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Credit Default Swaps designed to transfer credit risk, are a form of insurance linked to securities such as mortgage-back securities and bond issues. They are intended as a buffer in the event that the underlying investment goes bad and are in effect a form of financial insurance. They’re private, complex and murky contracts marketed like any other standard insurance policy. The problem is, those issuing the contracts can’t actually use the term “insurance” because the insurance industry is tightly regulated.
This is why Wall Street came up with the term “swap,” thereby allowing credit default swaps to fly under the federal regulator’s radar. The market, currently estimated at more than $62 trillion, is unregulated, prone to sloppy documentation and has no central clearinghouse.
Offering the swaps softened the edge for those buying mortgage-backed securities, because they were marketed as a risk-saving device for an already risky investment. If swaps actually did provide insurance, those selling them would have been required to have enough capital reserves to pay in case things went south. But because they were structured and sold as swaps, no back up capital reserves were necessary.
Credit default swaps play a significant role in a huge stealth and unregulated market and their lack of transparency has helped fan the credit crisis. In fact, they contributed to the problems that hit three of the largest firms on Wall Street—Bear Sterns, Lehman Brothers, and AIG. Basically these investment banks were not only selling toxic securities, they were selling bogus insurance to cover them.
Many credit default swaps have sunk in value as the mortgage-backed securities they support have imploded Bear Stearns was the first to fail—J.P. Morgan snatched them up for pennies on the dollar. Next came the Lehman Brothers’ bankruptcy. Then when AIG, the nation's largest insurer, couldn't even cover its own bad debts, the Feds stepped in with $85 billion to rescue them.
For more about the role credit default swaps played in the financial crisis seeWall Street’s Shadow Market.
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