Here’s an informative article on the AIG credit default swap disaster which helps illustrate how these derivative trades are so devasting.
A.I.G., Where Taxpayers’ Dollars Go to Die 
By GRETCHEN MORGENSON, in the NY Times
“DERIVATIVES are dangerous.”
That simple sentence, written by Warren Buffett, begins an enlightening discussion in Berkshire Hathaway’s most recent annual report. Mr. Buffett’s views on derivatives, gleaned from his own unhappy encounters with them, should be required reading for all United States taxpayers.
Why? Because we own almost 80 percent of the American International Group, the giant insurer whose collapse was a direct result of derivatives it sold during the late, great credit boom.
A.I.G. nearly barreled off the cliff last September, when it couldn’t meet its obligations to customers who had bought a version of derivatives called credit default swaps. Such swaps are like insurance policies; bondholders buy them to protect themselves from default on various forms of debt… 
…the sheer volume of derivatives engineered by a small London unit of A.I.G. suggests that taxpayers haven’t seen the bottom of this money pit.
…Because of the way A.I.G. wrote its swaps, and because the company had a double-A credit rating at the time, it did not have to put up collateral to assure its customers that it would be able to pay on the insurance if necessary. Collateral would be required only if A.I.G.’s credit rating were cut or if the debt underlying the swaps declined.
Both of these “unthinkable” events occurred in 2008. Suddenly, A.I.G. had to cough up collateral it didn’t have.
SO, you see, the rescue of A.I.G. also involved a bailout of its many customers, none of whom the insurer or the government is willing to identify.
…On Wall Street, those customers are known as “counterparties,” and Mr. Liddy wouldn’t provide details on who the counterparties were or how much they received. But a person briefed on the deals said A.I.G.’s former customers include Goldman Sachs, Merrill Lynch and two large French banks, Société Générale and Calyon…
So the meter is constantly running at A.I.G. Just as quickly as taxpayer funds flow into the firm, chunks of it go right out the door to settle derivatives claims…
When you look back with the benefit of hindsight, it is truly amazing how outsized A.I.G.’s insurance commitment was, at $440 billion. After all, in 2005, when A.I.G. put many of these swaps on its books, the market value of the entire company was around $200 billion.
That means the geniuses at A.I.G. who wrote the insurance were willing to bet more than double their company’s value that defaults would not become problematic…
Full article here.
