What's The Deal With 'Credit Default Swaps'? : Planet Money Here's this morning's Wall Street Journal, pouring the coffee for you:
NPR logo What's The Deal With 'Credit Default Swaps'?

What's The Deal With 'Credit Default Swaps'?

Here's this morning's Wall Street Journal, pouring the coffee for you:

The American financial system was shaken to its core on Sunday.

Whoa. We'll be awhile making sense of all this, but for now the scorecard reads: Lehman Brothers in bankruptcy, Merrill Lynch swallowed by Bank of America with the Federal Reserve's help, AIG looking for a lifeline, global markets flipping out, global bankers pooling money to calm the markets, investors watching a string of other banks for signs of collapse. (Wall Street Journal, New York Times, NPR, Calculated Risk)

Once you get past the huge headlines, you can start seeing the particular reasons for fear. One of the scariest factors here is something called a "credit default swap." After the jump, an explanation.

You can think of a credit default swap as a kind of insurance policy for lenders. Let's say you own a (very small) bank, and you have enough capital to lend out $1 million at a time. That's all the risk you can take.

Now imagine another bank comes along and says, "Hey, I can sell you insurance for another $1 million on loans. Just pay me a regular premium and lend, lend, lend." You want to grow, so you buy in. That's a credit default swap.

Lehman Brothers insured many, many loans through credit default swaps. How many? No one knows. Up until now, their books have been relatively private. Some surveys put the firm seventh for credit default swaps, in a global market worth perhaps $60 trillion dollars. Those loans, wherever they are and however many they are, are suddenly at risk. One broker used the phrase "immediate tsunami" to describe the potential devastation. Reuters is calling Lehman's failure the first big test of the system. Other big players, like AIG, are the first to feel the shockwaves.

If you hang on to nothing else about global economics, remember this: No credit = no economy. With untold numbers of banks waking up to untold risks, your everyday access to credit could shrink painfully. We borrow money for cars, homes, televisions, schooling, new enterprises. Maybe we borrow more than we should. But without that borrowing, there is no economy. Bankers who are worried about their exposed hind ends will be in a lot less likely to keep lending.

Time, March 17, 2008: Credit Default Swaps: The Next Crisis?