Credit Default Swaps: the gentle giant ... for now

One of the most dangerous form of financial contracts popular during our era is an ad hoc form of insurance called a "credit default swap". Some folks label them "derivatives", but that's a misnomer. In a nutshell the specific Wall-Street name refers to a contract to insure, just as a homeowner would sign with a licensed and well-capitalized firm. On paper it makes a lot of sense. A company holding debt wants to ensure that if the debtor defaults an insurer will step in and pay to keep the default from preventing the creditor from recovering its investment. The creditor is willing to pay a premium for this protection. Sounds like homeowner's insurance. What could be wrong with that?

Here's how it works in practice. Company A owns some debt and it's concerned about losing its principal if Debtor B defaults. Debtor B can be a corporation or a municipal or state government, or even a foreign entity. Aside from Lloyd's of London who will write an insurance policy? Someone with a lot more capital and wants to get a piece of the action (the premuim), that's who. Never mind that they're not licensed to insure against this and unregulated. The feds will look the other way if they're paid enough. (Remember how Al Capone bought off officials in Chicago to grow his business as a bootlegger?)
So Company A finds Company C who will make a deal to insure, charging a periodic premuim for the "policy". As long as the insured credit remains solvent there's no problem; Company C collects its premuims from Company A and Company A goes on merrily along believing it has paid to lay off its risk.
What happens though when the Debtor B defaults? Ideally Company C makes Company A whole and life goes on.

But here's the rub. What happens when Company C fails to assess its exposure to payouts and doubles down so to speak, loading up on contracts on the assumption that premuims will continue to roll on in and only a handful of payouts will wash ashore? What happens when a blizzard of defaults blows into town and buries Company C?

This happened in 2008. Insurance giant AIG played the role of Company C. While their suits were partying thinking the good times would never end the good times did indeed end, at least temporarily. They'd bet some of the ranch on red and the roulette wheel came up black.
After getting bailed out, did they make good on their promises to their Company A counterparties or did they just flip them the bird saying "sue us and spend hundreds of thousands of dollars in legal fees and years in court trying to collect" and hope most would assess the ROI and just go away?
I report, you decide.

Epilogue

The market in credit default swaps insures against tens of millions of dollars in default, far greater than the government can "bail out". An eagle-eyed reporter at Time magazine sniffed out the AIG debacle months before it occurred. She'd discovered that not only were insurers like AIG rolling the dice, but big banks were as well:

Indeed, commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps — where they acted as either the insured or insurer — at the end of the third quarter of 2007, according to the Comptroller of the Currency, a federal banking regulator. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active, it said.

When this gentle giant erupts into the financial nightmare from hell, we can forget about federal bailouts.