From the ‘why we’re fucked’ file, here’s a great little sample from a lengthy thread over on metafilter covering what’s up with credit default swaps:

20Rafaelloello, yes, that is true, but as I understand it, most holders of CDS have them hedged off to someone else. …”

In (most?) lines of insurance you cannot take out a policy unless you have an insurable interest in the asset or life. In CDS’s there was no requirement of this.

Somebody buys Rafaelloello’s mortgage, they want to hedge that risk with a CDS, fine.

5,000 other investors say, “Hey Rafaelloello hasn’t missed a mortgage payment, I want to “insure” that he continues to pay.”

Then 5,000 more say, “I’ll take that bet, because even though it looks like he’s going to continue to pay, I can hedge my bet that he wont…” Enter the next 5,000 “investors”.

Before you know it, Rafaelloello is the equivalent of a top-ranked college athlete. Tens of millions of dollars are being bet on my ability to perform, with no direct ties to the underlying assets (My home and my ability to pay).

You’re only hedged as well the ability of all parties to pay their bets/bookies/vigs obligations. In this ring of hedges it only takes a player or two to skip town and the whole game implodes.

The rest of the thread is over here, and it’s well worth a look if you’re trying to grok what’s going on with the financial system. I’ll repeat my oft repeated assesment though – in layman’s terms, it was a giant fucking ponzi scheme.