One of the least understood aspects of the financial crisis — but potentially the most damaging — is the market for over-the-counter derivatives and particularly one type of derivative known as a credit default swap (CDS).

The losses at American International Group (which was the recipient of a vast public bailout last year financed by the Fed of New York for the benefit of Goldman Sachs and the other large CDS dealers banks) stem in large part from CDS contracts. And there are many other AIG-type situations festering in the United States and Europe that will burst into bloom in coming months.

AIG’s sin was thinking it could buy low-risk growth through CDS, but even veteran CEO Hank Greenberg failed to understand the true risk of insuring credit losses. And the sad part is that in chasing growth by taking risks with CDS, Greenberg and AIG were entering a relatively low-margin business compared with traditional insurance.

What is the problem with CDS? The tension, especially regarding the large money center banks and other financial houses, comes from several basic flaws in the model for these instruments.

These are deliberate flaws built into the game that include the lack of a central counterparty, no effective limit on dealer leverage and a schizophrenic pricing methodology that has nothing to do with the several different types of underlying risk contained in these contracts. It is a market designed by and for the seller, to the disadvantage of the buyer. But CDS may also be thought of as a poker game where the dealers have few chips on the table.

It is very telling that more than a year into the crisis and six months since the AIG rescue, the Federal Reserve Board still refuses to enforce any type of credit margin discipline over dealers in the CDS markets, which would raise collateral requirements on dealer positions to realistic levels.

Thus the short-selling pressure on Citigroup and other wounded money centers is magnified many times above the true pool of investors with hedging needs, including the much maligned ranks of the hedge funds. You see, it is the banks too, not just the hedge funds, which sell short the securities of the other banks, a kind of speculator cannibalism.

What the Fed will not tell you is that it is the largest dealers — and not the customers like hedge funds — that are the systemic problem when it comes to CDS and inadequate collateral regulations.

Let me say that again: the systemic risk to the global markets comes not primarily from the rapacious hedge funds, who mostly are forced to post real collateral behind their trades, but from the other dealers and financial institutions in the United States and the European Union particularly. These banks are writing CDS positions to support short sales against other bank names or buying CDS to hedge regulatory capital needs or both.

For those of you with normal lives not cluttered with acronyms related to obscure financial instruments, a CDS contract is essentially a form of insurance on a corporate bankruptcy or default. Less generously you could call it a gaming contract. The contract says that the writer of the insurance is obligated to purchase a bond issued by Ford or Citigroup from the buyer in the event those entities default.

Thus when Lehman Brothers filed bankruptcy, the writers of protection via those CDS contracts had to pay the buyer of protection 97% of the face value of the Lehman Brothers bonds, because there is expected to be little recovery for bond holders in the Lehman bankruptcy. In the case of the government takeover of Fannie and Freddie Mac, the CDS protection payments were very low because there is little or no expected loss for bondholders — at least at the moment.

Many observers have been critical of hedge funds that do or at least did write naked CDS positions during the past several years, essentially like being short a put option, without adequate capital. Hedge funds generally don't have capital other than insider funds, thus the concern. This issue of adequate capacity and the ability of writers of CDS protection to pay last year almost led the New York State Insurance Department to unilaterally begin the regulation of CDS counterparties who were writing risk for regulated insurance companies.

It now seems that the large bank dealers and a number of banks in Europe are themselves the weakest link in the chain in terms of systemic risk. This reportedly is why then-Fed of New York chief Tim Geithner insisted on bailing out AIG — to prevent an AIG bankruptcy from dragging Goldman Sachs and other dealers down as well.

As the New York Times reported last year, Goldman was AIG's largest trading partner and CEO Herb Blankfein was in the room when the AIG bailout was hammered out by Geithner.

By failing to enforce margin limits on CDS leverage while investing new capital in Citigroup, Bank of America and other large banks via the TARP, the U.S. Fed and Treasury, as well as global regulators in the EU and Asia — are essentially trying to fill up a bucket with a hole in the bottom.

The Fed and Office of the Comptroller of the Currency (OCC) are entirely complicit in this contradictory effort to protect the ability of the major CDS dealer banks in London, Paris and New York to continue to do business without any basic prudential limitations. If the U.S. Congress truly understood the duplicity of the Fed and OCC when it comes to concealing the risk from over-the-counter derivatives, these agencies would be closed down tomorrow.

Consider that nothing was wrong with the basic model for unregulated derivatives markets such as CDS — then there would be no need for the global financial industry to have "torn up" $30 trillion or half of the notional amount of contracts during the past year!

The truth, by the way, is that these contracts were not always actually extinguished. Sometimes they are merely paired up with opposite contracts to "net out" the risk using the facility of the DTCC. Only time will tell if this approach to deflating the CDS bubble, which is many times the underlying cash basis, will succeed.

But even if you believe that most of the remaining $30 trillion in notional amount of CDS faithfully reported by the DTCC in New York is not problematic, this is happening as corporate default rates rise to historic levels. That still leaves trillions of dollars in net CDS exposure concentrated among some of the less savvy players in the global banking and investment worlds, including some of the largest banks in Europe. For example, UBS just announced thousands of layoffs at its investment bank as part of dramatic cost-cutting related to credit-related losses. Some even anticipate UBS closing its investment bank entirely.

The Fed and the OCC are entirely complicit in this contradictory effort to protect the ability of the major CDS dealer banks in London, Paris and New York to continue to do business without any basic prudential limitations, a pandering bias toward the largest banks that illustrates regulatory capture well.

When the political classes of the industrial nations reckon the final cost of managing down the CDS bubble, the only sane alternative will be to slowly allow some of the largest banks to be restructured, or merely wither as assets are sold.

The more savvy observers in the media are already asking what New York will look like without the large money center banks as anchor tenants. But the more pertinent question will be how many more Lehman Brother-style liquidations we will see in 2009.

Then the question will be asked, particularly in Europe and Washington: Is the wild growth of speculative markets such as CDS a sign of fundamental economic decay? When a speculative market grows to many times the real, cash basis and is therefore not validated by the real economy, is it any surprise that the largest banks in the world are insolvent?

While many of the global financial systems problems are traced back to housing or other base markets, the unlimited leverage of CDS may be reckoned as the catalyst for the global meltdown among the largest banks. Greenberg and AIG went into CDS chasing higher growth, but also bought big risks.

The bottom line: what remains of the CDS market will be cleared and settled by one or more central counterparties by mid-year. The market will be increasingly transparent. Meaningful margin discipline, collateral and risk limits will be imposed. This will have a devastating effect on the big banks' fixed income revenues, but will actually improve their balance sheets greatly and lower the overall risk in the US financial system.