"the more we think we're safe, the riskier things actually are."

Once more into CDS's with Felix Salmon:

"In other words, the driver of the financial meltdown was good old-fashioned credit markets: not the CDS market at all. A few buy-side investors, to be sure, lost a lot of money selling default protection, among them the two Bear Stearns hedge funds which went bust in the summer of 2007 and really got this credit crisis going. But financial institutions, with the exception of the monolines and AIG, were not net sellers of default protection, and therefore did not lose money on CDS when spreads started gapping out and people started defaulting on mortgages. Insofar as banks have lost money, they've lost money on real-money loans to real-world individuals and companies. They have not lost money by speculating in the CDS market."

Seems clear.

"The first question is to determine, in a sober and responsible manner, whether CDS were abused. So far, I've seen little if any indication that they were. The second question is how to regulate the amount of leverage that banks take on. And far from being "a hard thing to get at directly", that's actually very easy to measure: you just look at how big the bank's balance sheet is, and how much capital it has to support that balance sheet.

To be sure, hedge funds and other shadow financial institutions can use CDS to replicate a bank's balance sheet without regulation, and that's a problem. So maybe hedge funds should be regulated -- although now that their cost of funds is much higher than that of the banks, that might no longer be necessary.

As far as the banks are concerned, most of the losses they've taken have come straight out of their balance-sheet assets, or maybe out of SIVs which once were off-balance-sheet but which now are much more transparent. Occasionally you'll find some weird and wonderful instrument like the liquidity put, which seemingly comes out of nowhere to saddle a bank with enormous losses. But the liquidity put had nothing to do with CDS, and regulating derivatives would have done nothing to prevent it from happening.

This is why the CDS demonization meme is dangerous: it's basically the financial equivalent of all the security theater at airports. Regulating CDS might trick the public into feeling safer, but it won't do any real good at all. And if there's one thing we've learned over the course of this crisis, it's that the more we think we're safe, the riskier things actually are."

It all comes down to leverage, not the actual investment. What's so hard to understand? To the extent that people believe some voodoo is being used, that constitutes Fraud, not complexity, in and of iteself.