Personally, I've never been a big enough player to be in the market for credit default swaps, but they are analogous to something I've considered purchasing: earthquake insurance. About 7/8ths of California homeowners do not have earthquake insurance. If a small earthquake directly under my house knocks down my house and a few hundred around it, then having earthquake insurance would turn out to have been a great idea. But if The Big One knocks down a million houses, will any insurance company in the business be able to pay off? Would the federal government subsidize the obligations of the insurance companies? Or would the federal government just step in and pay off everybody, insured and uninsured? Or would SoCal revert to a permanent Mad Max wasteland of rubble?
I don't know.
The state legislature set up a public-private entity called the California Earthquake Authority, which boasts that it has $8 billion available to pay off earthquake damage. At $250,000 per house, say, that's 32,000 houses. But most houses aren't insured. On the other hand, a very large fraction of the damage would be done to commercial properties and infrastructure.
Both earthquake insurance and credit default swaps raise the issue of moral hazard. The hazard is obvious with credit default swaps. If you could get AIG to insure for a cheap price that your bundle of liar loans wouldn't default, why not create mortgage backed securities even more likely to default?
Moral hazard seems more implausible with earthquake insurance, but it does exist because there are big differences in potential earthquake damage in Southern California just blocks apart. After the big 1994 Northridge Earthquake, my dad saw a map in the newspaper of all the condemned buildings in the San Fernando Valley. He then looked up a geological map of the Valley that showed where all the old river beds ran.
A typical California riverbed has a trickle of water two feet wide in the midst of a "wash" of sand and gravel hundreds of yards wide. During a major winter storm, the entire wash fills with roaring water, depositing more sand and gravel. After the destructive flood of 1938, the LA River and its tributaries such as the Tujunga Wash were channelized into giant concrete ditches, allowing construction right up to the edge of the channel.
About 80% of the condemned buildings in the Valley after the 1994 earthquake turned out to have been built on top of the sand and gravel of the old river washes. You could see on a street built originally along the banks of the old LA River wash, apartment buildings on the sandy side of the street fell down, while the apartment buildings on the soil side stayed up. As the Bible says, the typical house or apartment building that fell down was a house built on sand:
And every one that heareth these sayings of mine, and doeth them not, shall be likened unto a foolish man, which built his house upon the sand:
For awhile after the 1994 earthquake, there was some interest in figuring out what parts of Southern California were more likely to fall down again. Maybe we should convert the place that were hardest hit to parks, or at least downzone them from multistory to single story dwellings. But, then, people seem to have lost interest in the subject.
And now that I think about it, this analogy is particularly fruitful. The global financial structure turns out to have been built upon the mortgages of the houses of what Wall Street called the Sand States (California, Nevada, Arizona, Florida)...