I have tried my best to explain how these credit default swaps work, and I think I now have the answer.
My father is in the fishing tackle business. He makes custom fishing reels for salmon, steelhead, trout and other sport fishing, among other gear and tackle. On a number of occasions, my dad has told me that he thinks he lacks the "economics gene" to understand economics. While I doubt that, I did want to try to find a practical way to explain - from my limited understanding - how this massive economic disaster took place. Here was my best honest attempt at explaining it, verbatim except for changing some names and purely personal details.
Business Model One - Fishing Reels.
Make fishing reels, market fishing reels, sell fishing reels, don't flee to Dubai with the money.
Business Model Two - Fishing Reel Default Swaps.
Offer to sell reels, maybe, but more importantly also offer Super Senior Liquidity Facility Reel Default Swaps, which would replace the top tranche (trawwwnch) of Super Senior AAA rated reels made out of styrofoam and nail polish with actual reels in the event that the phantom reels delivered broke or needed repair in some unforeseen event in Nova Scotia or Maine or in transit. The pricing of this Reel Default Swap would reflect its superior tranche (say it, you know you want to - "trawwwnch") over the lesser AA customers, who were promised better response from the fish to the smell of the cheaper styrofoam wafting 200 yards down river of the combination of styrofoam, dirt and sweat on the Susquehanna. They CHOSE to be behind the Super Senior Swaps in a shittier trawwwnch, losers.
The manufacture of these actual reels would be delegated to your 3 year-old grandson "Stan" and his Nigerian business partner, with his attorney father getting a transaction fee as legal counsel, your fishing buddy "Kevin" getting an appraisal fee for giving the styrofoam reels a AAA rating based on the opinion of the styrofoam dealer himself about his styrofoam's field worthiness, and an investment bank getting a supervision fee for printing the documents on 8.5x11 copy paper from Staples. But that doesn't matter because only an idiot would actually believe that a customer of a Super Senior Liquidity Facility Reel Default Swap would ever actually have a reel in need of repair, because if reels made out of aluminum and pressed wood plates never need repair, styrofoam never needs repair. You ever been to a styrofoam repair shop? No? Shut up and sit down.
Soon, however, you will need to produce $5 trillion dollars notional amount of Reel Default Swaps when these styrofoam reels break when first opened, and everyone in New Jersey and California is paying a mortgage now financed in part off of the capital raised by these Reel Default Swaps, so people are actually pissed. It's all profitable, until someone actually starts looking for a Swap Reel. You don't make those reels now, you are in the Swap business. "Stan" cannot make anything of economic value other than perhaps a turd, and his Nigerian business partner already has a pre-existing lien on the turd. "Stan" goes bankrupt, the Nigerian never existed it turns out and "Kevin" is in fucking Uruguay, fishing. Pissed off homeowners in Caldwell, New Jersey start to think about nuking your homwowners' association and your entire development; a few start talking to Pakistani kebab restaurant owners for tips on whom to call in Karachi.
Finally, when the whole operation is in receivership, your sales agent "Tex" is brought in to administer the federal CARP money (congame assistance and reconstruction program) for Good Catch Capital Management, but threatens to shoot the Secretary of the Treasury with the handgun that he owns as a native Texan if the government dares to cap his salary as manager of this $4.25 trillion in Good Catch Capital Management bailout money at a mere $500,000.
You are now in Dubai, fishing in an artificial river in the desert within a massive, 3-mile long fake riverbed with a 3.5 mile long roof, replete with mosquitoes and dog shit. You are on the phone with "Kevin" in Uruguay, laughing your ass off.
Welcome to derivatives, Dad.
Anyway, my Dad thought that others might appreciate this reel-ality based explanation of derivatives markets and the limits to their economic rationality. Thanks.