Financial Derivatives Persist: Credit Default Swaps Remain Potential Threats
In the lead-up to the 2008 financial crisis, the global financial system was heavily reliant on a relatively new financial instrument: credit default swaps (CDS). These derivatives, designed to protect against the default of a debt instrument, became a significant part of the financial landscape.
One of the key players in the market was JPMorgan Chase, which took over Bear Stearns before receiving a bailout. The market for CDS was not centralised, making it difficult to know who owed what to whom, and this lack of transparency would prove to be a major contributing factor to the crisis.
The market for CDS was vast, with an estimated $900 billion in 2000 growing to over $30 trillion by 2008. Banks, investment banks, hedge funds, and American International Group (AIG) were among the users of CDS. However, the market was not just used for insurance purposes, but also for speculation on assets that the holder did not own.
The subprime mortgage-backed securities that fueled the housing bubble began to default, causing a significant portion of the $30 trillion swaps market to come due. The institution most prominently known as the largest user of CDS during the crisis was AIG. The company's massive exposure to CDS contracts led to a bailout by the federal government.
Goldman Sachs and Morgan Stanley were also bailed out by the government, as the financial system teetered on the brink of collapse. The Depository Trust and Clearing Corporation claims knowledge of 90% of credit derivatives-market transactions, but the swaps market was not regulated in the same way as other financial markets.
The Commodity Futures Trading Commission (CFTC) was responsible for setting the rules for standardized swaps, but was underfunded and ill-equipped to handle the complexities of the market. The International Swaps and Derivatives Association ruled that a debt restructuring may not trigger the relevant CDS if the vast majority of lenders agree to it, but it could be triggered in the future.
The Dodd-Frank financial-reform bill was supposed to require all standardized swaps to appear on exchanges and run through clearinghouses, but the exact rules are still being negotiated. The market for CDS is currently estimated to be about $36 trillion, and while the financial crisis has passed, the lessons learned from it continue to shape financial regulation today.
Looking ahead, The Motley Fool has named its top stock for 2012, but the future of the CDS market remains uncertain. Greece has $70 billion in CDS at stake in its potential second bailout, highlighting the continued importance of these derivatives in the global financial system. As the market continues to evolve, it is clear that CDS will continue to play a significant role in shaping the financial landscape for years to come.
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