My understanding is that these derivatives were basically insurance under a different name. Normal insurance companies have reserve requirements, capital requirements, etc., that prevent them from selling policies above some multiple of their capital (10x?). That way, they'd have capital to pay claims if bad things happen. The financial industry was able to argue to the lawmakers and regulators that these derivatives shouldn't be subject to those rules, so the Masters of the Universe went crazy selling and buying these things with the expectation that they'd never have to pay off a significant fraction of them.

According to Wikipedia, it was a $45T market by the end of 2007, while the world GDP was $55T (according to the CIA Factbook). That's just nuts. Even if most of the money is offset by a bet on the other side, there's still a lot of money tied up in these things.

I don't think that declaring them void would work, but I don't know enough about the details.

Cheers,
Scott.

I agree: Unless the whole world's financial system implodes, there aren't going to be $45T in real losses. And if it does implode, then paper money isn't going to be worth anything anyway, so it still doesn't matter. Everyone on Earth isn't going to have to come up with $7500 each to pay off this paper.

With the offsetting bets on the other side, the $45T may actually be $450B in "real money" (1%). I agree.

The issues, as I understand it, are that:

1) These bets aren't disclosed, so nobody knows if BoA has $5B or $200B in these offset bets that are never going to be worth anything. BoA doesn't know because the folks they're dealing with have comparable investments with others, and they don't know, and so on. Since the world financial system is so interconnected, if, say BoA or Citi or Mitsui or Gazprom Bank or ... is actually insolvent (since their CDSs are worthless), then they'll drag down the rest of the system via other banks that are holding their paper.

2) The idea of a "Bad Bank" to swallow up these things has some appeal, but the issue is determining a "fair" price that results in the policy objectives without pricing them so high as to excessively reward the folks who got us in this while at the same time putting an even larger burden on society as a whole (lower growth, inflation, taxes, etc.). And what, if anything, the US should get in return for taking these things off their hands? And what happens to private investment in these banks if the Fed starts buying up toxic paper? Do they run for the hills, making the situation worse?

Paper losses (like your Beanie Baby example) are certainly in play here, but since banks have reserve requirements, there is a real impact when their capital is suddenly dramatically reduced. These CDS losses must have some significant impact on their capital (as I understand it, CDSs are how much of Wall Street was making their profits these last several years). Waiving reserve requirements, or dramatically reducing them, is probably not something we would want to do without strong safeguards and a lot of thought.

Cheers,
Scott.