Let's say that I run some
type of a pension fund, and I have $1 billion that
I need to invest someplace. And I dig around a
little bit, and there's this Company A over
here, and it needs to borrow a billion
dollars, and it's willing to give 10%
interest in exchange for borrowing that
billion dollars. So if I give these
characters over here my billion dollars, if I lend
it to them, if I lend them the billion dollars,
on an annual basis, they're going to
give me 10% interest. There's a problem here though. The rating agencies, the
ones that in theory should be independent, they've only
given Company A a BB rating. And this is a pension fund. I have to only invest in the
safest of safest of securities. I have to invest only
in things that are AA. And so here might enter
a character like AIG, and obviously things have
changed since their heyday. But AIG, based on at
least Moody's perspective, has a AA rating. So AIG could say, hey, look
pension fund, why don't you lend them the money,
and what we're going to do is enter into
a credit default swap. And what that essentially
is, is a form of insurance. Of that 10% every year, why
don't you give us 1% of that? And in financial
lingo, that's sometimes referred to as 100 basis points. And in exchange for that, in
exchange for that 100 basis points a year, you could view
this as the insurance premium, we are going to ensure
that if for whatever reason Company A defaults on that
debt, you can give us the debt, you can give us
that debt security, and we will just give you
back your billion dollars. Now from the pension's point of
view, this sounds pretty good. They're now getting a net 9%
of interest, 10% minus the 1%. And they're essentially getting
to lend to a BB company, but it's in effect
like lending to a AA, because as long as AIG
is good for the money, then the pension fund is
going to get their money back one way or the other. Now where this gets
a little bit shady is AIG right here didn't
have to do anything. What's interesting about
credit default swaps-- credit default swaps
sometimes referred to as CDSs-- is that even
though they are insurance, for all purposes
they are insurance, they are not regulated
like insurance. So typically an
insurance company when they insure
something, they have to set aside some money, in case
that thing actually happens. And they have to work out the
probabilities and all of that. Credit default swaps were
not regulated in that way. So AIG could do
this without having to set aside any type of money. And they could do
this over and over and over and over again,
kind of snowballing all of their
potential liabilities. And so you could imagine,
it's really good money while no one is
defaulting, but all of a sudden when people
start defaulting, then all of a sudden AIG is
going to be in trouble. And all the people who
thought they had, in effect, AA debt because AIG was
insuring it, might not.