Three weeks after running its first video on credit default swaps, 60 Minutes has returned to the subject with another in-depth analysis of CDS.
Frank Partnoy, a law professor at the University of San Diego, explains the concept of a derivative to 60 Minutes, as basically a “side bet”:
Think of it for a moment as a football game. Every week, the New York Giants take the field with hopes of getting back to the Super Bowl. If they do, they will get more money and glory for the team and its owners. They have a direct investment in the game. But the people in the stands may also have a financial stake in the ouctome, in the form of a bet with a friend or a bookie.
“We could call that a derivative. It’s a side bet. We don’t own the teams. But we have a bet based on the outcome. And a lot of derivatives are bets based on the outcome of games of a sort. Not football games, but games in the markets,” Partnoy explains.
Partnoy says the bet was whether interest rates were going to go up or down. “And the new bet that arose over the last several years is a bet based on whether people will default on their mortgages.”
And that was the bet that blew up Wall Street. The TNT was the collapse of the housing market and the failure of complicated mortgage securities that the big investment houses created and sold around the world.
But the rocket fuel was the trillions of dollars in side bets on those mortgage securities, called “credit default swaps.” They were essentially private insurance contracts that paid off if the investment went bad, but you didn’t have to actually own the investment to collect on the insurance.