.

Paul: I do too. I hope I'm wrong.

Roberts: You tend to be right on these things on occasion, though. Dr. Paul, it's good to talk to you. Appreciate it.

Ron is right about insurance. There are several important things to remember about insurance: too much makes for recklessness. For example, if people get unlimited insurance to build on earthquake or tsunami zones, they will cheerfully build flimsy stuff in these places. If homeowners have unlimited insurance to build in tornado or hurricane zones, they will ignore Mother Nature and pile on expensive and totally hopelessly functional buildings in these zones. It is OK to build where things can be destroyed! But to ask everyone to PAY for the mess is totally wrong in the long run. There has to be limits or everyone will be reckless and bankrupt any system doing this too much.

There has to be a price to be paid! During one housing collapse, from 1974-1980, many building owners would pile on insurance on a building and then hire arsonists to torch them. Much of NYC saw arson this time frame. All it took was passing a law concerning insuring buildings too much and it stopped. So here we are, across the planet, frightened governments are insuring more and more bank accounts...NO MATTER HOW RECKLESS THE BANKERS WERE!

Banks like Wachovia offered high returns on savings because they were being reckless with their lending. Now, people lose their accounts. The government wants to prevent the total loss of savings so they had the FDIC protect the little people of the middle class. But this is being rapidly expanded to protect the rich. This, in turn, encourages them all to be increasingly careless in search of bigger and bigger returns. Balance is lost!

[. . .]

As Cash Leaves, Money Funds Sign Up for U.S. Protection

Less than a week after the Treasury Department announced its ad hoc insurance program for money market funds, some of the nation’s largest mutual fund companies have already announced that they are signing up for coverage.

Those companies include Charles Schwab, Federated, Morgan Stanley, Putnam Investments, BlackRock and JPMorgan Chase. Several other companies said they would most likely enroll before the deadline on Wednesday.

But despite this new government safety net, investors have continued to pull cash out of money funds, especially the so-called prime funds, which have the widest latitude to provide short-term credit to banks and businesses.

According to iMoneyNet, a research firm, almost $80 billion was withdrawn from prime funds even after the new guaranty plan was announced on Sept. 19.
*snip*
All told, money fund assets have shrunk by $100 billion, to $3.33 trillion, over the last three weeks, and prime funds have dwindled by more than $370 billion, to $1.6 trillion.

Damn, they are now insuring PIRATES as well as gnomes! These investment bankers created the Derivatives Beast in order to insure themselves against losses. This is the 'hedging' all the offshore hedge fund hell hound pirates were yapping about all this time. Now that it has turned on them, they are running to our government which they have been bankrupting, seeking safety.

This stinks, big time. All their loot remains offshore! They want to protect this stuff while demanding the government they defrauded spend its energy on protecting them, not us. I remember last year when the US was boasting that all world money was flowing into US based accounts. But this was a lie. The HEADQUARTERS of the pirates were in the US. But the holding points for the loot was all offshore in Queen Elizabeth's pirate coves. The entire system is based on negative wealth flows whereby wealth flows OUT of the US, not INTO the US. This is very significant.

Credit was given to the US so that DEBTS were flowing into the US, NOT WEALTH. This is very simple and to stop it, equally simple. The US navy simply has to sail to all the pirate islands and seize them and the computers there. As well as the postal boxes. Then, locks are put on everything. Then the land forces of the government can enter the towers in NYC and elsewhere and seize the rest. But this won't happen because our government is owned, lock, stock and gun barrel, by these pirates who get their own way at every turn.

This is obvious with the feeding frenzy in DC this week. Once it was decided on Monday that the ONLY way to save our economic system is to let wild overspending slosh over everything combined with making money out of thin air, the top blew on this volcano. Note that there is now NO regard whatsoever to balancing any budgets even slightly. Instead, the feeling is, 'Hey, let's go all the way! WHO CARES? We have infinite credit!'

Zurichers Say UBS `Won't Go Bankrupt' Like Swissair

(Bloomberg) -- Hartmuth Wetzel stood in front of UBS AG's headquarters in Zurich, watching a flat-panel screen through a window for signs of a rebound in the Swiss bank's shares.

