Five years ago, billionaire investor Warren Buffett called credit default swaps a “time bomb” and “financial weapons of mass destruction” and directed the insurance arm of his Berkshire Hathaway Inc to exit the business.
Credit default swaps are derivatives designed originally to protect banks from borrowers who default—a sort of insurance.
These complex financial instruments, however, are believed to have contributed to the latest turmoil in the financial markets. Those buying the “insurance” didn't factor in the risk that the sellers of the protection might not pay.
Take, for example, the collapse of Bear Stearns, the sell off of Merrill Lynch and the meltdown at American International Group (AIG): in each case, credit default swaps played a role in their collapse.
Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof: How to Profit From the Coming Economic Collapse, said:
“This is the derivative nightmare that everyone has been warning about.
“They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down.”
Another well-intentioned invention of Wall Street that’s gone haywire. Just goes to show: you don’t have to be stupid to do stupid things.