Some of the cutting edge instruments devised to play in today's financial markets are so abstruse that only a small number of people in the world pretend to understand how they work, although that hasn't kept fund managers from vigorously rolling them out on the strength of a phone call here and an email there, completely off the books as far as the regulated part of their business is concerned, and, in the area of credit default swaps alone,
the outstanding value of the swaps stands at more than $45.5 trillion, up from $900 billion in 2001.
[…]
Bear Stearns held credit default swap contracts carrying an outstanding value of $2.5 trillion, analysts say.
—Nelson D. Schwartz and Julie Creswell, NYT, March 23, 2008
Credit default swaps are like insurance for investors against the sort of bad financial moves so often made by debtors, the kind that make it impossible for them to pay back the money they've been advanced by creditors. Except that actual insurance is a relatively regulated market with a long-standing legal obligation to come through for its policyholders, to have the scratch on hand to make good the claims on its policies that can be expected to be handled over time, and the market for credit default swaps, the one Bear Stearns had a 5% share of, has never been put through its paces, and it seems likely that the Federal Reserve, when it partnered with JP Morgan Chase to take down Bear Stearns, did it with an eye toward avoiding the unpredictable but potentially disastrous effects that firm's failure would have on just that market.
James Surowiecki goes on from there in The New Yorker.
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