DO YOU KNOW THIS WOMAN? YOU SHOULD. BERNIE MADOFF SURE DOES.

Do you know this woman?

She is quite smart, extremely well-educated, very attractive and one of the most influential people of this century.  Very few people know her name, her face, much less what she did, and how it has affected them.

She is the creator of the financial instrument of mass destruction that ruined your 401-k, that caused a worldwide recession, that triggered stock market collapses across the globe, that allowed a view into an abyss that no one has ever looked into in the entire course of human economic activity, that ended the world as we knew it, and may have shown us how the Age of America will end.

After graduating from Cambridge University with an advanced degree in mathematics, Masters was hired by JP Morgan in London. She and her team of bright young stars came up with an idea that would lighten the risk load of financial institutions by spreading the risk across the corporate spectrum with an instrument they called a Credit Default Swap (herein and forever after called CDS).

In its pristine academic form, the CDS is a good thing.  In the growing world economy, a marketplace so intertwined and commingled that the devaluation of a currency such as the Thai Baht could cause a meltdown of disastrous proportions, the spreading and sharing of risk by the risk takers was and is still a good thing.

CDS have been compared to insurance policies because one party pays a fee over a period of time and receives a payment in the event of a loss, usually a corporation defaulting on its debt instruments (bonds) or a company bankruptcy.

Sounds okay so far.

And make no mistake! Blythe Masters is not the villain here.  

The villains are the gnomes and trolls that frightened us in the fairy tales of our youth.  They still live and are very real. But instead of living under scary bridges and holes in the trees in the haunted forest, today they skulk about in hedge funds and trading rooms. 

Still in the shadows, but very, very real and really, really scary in ways that would have given the Grimm Brothers nightmares.

Masters' good idea went astray when one of these mutants decided the market was too limited to make any big money.

"Why don't we," asked the gnomes, "get some of that money floating around out there for ourselves?"

"How can we do that?" asked the trolls.  "We don't own any debt."

"Debt," said the gnomes with a Treasure of Sierra Madre lilt, "we don't need no stinking debt, senors. We'll just remove the direct connection between debt and obligation from the CDS and just say anybody could buy and sell CDS without having to own whatever the CDS was supposed to protect in the first place."

And so they did and everyone lived happily ever after.

Hah!

The confusion about a CDS being an insurance policy is clear.  An insurance policy of any kind can only be bought by someone (read person, company, city, church, etc.) that has a well defined insurable interest.  Otherwise, people, we would all be buying life insurance on Warren Buffett or Bill Gates, as well as property and casualty policies in Pakistan and India.The CDS market took this direction, odd as it may seem.


All went swimmingly until the lifeguard at the pool did a buddy check. Surprise!  Nobody had a buddy.


There was not even anyone in the pool.


If you have an ear or an eye that works, you know what has happened since then.  

Bernie Madoff does.  Can anybody say Kevlar?