Essentially, a credit default swap (cds) is a put option. The seller takes a generous fee for bearing the risk and in event of default, the buyer can put the net default obligation to them.

It becomes a time bomb when the cds is resold multiple times for the sake of generating fees across serial owners. And since the cds risk can be resold infinitely, a spread develops from fluctuations in risk and this creates another profit opportunity from trading.

Back at the operating risk end of things, it becomes convoluted re: who actually holds the obligation to perform on the cds and for how much. This leads to an unknown amount of counterparty performance risk existing throughout the global monetary system.

A cascading string of major bank failures and seizing up of lending short & long would begin a series of debt defaults covered by cds’s, which would also default to an unknown degree, as counterparties hold paltry capital against seas of cds obligations. This made the cds effectively a naked put option, with the default risk borne systemically by everyone.

No oversight or regulatory structure existed to assure that cds sellers had sufficient capital to cover the risks they were obligating themselves to, or monitor the collective exposure that built to worldwide economic stability. This was by design.

The put author relied on a few things:

· true default probability was much less than estimated

· their asset pool would cover any default events, if any

· there would not be a systemic default event

· availability of credit was perpetual

This was the extent of self-regulation covering the counterparty that bought the cds and the collateral risk partners to the deal (the rest of the globe).

The primary rating agencies (S&P, Fitch, Moody’s) put their stamp of quality on junk because a cds was purchased against it. With the appearance of AAA on balance sheets more credit could be taken against assets and more junk was purchased and covered by another cds. The underlying payment stream was junk-level performance risk hiding in plain sight.

The discovery and unwind of this market remains a tectonic risk to the stability of bank nationalization and monetary reconstruction taking place in the US & EU.