How about what is referred to as the underlying assets and indexes i'd say they shrank by $40-$50 trillions as was said ,so would'nt the derivatives have followed ?

Unfortunately, no. Say you're a hedge fund manager with a huge junk bond portfolio. Junk bond prices are falling, and due to extreme leverage you're getting close to the line. Do you liquidate, which is sure to drop prices even further, or do you buy "insurance?" Well, as long as someone out there is willing to write the policy, I guess we know the answer. In effect, you're betting the cost of insurance will be less than the cost of liquidating, and will buy you precious time while you wait for the market to turn. The policy writer is making the same bet BTW. He doesn't want you to fail. After all, you're one of his best customers!

This has the effect of forestalling liquidations, and as long as the insurer is able to pay out, the game can continue. Now you can see why AIG was bailed out. If they'd gone under it would have triggered a stampede, and who knows who might have been trampled?

Of course at some point the cost of insurance exceeds the liquidation value of portfolios. It's the same reason I don't carry collision insurance on my 86 Pontiac...heh.

ebear