Remember credit default swaps? The derivatives that some hedge funds (and banks) used to make not-so-small fortunes betting against the housing market. The derivatives that, in the process, multiplied subprime losses, and made it impossible to know just where they'd turn up. The derivatives that sunk AIG.
Yeah, those derivatives.
These "financial weapons of mass destruction," as Warren Buffett called them, turn out to be pretty simple, in theory. Credit default swaps (CDS) are just insurance on a loan. So when you buy a CDS, you're betting against a loan. And it doesn't have to be a loan you made. You can bet against a loan someone else made too. It'd be as if you could take out car insurance on someone you think is a bad driver. So if the loan defaults, you stand to make money. And if there's no default, you just wind up coughing up premium after premium, paying for car insurance on your good driver who never gets in an accident.
What could go wrong here? Plenty. For one, CDS have been traded one-on-one, not over exchanges, so it's been hard to know just who owes what. This opacity was a big part why banks stopped lending to each other during the financial crisis — they didn't know who'd been stuck holding the subprime bag (or if it was them). For another, you could sell more CDS protection than you could ever afford to pay out if everything went bad. (This was AIG's $180 billion mistake). But there are some pretty simple fixes here, and the industry has adopted some of them. CDS trades are now publicly reported, and go through clearinghouses that require collateral. So CDS are more transparent, and it's harder to sell them if you can't afford to pay them.