Saturday, October 4, 2008

The black swan that made all this madness possible...

Credit Default Swaps or... the insurance that was supposed to make Mortgage Backed Securities and Collatoralized Debt Obligations bullet proof..... aka... insurance against defaults.... check this story from Newsweek

"Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit."

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