Let’s pretend the three brothers sat around a table and placed bets on whether it would rain tomorrow. Tom bets with John and Dave, John bets with Dave and Tom, Dave bets with John and Tom. Some bets offset each other, some don’t. Everyone is betting and cross betting so much that no one knows what the final net end result is, but the guess is in the range of $10,000,000 in bets on whether it will rain tomorrow.
It rains the next day.
Tom, Dave and Steve all check their books, and low and behold no one has enough money to pay anyone else, even after they net out cancelling bets. So they turn to the rest of the family and say “guys we owe each other $10,000,000, you have to pay up or we won’t be able to pay each other.”
Replace Tom, Dave and John with JP Morgan, Goldman and BoA. Replace “whether it will rain tomorrow” with “whether Greece/Italy/AIG goes bankrupt”, and you have a pretty good understanding of credit default swaps (CDS) and the never ending CDS crises.
It really is that simple. When banks say they don't want CDS regulated, it's because they want to preserve the right to trade obligations they cannot pay, and turn around and scream EMERGENCY when they can't pay themselves.
Thanks for reading.
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