Credit Default Swaps
How credit default swaps — the financial instruments at the center of the 2008 crisis — work, and why they were called weapons of mass financial destruction.
Imagine you could buy fire insurance on your neighbor's house. You don't own the house. You don't care if it burns down,except that your insurance payout makes money if it does. So you have an incentive to hope it burns. Credit default swaps were that fire insurance, but for bonds. A bank loaned money to a corporation. That created a bond. Wall Street banks then created an insurance product: if that bond defaulted, you got paid. But you didn't have to own the bond to buy the insurance. Anyone could bet on anyone else's debt failing. It divorced the insurance from actual risk. In the early two thousands, AIG became the world's largest seller of this insurance.
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