Felix Salmon explains how the insurance that is not insurance has wiped out the banks and turned them into casinos:

Entities who want to really take on credit risk are called banks, and they do so by lending. People who sell credit protection in the markets, by contrast, are traders and speculators who trust in the liquidity of the CDS market and who are sure that they will be able to get out quickly if things turn against them. And thus is the CDS market used shunt risks off, unseen, into the tails.

Liquidity isn’t just dangerous in the loan market. Look at houses, which used to be highly-illiquid investments characterized by a long-term relationship between a homeowner and a lender. When did things fall apart? When that relationship was replaced by a frenzy of securitization and refinancings, with even 30-year mortgages lasting for just a year or two before they were paid off by someone flipping their house or deciding they needed a cash-out refinance. The more liquid housing became — the closer it came to being piggy bank, to be tapped for cash at any time — the more dangerous it became, as well.

Mr. Salmon does not believe that the CDS will be banned, but I’d like to see them regulated as real insurance, which would prohibit the naked CDS, for the same reason that they don’t allow you to buy insurance that pays you when you torch your neighbor’s home.

That’s been the law of the land for 266 years, but about 20 years ago, we let it slide, with disastrous results.