A simple but compelling observation by Floyd Norris in the NYT: "swaps" used to mean swaps, but then they were expanded to include protections that were tantamount to insurance:
As it happened, however, clever people on Wall Street followed the prescription laid down by Humpty Dumpty in Lewis Carroll’s “Through the Looking Glass:”
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”
When Alice protested, Humpty Dumpty replied that the issue was “which is to be master — that’s all.”
The word here is “swap.” It used to mean, well, a swap. In a currency swap, one party will win if one currency rises against another and lose if the opposite happens.
Credit-default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of the swap cannot meet its obligations. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.
But the people who dreamed up credit-default swaps did not like the word insurance. It smacked of regulation and of reserves that insurance companies must set aside in case there were claims. So they called the new thing a swap.
In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decisions they wished.
That decision, perhaps more than anything else, enabled the American International Group to go broke — or, more precisely, to fail into the hands of the American government. Had it been forced to set aside reserves, A.I.G. would have stopped selling swaps a lot sooner than it did.
The decision that swaps were not insurance meant that anyone could buy or sell them — or at least anyone who could find a counterparty.
Had credit-default swaps been classified as insurance, the concept of “insurable interest” might have been applied. That concept says that you cannot buy insurance on my life, or on my house, unless you have an insurable interest.
Meaning, you have to have skin in the game to ensure your reasonably non-self-destructive behavior.
Pretty sensible and a nice explanation that I've missed up to now. Simple works.
I will admit that I knew the swaps in question functioned like insurance; that's how I usually explained them--in rudimentary fashion. What I was missing was the knowledge that expanded function purposefully leveraged a rule-set gap. It makes the achieved abuse a lot easier to understand.