Credit Default Swaps

Q. Would you explain what a credit default swap is and why they’re so toxic?  It may seem like old news but I keep reading about them in the newspaper, but they never quite explain what they are and why they’re so dangerous, least ways so that I can understand what they’re talking about.

A.  A credit default swap is an unregulated derivative, a form of insurance that guarantees payment to an investor in the event that a particular investment goes bad.  They are not insurance in the usual sense because the issuer is not required to set aside reserves in the event of a claim. 

But that’s only part of the story. These products were designed to mitigate risk, but given their stupendous growth they have the potential to wreak havoc on the financial system.   From 2001 they grew from $900 billion to more than $62 trillion, today.  To put it in perspective, this is about equal to 70% of the total U.S. household wealth and about seven times the national debt.  The market is totally unregulated and the firms are so interlinked with one another and with other market players that they do not know whether their counterparties, as they’re called, have adequately protected themselves.  If and when defaults occur, some of the counterparties are likely to prove unable to fulfill their obligations as was the case with AIG and the four attendant bailouts it required. 

Credit default swaps took off as a way to bet on the likelihood of a default by a firm or an investment portfolio, without having to own any financial interest in the firm or portfolio. 

So, as they are presently constituted, it’s a form of gambling.  The only reason they are not deemed gambling is that in 2000, congress specifically exempted credit default swaps from gaming laws.  As a result, Eric Dinallo, the insurance superintendent for New York State, estimates 80 percent of the outstanding $62 trillion in credit default swaps were speculative. 

Initially, they arose as a hedge against uncertainty.  But, when the bubble for mortgage-backed securities burst and Lehman Brothers went under, the entire economic system was threatened.   Later, as defaults rose, A.I.G. (a far bigger player than Lehman Bros.) was also unable to make good on its swaps, until the government stepped in.  The payments by AIG went to about two dozen firms, including Goldman Sachs, Merrill Lynch, Bank of America and various European banks.  Had AIG not been bailed out, it was feared that it would precipitate a domino effect of financial failures that would have been truly calamitous.

The size of the ‘swaps’ market and the lack of governmental oversight leaves on with the feeling being feeling that herein lies another instance of an accident waiting to happen.  What is needed is transparency going forward.  Banks have resisted the idea of requiring that all trading in credit default swaps be conducted on exchanges, in the open and subject to full regulatory scrutiny.  But, it is an idea that is long overdue.

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