Credit Default Swaps: Still Here, Still Able to Wreak Havoc

JPMorgan Chase (JPM), the country's biggest bank, is reporting a $2 billion trading loss that occurred in the space of just six weeks. The loss reportedly involved the investments in "credit default swaps" -- yes, those same complicated investments that played such a large role in the financial crisis.

Here's what we know so far, and why credit default swaps still pose such a threat to the U.S. economy.

The tale of the London whale

The loss occurred in JPMorgan's chief investment office, or CIO, the unit in the bank assigned with hedging the bank's own investments.

In the last month, the CIO had been the subject of intense speculation in the markets, with rumors that a single trader in the bank's London office, nicknamed "the London whale," was placing enormous bets in the derivatives markets -- bets so big they were moving the markets themselves.

JPMorgan CEO Jamie Dimon had written these rumors off as a "tempest in a teapot," but as it turns out, they were true. The New York Times is reporting that Bruno Iksil, a French trader based in London, was responsible for taking the derivatives positions.

JP Morgan Chase is the biggest bank in the U.S., with a very strong balance sheet. As such, the $2 billion dollar write-off won't cripple the bank. But it raises concerns that these kinds of derivatives trades -- despite a raft of post-crisis regulation -- still have the potential to wreak great economic havoc.

How investment banks buy insurance

A derivative is a type of security whose price is dependent on -- or "derived" from -- one or more underlying assets, like stocks, bonds, or currencies. The specific type of derivative Iksil was reportedly using in his trades was a credit default swap.

Credit default swaps are used to protect against the default of an underlying asset. As with an insurance policy that insures you against a house fire, with a credit default swap you pay a premium and are insured against the default of a debt instrument.

A simple way to think about credit default swaps is as "counter bets" to the bets you've already made. Investment banks and hedge funds commonly use credit default swaps as investments in and of themselves, or to hedge against their own portfolio of investments.

Here we go again

Credit default swaps were at the heart of the financial crisis. They were dreamed up by Wall Street in the late 1990s and became popular fast. In 2000, the market was $900 billion. By 2008, it was more than $30 trillion.

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The problem was that as everyone and their mothers began taking out these credit default swaps, no one was keeping track of who owed what to whom. That is, there was no central clearinghouse that was keeping track of all those insurance policies out there.

As it turned out, many institutions had taken derivative positions against the mortgage-backed securities that became so ubiquitous in the early to mid-2000s.

When the mortgage-backed securities started to go south and the "insurance policies" started coming due, many institutions, like insurer American International Group (AIG), realized they couldn't cover their bets. Consequently, they would have gone bust -- taking the rest of the financial system down with them -- if they hadn't been bailed out by the federal government.

Waking Up and Smelling the Derivatives

For all the post-crisis hand-wringing over the behavior of the banks and other "too-big-to-fail" institutions that found themselves in mortal danger from the use of unregulated financial instruments like credit default swaps, very little has changed.

The Dodd-Frank reform bill was supposed to set up a derivatives clearinghouse, but that has been slow in coming. The Volker Rule, intended to stop banks from trading with their own money, is still two years away from implementation, and it's not clear that this trading loss would have been covered by it.

The call for stronger regulation in the wake of JPMorgan's massive trading loss has already begun. Jamie Dimon himself admitted that this event would play right into the hands of his critics. For everyone's sake, let's hope so.

Motley Fool contributor John Grgurich owns no shares of any of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase.