An excerpt from page 150, America, the True Origins of the Financial Crisis and the Future of the World Economy”

Credit Default Swaps (CDS)

If Mr. Spock, of Star Trek fame, spotted a CDS and had to describe it to Captain Kirk, he would have said, in his usual expressionless way: “They are insurance policies, Captain, but not as we know them.” CDSs pay out pre-specified amounts of money if someone else defaults. The difference between a CDS and a simple insurance policy is this: to insure your car against an accident, you must first own it. The CDS “market” allows one to buy an “insurance policy” on someone else’s car, so that if, say, your neighbor has an accident, then you collect the money! To put it bluntly, a CDS is no more than a bet on some nasty event taking place – mainly someone (a person, company or nation) on someone defaulting on a debt. When you buy such a CDS on Jill’s debt, you are, to all intents and purposes, betting that Jill will fail to pay it back; that she will default. CDSs became popular with hedge fund manageres (and remain so to this day) for reasons closely linked to the trade in CDSs.

Take, for example, a trader who invests in a risky CDO [Collateralized Debt Obligation]. If our investor undertook (in the good old pre-2008 days) to cover $10 million of default losses on this CDO tranche [a tranche is a slice of the overall deal], he could have received an upfront payment of $5 million, plus $500,000 a year! So long as the defaults did not happen, he would make a huge bundle without investing anything! Not bad for a moments work – until, that is, the defaults star piling up. To hedge against that eventuality, the trader would buy CDSs, which would pay him money if the mortgages in the CDOs he bought defaulted. Thus the combination of CDSs and CDOs made fortunes for traders at a time when defaults on mortgages were rare and uncorrelated. But when the defaults started happening, the issuers of the CDSs were badly burnt: they had to pay impossible amounts of cash to those who had bought them. MBIA’s bankruptcy was the entrée. The American Insurance Group (AIG) was the main course. It was served up when Lehman Brothers failed in September 2008. – its mountainous CDOs were mostly insured by AIG (which had issued CDSs against Lehman’s CDOs).

Afterword: Now the world chokes on others’ defaulted debt. Those who laid out this sick, twisted economic universe profit and prosper mightily. However, the real economy is flattened like a pancake and real people suffer the horrors due to the greed of economic zombies.