The Next Big Financial Debacle?

Some experts on a risk management mailing list I'm on are guessing that there's a new finanical bugaboo on the horizon, credit default swaps derivatives, that could make the sub-prime problems look like small change. Two parties enter into an agreement. One pays the other a fixed sum periodically though a coupon bond - which means that the second has purchased the bond from the first. The second doesn't have to pay anything else, and keeps collecting interest over the life of the bond (and, presumably, recaptures the initial investment) unless some pre-determined credit event - such as a debt restructuring, bankruptcy, or a drop in credit rating - occurs. In such a situation, the second party pays a fixed sum to the first and then the entire arrangement is terminated.

The derivates can become a form of credit insurance, with the second party being the insurer. However, they can also allow third parties to speculate on an entity's ability to repay a debt - legalized gambling, I think it should be called. So long as you only have the occasional credit explosion, the system can work. But what happens when you have one comapny after another in trouble? Now you have to wonder whether the insurers actually have the money to cough up - and some of the big players in that market are the very financial institutions that have been pouring money out because of the sub-prime mess.

According to an article in Wikipedia (link above), these are the most widely traded credit derivative product. More so than mortgage-backed bonds. The outstanding swaps currently top $46 trillion - with a t. To add some perspective, the US stock market is only $22 trillion, with mortgate securites hitting a mere $7 trillion. And an article in Bloomberg notes that this is the fastest-growing form of derivative on the market.

This could bear out Warren Buffet's remarks from 2003, in which he called derivatives in general "financial weapons of mass destruction" that could hurt the entire global financial system, and not just the people involved with the specific transactions.