Of all the things I’ve read lately about our current coaster ride, the most revealing was this couple of paragraphs, way down in a January 15 piece in the Wall Street Journal by Susan Pulliam and Serena Ng, titled “Default Fears Unnerve Markets.”

The article is about a class of derivatives called credit-default swaps. If you’ve never heard of them, it’s because they aren’t the sort of deals available to the the likes of you and me. The article does its best to explain them by analogy: they “work like a side bet on a football game.” Institutional traders place bets based on the perceived odds that other parties will default on bonds or loans. Then they buy and sell their bets amongst themselves.

Here’s the bit that opened my eyes:

With no central trade processing of credit-default swaps, defining trading-partner risks can be a Herculean task. Mr. [Warren] Buffett learned the difficulty of unraveling such complex instruments in 2002 when he directed General Re Corp., a reinsurer that had been acquired by his Berkshire Hathaway Inc., to pull back from the business of these swaps and other derivatives. It took General Re four years to whittle the business from 23,218 contracts to 197 by the end of 2006.

Doing so involved tracking down hundreds of counterparties to General Re’s trades, many of which Mr. Buffett and his colleagues had never heard of, he says, including a bank in Finland and a small loan company in Japan, to name just two. One contract, Mr. Buffett says, was designed to run for 100 years. “We lost over $400 million on contracts that were supposedly” safe and properly priced, “and we did it in a leisurely way in a benign market,” Mr. Buffett says. “If we had to unwind it in one month, who knows what would have happened?”

We’re about to find out “what would have happened” because it’s unfolding right now. Bets are getting called. People are finding out that liabilities they pushed out the door a long time ago have invited themselves back in and are licking their lips, ready to start biting arse. The stock market makes the headlines but it’s only a proxy for the real bloodbath.

Keep your fingers out of the way if you can.

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