Credit Default Swaps: Weapons of Financial Destruction

In an effort to better understand the financial meltdown that continues to batter both the markets and our economy, I have read a few articles seeking to answer the questions: How and Why? How did we get ourselves into this mess, and why are there no checks and balances to prevent banks and mortgage lenders from making bad decisions.

Fortune Magazine has a great article in its October 13th issue called The $55 Trillion Question. The main point of the article is to educate people on a little known and unregulated market of exotic securities called Credit Default Swaps. Credit Default Swaps have “played a critical role in the unfolding financial crisis by ostensibly providing “insurance” on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble. “If CDS had been taken out of play, companies would’ve said, ‘I can’t get this (risk) off my books,’” says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. “If they couldn’t keep passing the risk down the line, those guys would’ve been stopped in their tracks. The ultimate assurance for issuing all this stuff was, ‘It’s insured.’”

The bottom line is that Credit Default Swaps are simply insurance against bad bets. Banks and mortgage lenders realized the only way it possibly made sense to give money to someone with a large amount of financial risk was to take out an insurance policy against their default. “It’s sort of like I think you’re a bad driver and you’re going to crash your car,” says Greenberger, formerly of the CFTC. “So I go to an insurance company and get collision insurance on your car because I think it’ll crash and I’ll collect on it.” Warren Buffett calls this financial derivative “financial weapons of mass destruction.”

Another part of the problem is that the market for Credit Default Swaps is completely unregulated—anyone can place a bet on whether a bond will fail. The difference between trading CDS and a casino is that when you put $10 on black 22, you’re pretty sure the casino will pay off if you win. A CDS offers no such guarantee. So when all these banks and mortgage lenders move to collect their “winnings” at the same time, the actual money dries up fairly quickly and eventually they are forced to either write off the bad debt or close their doors—or hope for a $700 billion bailout.

Wall-Street continues to show its inability to manage risk and protect legitimate investments—not to mention the ridiculous pay packages for CEOs—even if their companies fail. As a consumer and self-identified “small fish in the big investment game,” I could practically vomit at what’s happened to most American’s investments—including mine. The big players and self-loathing greed infesting Wall-Street continues raking in millions while we suffer in this bloodbath. One of the biggest problems: unregulated financial derivatives called Credit Default Swaps. I have a feeling big changes are on the horizon. Keep buying and don’t sell your investments!