Credit Default Swaps (CDS) are one of the primary reasons for the crash of the American financial system. Given their impact, one would expect to see a political backlash against the practice through the various media outlets that report on Washington’s finger pointing, but the backlash hasn’t happened. What reprimands have been handed out have been quietly conducted so that the average taxpayer, now suffering in a broken economy, hasn’t heard about the CDS scandal or its implications. Politicians don’t want taxpayers thinking about Credit Default Swaps because congress is responsible for making them legal after 91 years of their being a felony offense. It is not incidental that Warren Buffett famously described CDS and other derivatives that are bought speculatively as “financial weapons of mass destruction.”
Though there are a number of different varieties of Credit Default Swaps, and all are fairly complex, the easiest way to think about them is that they are like betting without any assurance that either party has the money to cover their bet. The impact of a Credit Default Swap (or a bet) can be collectively illustrated by this simple example: imagine some Company A makes a $1 million bet with Company B that “John Smith” will default on his $200,000 mortgage. When the mortgage is defaulted, Company B owes Company A $1 million. The financial problem, ignoring for a moment the Credit Default Swap, is that the bank holding John’s mortgage is $200,000 out of pocket. The CDS compounds the problem because, not only is the bank out $200,000 but Company B is also out another $1 million. In the end, the $200K mortgage had a $1.2 million impact. If Company B had money on the side specifically to cover the bet, then this financial crisis would simply be Company B’s to handle, but our elected representatives did not bother to ensure that these companies had the money to cover their bets.