For the most part derivatives are insurance contracts,
although some use them as speculation vehicles <g>
When a large financial flood happens, flood insurers
get broke, flood victims don't get paid, real estate
drops, cause flood insurance gets very expensive. The latter
is really a reflection how derivative collapse influences
asset prices.
And then... there are transactions between banks. When a
few collapse, they stop trusting insurance someone wrote,
and then stop dealing with each other. The market freezes.
The credit market froze last week, as insurance contracts
written by Lehman, Merrill and AIG were open ended, with
nobody on the other side.
In the bond market, for example, when a subprime borrower
comes and asks for a loan, while the AAA-rated company
insures the debt written, it makes it much easier to get
a loan, and there are plenty of buyers of AAA-rated debt
created from a bad borrower. Now the insurance companies
collapsed and don't want to insure anything, insurance
got extremely expensive. On top, not many want to insure.
So, things collapse below where the bottom would be, should
there be no insurers in the first place. |
