To spice it up a bit, recall that these are the things Warren Buffett has called “weapons of mass destruction,” said he doesn’t understand them, and lost hundreds of millions of dollars through his insurance companies to unwind credit-default contracts they had acquired. The Journal brings up Bear Stearns and says its fall could have led to a domino effect on Wall Street because of CDS.
Credit-default swaps were a factor in the recent troubles of Bear Stearns. Hedge funds and other firms that were on the other side of credit-default swap trades with Bear tried to exit from their positions or pass them on to other brokers. That set off a broader panic about Bear’s health as a counterparty, which pushed the firm to the brink.
Swaps also played a deciding factor in the Federal Reserve’s dramatic intervention. If Bear went down, others could have been dragged down through their exposure to the firm through swaps.