Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.
"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.
"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.
"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.
But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side.""Now, who was selling these credit default swaps?" Kroft asks.
"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says.
"These investment banks were not only selling the securities that turned out to be terrible investments, they were selling insurance on them?" Kroft asks.
"Well, it made it easier to sell the terrible investments if you could convince the buyer that not only were they gonna get the investment, but insurance," Greenberger explains.
But when homeowners began defaulting on their mortgages, and Wall Street's high-risk mortgage backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off their obligations.
Bear Stearns was the first to go under, selling itself to J.P. Morgan for pennies on the dollar. Then, Lehman Brothers declared bankruptcy. And when AIG, the nation's largest insurer, couldn't cover its bad debts, the government stepped in with an $85 billion rescue.
Asked what role the credit default swaps play in this financial disaster, Frank Partnoy tells Kroft, "They were the centerpiece, really. That's why the banks lost all the money. They lost all the money based on those side bets, based on the mortgages."
How big is the market for credit default swaps?
Says Partnoy, "Well, we really don't know. There's this voluntary survey that claims that the market is in the range of 50 to 60 or so trillion dollars. It's sort of alarming that, in a market that big, we don't even know how big it is to within, say, $10 trillion.""Sixty trillion dollars. I know it seems incredible. It's four times the size of the U.S. debt. But that's the size of the market according to these voluntary reports," says Partnoy.
He says this market is almost entirely unregulated.
The result is a huge shadow market that may control our financial destiny, and yet the details of these private insurance contracts are hidden from the public, from stockholders and federal regulators. No one knows what they cover, who owns them, and whether or not they have the money to pay them off.
One of the few sources of information is the International Swaps and Derivatives Association (ISDA), a trade organization made up the largest financial institutions in the world. Many of them are the very same companies that created the vast shadow market, lobbied to keep it unregulated, and are now drowning because of unanticipated risks.
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