Question

7. With regard to credit default swaps, explain: a) The general concept b) The contributing role they played overall in the Great Recession c) The unusual application of them in the “The Big Short”

Answer 1

(7) (a): Credit default swaps are financial derivatives that enables the investor to enter into a swap agreement so that the credit risk that is exposed to can be systematically offset with that of the risk of another investor. In this financial derivative of contract the credit exposure of fixed income products is transferred between two or more parties.

(b): Credit default swaps played the most important role in the Great Recession. The market for credit default swaps was unregulated and as such this financial product was largely used by banks to insure complex financial products. While credit default swaps were meant to allow or enable market participants to transfer and redistribute credit risk its misuse by several large banks made it a systematic risk to the stability of the financial markets. Banks used customer deposits to invest in swaps and riskiest swaps were purchased by banks who were lured by greed. Credit default swaps started encouraging speculation and when the bubble finally burst there was a large financial meltdown and recession.

(c): In “The Big Short” credit default swaps were purchased by Michael from large banks. This was done as a financial investment and the purpose. Michael was a hedge fund manager who sensed the collapse of the U.S. housing market. In the year 2005 Michael created a credit default swap so as to short the housing market. While Michael’s viewpoint and approach was rejected by one and all in the end he ended up laughing all the way to the bank by earning as much as 500% return for his investors.