[Warlord]

The problems with pricing that you note come from issues relating to the estimation of default probabilities on the underlying mortgages and the correlations for bundled mortgages. You're right in the sense that as credit derivatives became increasing complex, correlations become increasing difficult to estimate. At first, credit derivative were a means of dealing with increasing regulatory pressure to loosen lending standards for community” building purposes. Then, when things got hot, credit derivatives were also use as a means of investment for investors looking for yield.

But these are issues of the appropriate management of credit risk. Credit derivatives are like guns: Guns should not be banned because bad actors use them to kill innocent folks.

[Truthsearcher]

What about a megaton TNT bomb? There are some weapons that cause such collateral damage when misused that we don’t allow private individuals to own them simply because potential damage is too high for society to bear.

Is the CDS more like a gun or a massive bomb in this scenario?

[palmer]

At first, credit derivative were a means of dealing with increasing regulatory pressure to loosen lending standards for community” building purposes. Then, when things got hot, credit derivatives were also use as a means of investment for investors looking for yield.

Lots of good facts there, but I'm not sure how you obtain your conclusion. Once the default risk of some securities is transformed into the default risk of a major CDS counterparty like AIG, then the pricing calculation turns into a govt bailout probability calculation which is indeed what happened.

At the same time the holders of the CDS like Goldman Sachs who used them to speculate on the default crisis as a whole have a economic incentive for particular failures, because the more likely the underlying MBS are to fail, the more GS's CDS for them are worth.

It's a tool for complete financial system failure, not a gun to shoot a specific target, but a building full of gunpowder in the center of the financial district.