(The Big Money) When you hear that the collapse of AIG or Lehman Bros. or Bear Stearns might lead to a systemic collapse of the global financial system, the feared culprit is, largely, that once-obscure (OK, still obscure) instrument known as a credit default swap.

When you hear that the collapse of AIG or Lehman Bros. or Bear Stearns might lead to a systemic collapse of the global financial system, the feared culprit is, largely, that once-obscure (OK, still obscure) instrument known as a credit default swap, reports The Big Money. REUTERS/Slate/Handout

So, what is a CDS, and why is it so dangerous?

At first glance, a credit default swap seems like a perfectly sensible financial tool. It is, basically, insurance on bonds. Imagine a large bank buys some bonds issued by General Electric. The bank expects to receive a steady stream of payments from GE over the years. That’s how bonds work: The issuer pays the bondholder some money every six months. But the bank figures there’s a chance that GE might go bankrupt. It’s a small chance, but not zero, and if it happens, the bank doesn’t get any more of those payments.

The bank might decide to buy a CDS, a sort of insurance policy. If GE never goes bankrupt, the bank is out whatever premium it paid for the CDS. If GE goes bankrupt and stops paying its bondholders, the bank gets money from whoever sold the CDS.

Who sells these CDSs? Banks, hedge funds, and AIG.

It’s easy to see the attraction. Historically, bond issuers almost never go bankrupt. So, many banks and hedge funds figured they could make a fortune by selling CDSs, keeping the premium, and almost never having to pay out anything.

In fact, beginning in the late ‘90s, CDSs became a great way to make a lot more money than was possible through traditional investment methods. Let’s say you think GE is rock solid, that it will never default on a bond, since it hasn’t in recent memory. You could buy a GE bond and make, say, a meager 6 percent interest. Or you could just sell GE credit default swaps. You get money from other banks, and all you have to give is the promise to pay if something bad happens. That’s zero money down and a profit limited only by how many you can sell.

Over the past few years, CDSs helped transform bond trading into a highly leveraged, high-velocity business. Banks and hedge funds found that it was much easier and quicker to just buy and sell CDS contracts rather than buy and sell actual bonds. As of the end of 2007, they had grown to roughly $60 trillion in global business.

So, what went wrong? Many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis, details of which are covered here 1. As those mortgage-backed securities and collateralized debt obligations became nearly worthless, suddenly that seemingly low-risk event-an actual bond default-was happening daily. The banks and hedge funds selling CDSs were no longer taking in free cash; they were having to pay out big money.

Most banks, though, were not all that bad off, because they were simultaneously on both sides of the CDS trade. Most banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection to someone else at the same time. When a bond defaulted, the banks might have to pay some money out, but they’d also be getting money back in. They netted out.

Everyone, that is, except for AIG. AIG was on one side of these trades only: They sold CDS. They never bought. Once bonds started defaulting, they had to pay out and nobody was paying them. AIG seems to have thought CDS were just an extension of the insurance business. But they’re not. When you insure homes or cars or lives, you can expect steady, actuarially predictable trends. If you sell enough and price things right, you know that you’ll always have more premiums coming in than payments going out. That’s because there is low correlation between insurance triggering events. My death doesn’t, generally, hasten your death. My house burning down doesn’t increase the likelihood of your house burning down.

Not so with bonds. Once some bonds start defaulting, other bonds are more likely to default. The risk increases exponentially.

Credit default swaps written by AIG cover more than $440 billion in bonds 2. We learned this week that AIG has nowhere near enough money to cover all of those. Their customers-those banks and hedge funds buying CDSs-started getting nervous. So did government regulators. They started to wonder if AIG has enough money to pay out all the CDS claims it will likely owe.

This week, Moody’s Investors Service, the credit-rating agency, announced that it was less confident in AIG’s ability to pay all its debts and would lower its credit rating. That has formal implications: It means AIG has to put up more collateral to guarantee its ability to pay.

Just when AIG is in trouble for being on the hook for all those CDS debts, along comes this credit-rating problem that will force it to pay even more money. AIG didn't have more money. The company started selling things it owned-like its aircraft-leasing division 3. All of this has pushed AIG's stock price down dramatically. That makes it even harder for AIG to convince companies to give it money to pitch in. So, it's asking the government to help out.

AIG might be in trouble. But what do I care? Because the global economy could, possibly, come to a halt.

Banks all over the world bought CDS protection from AIG. If AIG is not able to make good on that promise of payment, then every one of those banks has lost that protection. Overnight, the banks have to buy replacement coverage at much higher rates, because the risks now are much worse than they were when AIG sold most of these CDS contracts.

In short, banks all over the world are instantly worth less money. The numbers seem to be quite huge-possibly in the hundreds of billions. To cover that instantaneous loss, banks will lend out less money. That means other banks can’t borrow to pay this new cost, and weaker banks might not have enough; they’ll collapse. That will further shrink the global pool of money.

This will likely spur a whole new round of CDS payouts-all those collapsed banks issue bonds that someone, somewhere sold CDS protection for. That new round of CDS payouts could cause another round of bank failures.

Generally, with enough time, financial markets can adjust to just about anything. This, though, would be an instantaneous transformation of the global financial system. Surely, the worst part will be the confusion. CDS are largely over-the-counter instruments. That means they’re not traded on an exchange. One bank just agrees with another bank to do a CDS deal. There’s no reliable central repository of information. There’s no way to know how exposed a bank is. Banks would have no way of knowing how badly other banks have been affected. Without any clarity, banks will likely simply stop lending to each other.

Since we’re only just now getting a handle on how widespread and intertwined they have become, it seems possible that AIG, alone, could bring the global economy to something of a standstill. It’s also possible that it wouldn’t.