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[mcmike]

Warren Buffett warned regulators about fancy derivatives years ago, but there was too much money being made at the time for anyone to listen.

Credit default swaps were created as insurance to protect banks from bad borrowers who couldn't pay back their loans. Unfortunately, no one ever thought about or factored the risk involved if the sellers of this sort of protection couldn't pay.

The numbers involved here are absolutely staggering: from 1999 to 2007, the credit default market rocketed from around $600 billion to over $45 trillion. Yes, trillion. With that sort of widespread exposure to risky loans, any hiccup was bound to have severe consequences.

American International Group (AIG) themselves had over $18 billion in losses from guarantees it wrote on mortgage-linked derivatives.

The Bottom Line

A good analogy to what most taxpayers deal with on a daily basis would be car or home insurance. When there is an accident or fire, you expect your insurance company to make good on your insurance claim. Seemingly, none of these insurers ever expected any accidents within the credit default market. Many companies rushed into the lucrative space, as they tend to do when a market becomes as large as the credit default market got.

The problem is that AIG (which insures a whole lot of other things, like cars, homes, etc.) didn't manage its risks correctly, and could no longer sustain itself on its own - they simply owed much more money to their clients than they could possibly pay back. The lesson learned here is that tighter regulation needs to be passed to limit insurers' amount of exposure to risky debt-based products, or scenarios like we are seeing now are bound to happen again.


http://www.knobias.com/story.htm?eid=3.1.6ca3ece9c74781406b46dbfcca4698cf889c710f24e1cbdeea3e8f92462db563