Financial weapons of mass destruction

let's think a little bit about why credit default swaps or we're famously referred to by Warren Buffett as financial weapons of mass destruction weapons of mass destruction at the center of it and there's not just one credit default swap writer but I'll put one in the middle because each of them are writing many many credit default swaps a IG is the most famous but you have some writer here they're given some good credit rating maybe in the past that credit rating was actually earned by a credit rating agency and then frankly the credit rating agency got a little sloppy and really didn't wasn't willing to downgrade them given all of the credit default swaps all the obligations that are taking on credit rating agency and as you could tell I kind of view these guys and these guys are the main culprits and maybe a little bit of the regulatory agencies saying hey look these guys are writing insurance maybe we should actually regulate them but with that said you have companies over here I'll do the companies in this pink color and they want to borrow money from other parties let's say investors I'll do the investors in this orange company in this orange color so the investors are lending the money the companies give them interest so investors lending money giving interest lending money giving interest lending money giving interest and then these investors it seems pretty reasonable say hey look there's a guy over here with the double-rail rating the people that we're lending to don't have a double A rating maybe this guy has a B maybe this guy has a double B maybe this guy only has a single a and so he says look I want to be completely safe here so I'm going to pay a little bit of a premium to AIG or to the writer whoever the writer is and in exchange I will get insurance I will get insurance on on this debt I will I will get insurance in assurance and it seems pretty reasonable except for the fact that this player right over here did not put out any money aside or do not put the appropriate amount of money aside to properly take to properly account for all of these liabilities all of this risk that is taking on and also all of these risks are correlated you can imagine a situation where the economy goes bad all of a sudden not now all of a sudden this company defaults on its debt and this company defaulted in debt in fact when the economy is good it's likely that very few of these companies are going to default and when the economy goes bad it's likely that many of them will default but the real problem is is as soon as these defaults start happening then the credit default swap writer is going to have to actually start paying for the defaults they'll get the bad debt and in exchange they'll make the other side of the credit default swap that the holder of it they will pay them make them whole and so this could take them out of business and all of a sudden the people over here who are who thought that they had insurance no longer do and they might actually say wait I can only hold double a debt and they might actually have to dump this debt onto the market even worse you have all the people who all of the people over here who didn't lend any money to anybody but they really just wanted to make side bets either the side bets might have been pure directional bets on the state of the economy saying hey I think a bunch of companies or I think this company in particular is going to default on its debt and they too could get credit default swaps really as just side bets so just for maybe maybe this right here is one billion dollars in debt maybe these all of these parties took side bets on this guy so even though there's only a billion dollars of debt here there might be four or five or ten billion dollars worth of insurance on that 1 billion dollar bet so if all of a sudden this one company can't pay its 1 billion dollars now AIG is on the line not for 1 billion but for four or five or six billion however much it insured it for so it allows people to insure for things that they don't have the other the offsetting liability for and so you can imagine these guys some of these people if this guy fails we'll just kind of take a loss and and that's bad and all of the rest because they were expecting that they wouldn't but some of these players might have had offsetting hedges they the only reason why they might have felt comfortable taking on some other liability as they said look if the economy gets goes really bad I have I have this insurance over here and they did that transaction with another third party now all of a sudden if if the economy goes bad and these guys say hey look I'm in a lot of trouble good thing I have this credit default swap but it turns out that they don't because the counterparty here fails the credit default swap writer now all of a sudden this guy becomes insolvent but this guy was was dependent on this guy paying and he thought he was good because he even looked at this guy's books and said this guy had offsetting hedges and now this guy might fail and so you could have this entire cascade through the entire financial system