"Financial weapons of mass destruction,” Warren Buffet called them: credit default swaps. Pioneered by JP Morgan in the 1990s, these financial instruments were bought by banks as insurance that debts would be repaid. The innovation thrived until firms like AIG started defaulting on credit swaps that insured home mortgages—and Wall Street took the brunt.
Everyone who owned credit-swap-protected home mortgages suddenly faced losses worth billions and credit woes to match—which is why Washington bailed out AIG. Now the fate of credit swaps hangs in the balance: Some analysts advise regulating them, while others want them canned. But "if you outlaw them," one expert warns, "then the financial engineers will just come up with something else that gets around the regulation."