Credit default swaps have been a major element in the ongoing financial crisis. That doesn’t mean it’s necessarily easy to understand just what the problem is with them. I’ve taken a crack at it in the past, but more recently I heard an analogy that makes the entire situation a lot easier to visualize.
I heard the analogy during a radio interview with Doug Noland, a mutual fund manager who’s been writing dire weekly analyses of the credit market for years. It went something like the following.
Imagine a city near a river that is prone to the occasional flood. At some point, an enterprising citizen gets into the business of writing flood insurance, collecting premiums from insurees in exchange for a promise to pay back the insurees should a flood do any damage to their properties.
Now, imagine that there is an unusually long drought and the river goes a long time without experiencing a flood. Other enterprising types begin to notice that the flood insurer has for years been collecting all this money for doing absolutely nothing. A flood hasn’t taken place for ages — maybe climate patterns have changed so that the river doesn’t flood any more. And even if it does flood at some point, they will probably be retired by then. They want in to the easy money flood insurance game too.