Opsec, thank you for asking. This is an important discussion, and everyone should benefit from it. Sometimes some of us don't know what other people don't know, and we use jargon without explaining it. Please keep asking questions, so that everyone will benefit from the discussions, and learn something new.
A "derivative" is a contract whose value depends on on the value of another contract. That is a very broad definition, but necessarily so because there are huge numbers of types of derivatives. Some examples will help:
You know what stock options are; sometimes employers give them to employees as incentives. The ones that employers give to employees are of the form
"You have the right, but not the obligation, to buy x*100 shares of ABC stock at $y a share, within z years."
Now, if the price of ABC stock is MORE THAN $y/share, then you potentially have an instant profit. You can also buy stock options, and you can buy them with several different kinds of terms. The one where you have an option to buy is called a "call". There is another one giving you the option to sell, called a "put". The terms of a put look like this:
"You have the right, but not the obligation, to sell x*100 shares of ABC stock for $y a share, within z years."
The reason you might buy such a thing, is that maybe you have ABC stock, and can't sell it yet (maybe you don't want to trigger a short-term capital gain, or you just have so bloody much you have to sell it off slowly or you'll crash the market). So in that case, buying the put is "insurance" against the price going DOWN. If the price goes DOWN, your stock option magically becomes worth more money, and it compensates you for your real or paper loss.
In fact, you don't even have to own ABC stock. Suppose that you think that ABC stock is about to plunge. You could speculatively buy some put contracts on it. If you are right, you could make huge amounts of money very quickly, starting with a relatively small wager. If you are wrong, you only lose the money that you used to buy the puts; it's not like shorting a stock, where you have unlimited liability.
Credit derivatives are contracts whose terms are based on certain events related to bonds. Bonds are basically just resellable loans. If you borrow money to buy a house, then your loan is pooled with a bunch of other loans (probably), and a bank sells off the right to collect the payments on these loans--now this can get quite complicated, so don't worry too much about the details.
Let's keep it simple and talk about municipal bonds. Let's say that the government of Orange County, California, wants to borrow money. They can go to an investment bank, and borrow money. To get the money, the investment bank sells bonds (this is why investment banks are so rich--they take their profit up-front, before defaults and bankruptcies occur!). The bondholders are now the creditors to Orange County. If Orange County pays back the loan, the creditors get their money back, plus interest.
But as we all know, Orange County was involved in one of the biggest bond defaults of all time. How can the investment bank sell Orange County bonds, if potential investors are afraid of Orange County not paying them back?
Well, traditionally, you can make the deal by sweetening it. The investors want to be rewarded for taking the risk; that means that they will demand higher interest. But investment banks don't like that idea!! If Orange County can barely afford the loan as it is (which is why the problem occurs in the first place), then maybe they won't borrow the money! And then the investment bank would not make its own profit.
So, someone came up with a new solution: credit default "insurance". For a relatively small fee (compared to higher interest rates), a third party agrees to pay money if the borrower defaults on the loan.
This is a derivative, because it is based on the value of something else (the loan, that is, the bonds). It is called a "credit default swap".
The people who make these agreements are called the "underwriters". Now, who are the underwriters?
Well, we don't know exactly. You see, this is a highly unregulated, unorganized market. We think they are typically speculators looking for a supposedly "easy" income stream.
In the real insurance industry, you have to have huge pools of funds, to prove that you really can pay up in the event that a covered event has happened. Right now, the insurance industry is probably on the line for storm damage along the Gulf Coast. Now, one of the things that the insurance industry did, was it refused to cover certain properties--such as those that are too close to the waterfront--because the risk was too high. (by the way, the insurance companies invest their pools of funds, ostensibly in very low-risk investments. What do you suppose happens if insurance companies lose some of the money that they pooled to indemnify--that is, pay up on--covered losses?)
The credit default swaps did NOT manage their risk. They were covering everything and anything. It appears to outside observers that what they were after were the premiums. To hell with actually paying up in the event of an insured event happening!!
So, interest rates were kept artificially low, through promises of "insurance" coverage if the debtors defaulted. Now that the credit insurance biz is about to be uncovered as a massive fraud, it is likely that interest rates will soar, to compensate lenders for the possibility of defaults, and to try to lure them back to American credit markets, knowing that the market is highly fraudulent.
It is worth noting, that SIR ALAN GREENSPAN ENCOURAGED THIS FRAUD.
