Here’s a riddle for you…

What product is often compared to insurance by experts even though other experts make a point of saying it shouldn’t be confused with insurance?

What product’s market is said to be worth seventy trillion (yes, trillion with a “t”) dollars even though no one knows how much the product is actually worth?

What product’s market has been completely devoid of regulation even though experts had been cautioning that its crash was impending–and that said crash would have massive repercussions?

Give up?  The answer is the credit default swap.

If you’re like me and virtually everyone else in the world, you may have heard this term once or twice in passing over the past several years only to see it in the headlines almost every day for the last several months.

And, if you’re like me, you could probably use a hand making sense of the discussion surrounding credit default swaps.  Let’s see if we can break down this complicated financial instrument so it all make a little more sense…

Defining a credit default swap isn’t that tough.  Lil’ ol’ Wikipedia actually does a good job of laying it out:

A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults CDS contracts have been mistakenly compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if a specified event occurs. However, there are a number of differences between CDS and insurance; the buyer of a CDS does not need to own the underlying security; in fact the buyer does not even have to suffer a loss from the default event.

That gives you an idea of what a “CDS” is, but it doesn’t really explain why they exist.  We can turn to Investopedia (that’s two “pedias” in one post, kids!) for a little context:

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Which brings us to a more pragmatic consideration.  Who, specifically, has been using credit default swaps and why have they been doing it?  Time Magazine explains it rather nicely, even though it does tread on the wrong side of the Wikipedia definition’s admonition against making a comparison with insurance:

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It’s supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

Now that might not seem like the biggest deal in the world when you consider the scope of the overall economy, but it actually is one of the biggest things out there.  The CDS market was a seventy trillion dollar business.  And almost 40% of it is in the hands of major financial institutions.

So, why is that a bad thing?  Sure, there’s a lot of money in the CDS market.  That, in and of itself, isn’t a problem.  What’s the problem?

There are several.

First, a lack of regulation/oversight/rule-making/whatever led to a very serious problem in the credit default swap biz.  Namely, people started trading these instruments back and forth with no one really bothering to consider whether the people taking on the risks associated with the swaps actually had the means to make good on them in the event of a default.  That wasn’t a well-known problem until…

Second, (you guessed it)  defaults started happening.  You can blame that on the subprime mortgage crisis or any of the other potential explanations for our journey into the land of recession.  The fact of the matter, however, is that defaults started springing up and the folks who were supposed to be able to cover the associated costs have been coming up short.

Third, these defaults and the failure of credit default swaps is giving banks a good reason to reconsider some of the bond lending and other investments they were willing to make earlier.  All of that talk about a credit freeze is starting to make sense, isn’t it?  As the aforementioned Time article noted, ” this could impact everyone from mortgage-seekers to municipalities that need money to fix roads and build schools.”

Fourth, there’s this even bigger problem of a potential domino effect.  You see, all of that crazed CDS trading, in hindsight, seems a little divorced from reality.  Consider that one expert explained that those who own default swaps don’t even know what they’re worth.  No one does.  No one has any good idea to figure that out, either. That led him to ask a very important question:

How does a global financial system work when you don’t know how to value assets?

The answer is scary because a global finance system may not be able to work at all under those circumstances.  Remember, we’re talking about seventy trillion in investments.  Thus, one columnist stated:

It could take years of litigation to figure out who owes whom what. The fear is that once the system starts failing, there will be “cascading defaults” and because the CDS market is so huge, its failure threatens the whole global economy.

I know this post is a little heavy on the doom and gloom.  It’s worth noting that not everyone shares the perspective that the CDS market’s unraveling will lead to all of us living like Man and Boy in The Road.  Whether they believe that letting the market run its course or appropriate interventions can stop the “cascade”, there are people from all economic and political persuasions who do see a way out.

Let’s hope one of them is right.

And that we follow his or her advice.