Can anyone explain this: "The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion."

My understanding was, if you have $1 billion in outstanding debt, and that defaults, then the people providing the credit default swap would have to pony up $1 billion. So who are they giving the other $5 Billion to?

A CDS doesn't necessarily have to be tied to debt, it's basically just a bet whether a third party will or will not go bankrupt. It is commonly used to hedge debt, but it doesn't have to be.

See: http://en.wikipedia.org/wiki/Credit_default_swap

Does anyone trade in second and third derivatives?

For example, the value of the risk of a credit derivative. Or the risk of the risk of a credit derivative.

Roughly, yes. The simplest example to think of is a derivative in a stock of a financial entity that mostly holds derivatives.

In general the credit default swap (CDS) causes a lot of these problems. Basically, a CDS is buying insurance against a third party going bankrupt. So if company A buys some complex financial product from company B, but A is afraid B might go bankrupt, A might buy a CDS from company C. The terms of the CDS would be something like, company A pays C a constant slow stream of money (like insurance premiums), and if B goes bankrupt, C pays A a big chunk of money.

So in essence, the CDS is valuing the risk that B will go bankrupt. But B might be a financial company that is itself holding all sorts of other derivatives. So in essence the value of the CDS is a derivative of all the other stuff that B is holding.

So when all of A, B, and C in this example have tons of mortgage-backed debt, there's a domino effect where if either B or C goes bankrupt, it puts even more risk on A's hands.

In essence - yes.

Firms will hedge and hedge and hedge (and hedge) internally and between each other. These are essentially derivations.

Also, a complex instrument might require multiple hedges. These hedge positions might be confounded in themselves - so you might put together a strategy between your hedges.

It's becomes a bit of a financial Jenga - which is why one or two key failures is getting people very nervous.

I'm beginning to suspect that many problems are a result of people not being able to keep track of what does what for who's benefit. Seriously, it sounds like a bankruptcy seminar I went to. Banks trying to foreclose were getting upset when judges started to tell them to produce the title to the loan. It turns out they had repacked and sold them and never actually delivered the titles. The excuse was "its on someone's desk somewhere." But the laws in some states require you to bring it to court to prove you own the loan. And they couldn't, even though everyone knew who owned the loan, nobody had the piece of paper.

Once the Jenga pile collapses, I highly doubt people will be able to figure out who owes what to who, even though they claim to have hedges against this, that and the other.

Credit default swaps were also interesting: http://en.wikipedia.org/wiki/Credit_default_swap