Question

Recall our discussion of the financial crisis. Why did the sale of so many credit default swaps make a bad situation much worse?

Answer 1

Swaps allow purchasers to buy protection against a low probability but devastating event. It is like an insurance policy where the buyer makes periodic payments to the seller. Most CDS protect against the credit risk of mortgage-backed securities, junk bonds, and collateralized debt obligations.

Swaps protect lenders against credit risk. That enables bond buyers to fund riskier ventures than they might otherwise. Investments in risky ventures spur innovation and creativity, which boost economic growth. Companies that sell swaps protect themselves with diversification.

Swaps were unregulated until 2009. That meant there was no government agency to make sure the seller of the CDS had the money to pay the holder if the bond defaulted. In fact, most financial institutions that sold swaps were undercapitalized. They only held a small percentage of what they needed to pay the insurance. The system worked until the debtors defaulted. Unfortunately, the swaps gave a false sense of security to bond purchasers. They bought riskier and riskier debt. They thought the CDS protected them from any losses.

There are a couple of aspects to be considered about the financial crisis-

1. By mid-2007, there was more than $45 trillion invested in swaps. That was more than the money invested in the U.S. stocks, mortgages, and U.S. Treasurys combined. In fact, it was almost as much as the $65 trillion produced by the entire world. The problem was that Lehman Brothers had $400bn debt covered by swaps. The sellers of the swaps like AIG didn't expect all the debt to come due at once. And When Lehman declared bankruptcy they didn't have enough cash on hand to cover swap contracts and had to be bailed it out.
2. Banks had begun using CDS to insure complicated financial products and traded them in unregulated markets. The buyers didn't understand their risks because they didn’t know the underlying assets because the products were so complicated. Thus, swap sellers were hit hard during defaults and the CDS market was in shambles overnight. No one was buying them and they had to cut off funding for small businesses and mortgages, leading to high unemployment.

Thus, If an institution fails in a highly interconnected derivates market, it can lead other institutions to fail as they make losses on their exposures. This could thus lead to a collapse of the financial system and in the event of the failure of a major financial institution., CDS are worse because their value jumps, and often by large amounts, when a default occurs.