I believe that everyone wants to know more about staff that ruined our economy. Here is one called Credit Default Swaps which I will explore more using an article called Credit Default Swaps: The Next Crisis?
Credit Default Swaps (CDS) are second cause of the credit hurricane in financial crisis. Credit Default Swaps, which were invented by Wall Street in the late 1990’s, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default – that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised.
“CDS were seen as easy money for banks when they were first launched more than a decade ago. Why? The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economy times.”
Even though CDS appear to be similar to insurance, it is not a form of insurance. Rather it is an investment that “bets” on whether a “credit event” will or will not occur. CDS do not have the same form of underwriting and actuarial analysis as a typical insurance product rather is based on an analysis of the financial strength of the entity issuing the underlying credit asset (loan or bond).
“(…) Commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps – where they acted as either the insured or insurer – at the end of the third quarter of 2007”
There are no regulatory capital requirements for the seller of protection. Credit default swaps can be written by just about anyone, but usually it’s insurance firms or investment banking house. American International Group (AIG), the large insurance corporation had bought many CDO and had written many CDS to protect investors against default of the CDO. By purchasing the CDO, AIG has eliminated the need for insurance contracts against their default, thus reducing AIG’s risk of needing to make insurance payments.
“AIG recently reported the biggest loss in the company’s history largely due to an $11 billion write-down on its CDS holdings”
Whether greater regulation would have prevented this crisis isn’t certain, but AIG was allowed to take these risks in the absence of regulation. Because the “credit-default swaps” it sold as a form of insurance that were not regulated, AIG wasn’t required to set aside money in reserve to cover potential losses from the mortgage-backed securities. The investment strategy was based on the belief that housing prices would only go up. When housing prices fell, there was nothing to cover the losses.
