The people who recognized the high likelihood of defaults were able to profit from that likelihood – First , they could sell the mortgage securities short – a straightforward wager that has long been available.
Second , they could buy credit default swaps (CDS) from banks and insurers like Merrill & AIG , who charged very little to the other side to make the bet. These were essentially a side bet that anyone could make about a certain mortgage bond or security. It paid off fantastically if the bond went into default or was close to default.
Where the junk mortgage bonds were in the hundreds of billions, the Credit Default Swaps were in the Tens of TRILLIONS – CREDIT DEFAULT SWAPS were a STAGGERLINGLY LARGE $72 TRILLION DOLLARS – that’s a Seven with Thirteen ZERO’s Folks – $72,000,000,000,000
If the sellers of the Credit Default Swaps had to pay off in large part , the liability greatly exceeded the total bank capital in the United States and possibly in the world.
The derivatives based upon the junk mortgage bonds could be , and were not in any way limited to the size of the mortgage. It is this liability that swamped the banks , investment banks and insurers. It is the Credit Default Swap Liability that broke AIG and Lehman Bros.
Lehman was so large that when it failed
Bankers panicked. If Lehman could fail , then anyone could fail. The banks that were still solvent figured they had better hoard their assets and stop making loans. This led to the ongoing credit freeze and economic downturn with a drastic fall in prices of all kinds of securities , real estate and commodities.
It also led to a massive credit squeeze on hedge funds , a credit dry up and monster fall of asset prices. This snowballed into forced stock and other assets on a huge scale leading to still greater falls in securitiy prices.
The worldwide panic is still unfolding , leading to huge infusions of liquidity into the Worlds Banks and the semi-Nationalization of United States Banks to bolster world markets and economies. These were drastic steps for drastic times , all generated by derivatives.
Warren Buffett had warned us against them back in 2002 and again he was right. Buffett stated that “ .. derivatives bought speculatively are WEAPONS OF FINANCIAL MASS DESTRUCTION .. the range of derivatives contracts is limited only by the imagination of man or sometimes , so it seems , MadMen.“