Swaps for Credit Default Remain a Looming Risk
In the aftermath of the 2008 financial crisis, the role of credit default swaps (CDS) in the global economic meltdown remains a subject of interest. These financial instruments, designed to protect against the default of a debt instrument, were used not only for insurance but also for speculation on assets that the holder did not own.
The swaps market, which ballooned from $900 billion in 2000 to more than $30 trillion by 2008, was largely unregulated and opaque. Transactions were often made privately, without a centralized clearinghouse, making it difficult to know who owed what to whom. This lack of transparency contributed to the crisis, as when subprime mortgage-backed securities began to default, a significant portion of the market started coming due.
The International Swaps and Derivatives Association (ISDA) ruled that a Greek debt restructuring might not trigger relevant credit default swaps, a decision that was criticized for its lack of clarity. The ISDA's ruling was just one example of the industry's self-regulation, which has been a point of contention.
The Dodd-Frank financial-reform bill of 2010 was intended to address these issues by requiring all standardized swaps to appear on exchanges and run through clearinghouses. However, Wall Street is still haggling over the exact rules, and the swaps market remains less transparent than many would like.
The Commodity Futures Trading Commission (CFTC), which is primarily responsible for setting the rules, is woefully underfunded. This has led to delays in implementing the Dodd-Frank reforms and left the market vulnerable to potential abuses.
The financial crisis saw several prominent institutions requiring bailouts. JPMorgan Chase rescued Bear Stearns, while Goldman Sachs and Morgan Stanley were bailed out by the federal government. Bank of America saved Merrill Lynch with a last-minute purchase. American International Group (AIG) also received a significant bailout, much of which was tied to its CDS exposure.
Despite the crisis, the CDS market has not shrunk significantly. The current market is estimated to be about $36 trillion, with banks, investment banks, hedge funds, and AIG among the users. The rules for handling CDS in Germany are primarily determined by a combination of general contract law principles, securities trading law, and banking supervisory regulations, with recent changes focusing on adapting to international standards and reforms like Basel IV.
As we approach a decade since the financial crisis, a lot of swaps exposure is still floating around, waiting to be triggered. The lessons learned from the crisis have led to stricter regulations, but the swaps market continues to be a complex and potentially risky area of finance. The Motley Fool, in a departure from the topic, has even called a delightfully straightforward investment its top stock for 2012.
