Why Did the Credit Default Market Grow So Large?

It was because of the damn econometricians and their faulty equations, again. This time they assumed risk = 0. Michael Lewis explains:

...What really happened was that traders on Wall Street have the risk on their books measured by their bosses, by an abstruse formula called Value at Risk. And if you're a trader on Wall Street you will be paid more if your VaR is lower -- if you are supposedly taking less risk for any given level of profit that you generate. The firm will reward you for that.

Well, one way to lower your Value at Risk as a trader is to sell a lot of credit default insurance because the VaR formula doesn't count it as risk. Because it's so unlikely to happen, the formula doesn't grab it. The formula thinks you're doing business that is essentially riskless. And the formula is screwed up. So this encouraged traders to sell lots and lots of default insurance because, while they get a small premium for it, it doesn't matter to them because the firm is essentially saying, "Do it, because we're not going to regard this risk you're taking as actual risk."

It's insane. That market is huge as a result...