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From NPR News, this is All Things Considered. I'm Robert Siegel. A couple months ago, few people outside the financial world had even heard the words credit default swap. But now, these obscure and financial instruments are shouldering much of the blame for destabilizing the global financial system. Alex Blumberg of Chicago Public Radio's "This American Life," reports on how credit default swaps almost brought down the world's largest insurer.

ALEX BLUMBERG: Earlier this month, the US Congress got its own tutorial on credit default swaps from Eric Dinallo, the New York state insurance superintendent.

Mr. ERIC DINALLO (Insurance Superintendent, New York): It's where you own a bond. Let's just say you own Ford bonds and you want to hedge your risk that Ford is going to default on those bonds. So you go to a third party and you ask them to essentially insure you against that default. That's the swap.

BLUMBERG: Dinallo is speaking here at the House Oversight Committee hearing on the AIG bailout. AIG, you may remember, was the big insurance company that had to be rescued by the government last month. They had to be rescued because they were about to go bankrupt. They were about to go about bankrupt because they had promised a lot of money, money that it didn't have, to people holding credit default swap agreements with them. How much money? Here's Martin Sullivan, the former CEO.

Mr. MARTIN SULLIVAN (Former CEO, AIG): From recollection, I don't believe the number got to $500 billion, but it was certainly in totality around $400 billion, yes.

BLUMBERG: One problem for AIG, a lot of the people they owed money to had not bought credit default swaps from them for insurance. They'd bought them for speculation. Here's how this works. Let's say there's a guy named Frank and he has a life insurance policy. When he dies, the beneficiary gets a million dollars. Now imagine a whole bunch of other people saying, I want a million dollars if Frank dies, too. And so they take out life insurance policies on Frank. Now imagine Frank dies, and all the people who bought their policies bought them from the same company. That company, more or less, was AIG. But the fact that the biggest insurance company in the world was brought down by these unregulated securities might not even be the scariest part. Usually, people who traded credit default swaps did something different than AIG did. Something that was supposed to make them safer, but might possibly have made the whole system more dangerous. They did something called netting. Now, let's say I'm a hedge fund. I have $100 million and I have a hunch that the investment bank Lehman Brothers is going down. I go to AIG and I buy a credit default swap on $1 billion. I pay AIG $20 million a year, and the deal is, if Lehman can't pay its debts, AIG owes me $1 billion. Now, over the next few months, my hunch starts to look more likely. Lehman starts looking riskier. Their profits go down, say, and unfavorable news reports comes out about them. When this happens, Lehman becomes, basically, more expensive to insure. Just like the more traffic accidents you have, the higher your insurance premiums go, the sicker you look as a company, the more it costs to buy a credit default swap protection against you. And I am perfectly poised to take advantage of that. I go out and I now sell credit default swap protection. I'm not buying this time. I'm selling. But because people are more scared about Lehman, the price is higher. I can now sell it for $40 million a year. So I'm paying 20, but taking in 40, a net profit of $20 million a year. And my position is what they call hedged. My position is totally safe. If Lehman defaults, I'll owe my buyer $1 billion, but AIG will owe me $1 billion. The trades net out. And in the meantime, I'm taking in a cool 20 million a year. And this situation, where every trade was matched on the other side with another trade, this situation was much more common. I would sell protection to Morgan Stanley, say, and buy it from Goldman Sachs. Goldman Sachs, in turn, would sell protection to a hedge fund, who in turn would buy from another hedge fund, and so on down the line. Satyajit Das, who calls himself Das, is a risk consultant with nearly 20 years experience working with credit default swaps. He says netting works fine as long as everyone who's netting stays in business.

Mr. SATYAJIT DAS (Risk Consultant): If the chain breaks down anywhere where one party does not actually honor their contracts, then the losses multiply very rapidly. It links everybody together in this unholy chain.

Mr. JON ZUCKER (Former Employee, Credit Default Swap Desk of a Major Bank): The greatest danger, that's a tough question.

BLUMBERG: This is Jon Zucker, who worked at a credit default swap desk at a major bank for five years. He left in 2007. And if you ask him what the greatest danger is, after careful deliberation, he arrives at a conclusion, which is basically this - if everyone in the chain knew the financial stability of everyone else in the chain, then all this would probably be fine. But the problem is because every deal is private, they don't know.

Mr. ZUCKER: You don't know; it's far from transparent. You know the notion is that I'm working here at the New York Money Center Bank and some small bank in Asia goes down and suddenly it just hits the tipping point and several other banks fail and suddenly it's affecting me. I never had a clue.

BLUMBERG: And this lack of information is what has been causing huge problems. It is one reason that credit has been freezing up. Banks have been afraid to trade with each other because they don't know what bets anyone has made. And this, in turn, was one reason the government felt it had to step in with a Bailout because all the banks are linked through these credit default swaps. If one bank goes down, they all could. I guess the question is things blow up and then my tax dollars have to be used to come in and sort of bail this out. First of all, is it fair for me to be mad and who should I be mad at?

Mr. ZUCKER: That's a great line. Is fair for me to be mad and who should I be mad at? Is it fair for me to be mad?

BLUMBERG: In keeping with this analytical nature, Jon Zucker didn't answer this question right away. But it didn't seem at least to me, an attempt to dodge the question as much as an attempt to formulate right there on the spot, a mathematical model to determine the fairness of my potential outrage.

Mr. ZUCKER: So you're asking the question. Can I set up a system where their mistakes will never affect you?

BLUMBERG: Yeah. It's a long pause, Jon.

Mr. ZUCKER: Yeah, sorry about that.

BLUMBERG: No, no. It's OK. It's OK.

Mr. ZUCKER: Look, I'm a quantitative guy.

BLUMBERG: Yeah.

Mr. ZUCKER: So I tend to think of the world in terms of models.

BLUMBERG: Uhuh.

Mr. ZUCKER: And there is a lot of 20/20 review, hindsight review of this in saying people should have caught all this stuff. There, the regulators completely screwed up. I'm not 100 percent sure of that, but one thing I do know is that in terms of intent, there was no intent to regulate. And from that point of view, they should be held accountable for some of the mistakes. ..TEXT: BLUMBERG: Recently, the regulators have started to take action. Earlier this month, Congress held hearings on how best to regulate the credit default swap market. And the chairman of the Securities and Exchange Commission, Christopher Cox, who's been criticized for in the past for lax oversight of the financial markets, recently wrote an op-ed in The New York Times, calling for greater regulation of credit default swaps. Most people seem to believe that the best thing would be to set up a central clearing house for credit default swaps, or an exchange, where they could be publicly traded like options, or commodity futures. But everyone also says it's a complex world. The people who invent these financial products are making small fortunes, and the regulators will always be playing catch-up.

SIEGEL: That's Alex Blumberg of Chicago Public Radio's "This American Life." He reported this story along with NPR's Adam Davidson. And you can find much more on the global economic crisis at our Planet Money blog and podcast at npr.org/money. This is All Things Considered from NPR News.

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