Could Credit Default Swaps Tank the Market?

They just might according to this observation. So I decided to check out what the hell these CDSs were and they found out that it could be quite scary if they failed.

Credit Default Swaps, or CDS, offer financial firms a quick way to offload
part or all their exposure to debt backed by state and municipal governments,
corporations, or structured debt tied to consumer loans. ‘Wrapping’ is a
technique securities underwriters use to increase the credit ratings of lower
rated debt to make it easier to sell to investors.

So if these CDSs are tied to subprime mortgages and they start to fail then the rug will actually be pulled out from under these derivatives. It is kind of like owning Call Options in a company that suddenly went bankrupt. The options suddenly become worthless pieces of paper but these things are worse because other layers of derivatives are based on these.

Also they may be "wrapped" into bundles of debt as also described in that article and stamped with a AAA rating because they were insured by MBIC and Ambac. Now that those companies might lose that AAA rating the debt they insured might also lose that rating. So essentially the "wrapped" securities could go from AAA to junk overnight. And that would be bad for every holder of one of these wrapped securities and the market as a whole.

Remember there is a $500 trillion dollars worth of these various derivatives floating around. If what they are derived from fails then a recession might turn into a depression real fast.