Wait, the Derivatives market is worth $1,200 TRILLION dollars???

[coalition_unwilling]

47. Here's a good example from real life: AIG sold credit default swaps against

the possiblity that bonds on mortgages would suffer defaults if the real estate bubble popped. Of course, few at the time ever thought that real estate prices would stop ascending (despite the fact that the real estate boom-bust cycle occurs almost as regularly as clockwork).

So AIG was legally required to pay out if the real estate bubble burst. But (and here's the big BUT): AIG was not legally required to maintain adequate reserves against the possibility that the real estate bubble would burst. So when the real estate bubble burst and AIG was required to pay out on all the CDSes it had sold, it did not have the funds to pay out. Instead, the taxpayers had to bail it out. Note that a sizable portion of those bailout funds were direct pass-throughs to Goldman Sachs (which had bought massive amounts of AIG's CDSes), even though Goldman Sachs had little or no insurablitiy interest (meaning GS held no underlying assets that required it to hedge with CDSes).

If AIG could not pay off on its CDSes, then GS would go belly-up because AIG did not pay. If GS went belly up, that might trigger the entire house of cards to come crashing down.

That's as near as I can come to providing a simple explanation of how a crash could occur.