Term of the day: Credit default swap

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It’s not that AIG is too big too fail—rather that it’s too connected to the rest of the financial system for policymakers to stand by and watch it collapse.

At the heart of that connectedness is the credit default swap (CDS). Not familiar? Back in March, Janet Morrissey wrote a story for Time.com explaining what they are, why they might be the next crisis (which a lot of people have been saying for a long time, not that anyone did anything about it), and what the effect would be for folks who don’t work on Wall Street. To quote:

A meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis. If bond insurance disappears or becomes too costly, lenders will become even more cautious about making loans, and this could impact everyone from mortgage-seekers to municipalities that need money to fix roads and build schools.

Although in the case of AIG, the Feds stepped in not because of what they knew might happen, but because of what they knew they didn’t know about what might happen. Which makes it better?