- swapping anyone?

Experts say that the main prime candidate responsible for the present financial debacle is what they called the credit default swap.

A credit default swap is basically a contract between two parties one of whom is giving assurance to the other that he will be paid in the event that a financial institution or a financial instrument fails. It is an insurance contract. But they have been careful not to call it as such because if it were insurance it would be regulated.

Imagine this. US mortgage banks had lent in total, hundreds of billions to various homeowners. Within the hundreds of billions are some good loans and some subprime loans (i.e. those that were lent to borrowers who have poor credit or very little equity in their homes).These US mortgage banks would sell the loans to investment banks. The investment banks would then split the loans into what they called "tranches." The tranches that contained good loans would offer a lower rate of return with less risk while those tranches that have subprime loans would offer high rate of return with greater degree of risk.

A third party (e.g an insurance company) would come along to guarantee the loans. The guarantee is what they called a credit default swap. It is basically an insurance contract or a derivative which derives it value from the underlying assets i.e. the pool of mortgage loans.

Investors are lured into investing in such pool of loan mortgage since it is being "insured." Most investors have no inkling of what is a credit default swap. They have high regards for the investment bankers with impressive MBAs, who use high sounding technical terms that even they themselves do not understand. The problem is that the insurers were writing so much insurance on so many bad loans that when eventually when the loans get defaulted by the subprime borrowers, the very insurance companies that wrote the credit default swaps are also facing the danger of collapsing. This is what happened with AIG. The rest is history.