First, understand that they are already a big problem. From the Washington Post:
"Scarier than the bad mortgages are those unregulated credit default swaps that financier George Soros has been warning about. There are $45 trillion of those esoteric instruments sloshing around the global financial system. They were invented as a hedge against debt defaults, but even the financial smart guys don't fully understand their impact or how to price their real value."
So what are they?- I asked Claire's father. Here's how he explained it to me:
Imagine that Christine (my mother-in-law) borrows 100 dollars from Rufus. In exchange, she gives Rufus a bond pledging to pay back the 100 bucks.
But, Rufus starts worrying about it. Maybe Christine isn't so good with her money. How can he be sure?
So, Claire offers to insure the bond for 20 "basis points", or about 20 cents.
Rufus is still worried, so Claire offers to give Rufus 100 dollars and take the bond. So, now, she could well have $100.20 in the end, which is a decent profit (imagining that she has several of these bonds with the same basis points). Besides, Christine has never defaulted.
But rumors start circulating about Christine. Maybe she really can't pay back the loan. In the end, she has losses of 2%, so Claire is out $2.00 of her own money.
AIG wrote a lot of these policies apparently.
Another thing her father said that was interesting was to relate a comment that had been made to him about two years ago by a friend in the financial sector: "There is entirely too much liquidity sloshing around the world economy right now, and things are all out of balance. But we can be sure that the market will eventually right itself, and when it does a number of big names are going to disappear." That is coming to pass.
Lastly, he said something worth pondering- in most of our lifetimes on earth, there has not been a financial crisis in the western world equivalent to this.