How detached from reality did we become as the world of derivatives grew ever larger and profitable for those who peddle them? Here’s a story one Fortune 500 CEO told me when I shared my fears that credit default swaps could be the next big shoe to drop:
I have no unique perspective on CDSes, but I have to admit that when I first learned of them, some years ago, and got an explanation of how one worked on our own company, it went like this: “Say you own company X’s bond but don’t want to take company X’s credit risk. Then you sell a CDS, pocket the difference, and you’ve eliminated your risk of default by X. You basically then own a government bond.” My reply was: “I used to work on Wall Street. In those days, if you owned an XYZ bond and didn’t like the credit risk, you would sell the XYZ bond and buy a government bond. Then you didn’t 'basically' own a government bond. You actually owned a government bond.” The banker I was talking with had no reply to that.