``UBS won't go bankrupt,'' said the 65-year-old industry consultant, who was debating the financial crisis in a crowd of mostly middle-aged men nervous about the fate of Switzerland's largest bank. Wetzel said the stock had already fallen too much for him to sell it, and besides, he has his cash in the bank. ``That's my hope.''

Writedowns of $44 billion, the most by any European lender, helped cut 70 percent off UBS's market value from its peak last year and eroded confidence in the country's third-largest private employer, which traces its roots back more than 150 years. UBS, which says the three keys in its corporate logo signify confidence, security and discretion, this year reported the first outflows of client assets in almost eight years, driven by Swiss customers.

When the gnomes of Switzerland sold a huge amount of their gold reserves, I said, 'This is the end of Switzerland as a great banking power'. And so it goes. They wanted to prove that gold was useless. Instead, they proved themselves useless.

Latin America Economic Boom Threatened as Credit Freeze Deepens

(Bloomberg) -- Latin America's fastest economic expansion in 30 years may be coming to an end as the global credit crunch stunts investment and squeezes demand for the region's commodities.

``We're in a serious economic crisis,'' Colombian Vice President Francisco Santos said in an interview in his Bogota office. ``Financing is going to get scarcer and scarcer, and that means that investment is going to be difficult to attract.''

The region's growth in 2009 may be cut to less than 3.3 percent, from 4.6 percent this year, according to economists at Barclays Capital. The slowdown will make it harder to further reduce poverty that's fallen to its lowest levels since before the ``Lost Decade'' of the 1980s in which countries borrowed more than they could repay.

All bubbles are the same. For the last 500 years, we have a clear record as to how they develop and collapse. Yet no one learns. Even when people swear they will be sober and careful, once some great banking power decides to run riot, they all run riot. The present bubble popping started in China, not the US. China, not the US, decided to raise reserve ratios of the bankers. China, not Europe, decided it was time to push down the wild stock markets.

This has changed the flows of the planet and the frantic efforts to keep this bubble from popping is just making things worse, not better. We KNOW how this will end: all the profits of the bubble economy must be eaten by one of the divine beings who control our fates. We can't keep it. The INFRASTRUCTURE this built will remain if we don't go insane and destroy all if it, too, in massive world wars. But History gets the last laugh. Humans nearly always destroy this in massive wars when bubbles pop! We can't help ourselves. This is because we are not only a species that likes to build, we are killers who like to destroy.

Watch any child playing at building blocks or sand castles. Always, the child or its playmates end up knocking it all back down.

Derivatives—what the heck are deriviatives?

Here is the most simple explanation of derivatives I've found. Apparently others have also thought so, since I've seen this link in several places.

Keep in mind that this is written by someone who wants to convince you to follow his "Turning in flation into wealth" program.

Nonetheless, it actually made the whole mess sound logical and, in an unregulated economic environment, relatively inevitable.

A tiny part of the beginning of it, worth seeing simply because of the great graphic:

Daniel R. Amerman, CFA, InflationIntoWealth.com

The Rapid & Dangerous Collapse of AIG

“The particular risks that brought the company (AIG) to the brink of bankruptcy seem to lie not with its core insurance businesses but with its derivatives-trading subsidiary AIG Financial Products. AIG FP, as it's called, merits a mere paragraph in the nine-page description of the company's businesses in its most recent annual report. But it's a huge player in the new and mysterious business of credit-default swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad.”

Time, September 17, 2008

On September 1^st, few knew that AIG, the largest insurance company in the world with over $1 trillion in assets, was in deep trouble. By September 12^th, the rumors about major trouble were everywhere. By September 15^th AIG’s corporate life expectancy was being measured in days, and the question was: bankruptcy, buyer or bailout? By the evening of September 16^th, the federal government had massively intervened, making an $85 billion loan to AIG in exchange for a controlling 79.9% equity share of the company.

Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.

How great is the real danger? The bulk of the remainder of this article explains the extent of the danger. With a few market changes, this is the credit derivatives primer as published on May 2^nd of 2008. There is also new material at the end of the article, talking about what could be anticipated, and introducing some solutions.