The Credit Crisis, Act II: How One Smart Idea Brought the World Economy to Its Knees

Ever wondered why the collapse of the subprime mortgage market would escalate into a worldwide financial crisis of a magnitude never before seen? The answer in three words: Credit default swaps.

Warren Buffet called them “financial weapons of mass-destruction.” Credit default swaps, or CDS for short, are a new financial instrument created in the mid 1990s. They were originally intended to give banks a way to take out insurance against loans turning bad. With the advent of credit default swaps, instead of holding a cash reserve as security against bad loans, banks could simply purchase insurance against defaults. This freed up cash reserves for making more loans, and in turn, earning even greater profit. If loans went bad, the company issuing the insurance would be on the hook, not the bank or the financial institution issuing the loan.

The first credit default swaps were introduced in the mid-90’s. They quickly grew in popularity, particularly after Congress approved the Commodity Futures Modernization Act in 2000. The Act was meant to deregulate the financial markets, and it removed previous federal oversight on derivatives and credit default swaps. The idea was that Wall Street, left to its own, would come up with newer and greater financial products that would help create even greater wealth for the country.

Earn money Wall Street did. But unfortunately, not in a way that would create wealth for the country. The cat was away and the mice began to play. With credit default swaps totally unregulated, smart investors quickly figured out that you could use them to place bets on the underlying financial instrument they insured. You didn’t even have to own the underlying investment to collect on the insurance if something went wrong, so the downside risk was small.

Credit default swaps essentially developed into a form of legalized gambling. They enabled hedge fund managers and other savvy investors to place bets against the entire housing market. All they had to do was purchase an inexpensive insurance policy. Then, if the housing market began to go south, these investors stood to cash out big time.

Within less than ten years, the CDS industry spurned the largest financial services boom the U.S. has ever seen, growing from $100 billion to more than $50 trillion. Credit default swaps weren’t just used to create bets on the U.S. mortgage market, but on pretty much anything from automobile manufacturers to local communities. In the process, Wall Street traders and investment bankers earned billions in salary and lucrative bonuses.

Then the housing market collapsed. The music stopped playing and suddenly everyone discovered that no one had put out chairs to sit on. Because credit default swaps were completely unregulated, the banks, investment houses, or insurance companies that sold them were not required to have a reserve of money set aside to pay off the insurance should the underlying assets go into a tailspin.

A default here and there was not a problem. However, the problem with mortgage defaults was that defaults are systemic: growing defaults trigger less credit, which triggers more defaults, and so on. So when the housing market went into a tailspin, the companies selling credit default swaps were suddenly holding not just one bad bet, but trillions of dollars of bad bets. And when investors lined up to cash out on their credit default swaps, there was not enough money to make good on them.

Overnight the companies that were heavily invested in credit default swaps became insolvent: Lehman Brothers went bankrupt, Bear Stearns was sold for pennies on the dollar, and insurance giant AIG had to be propped up by a huge infusion of tax payer money.

So who is ultimately to blame for this mess? The problem with credit default swaps is that no one fully understood the risk. Deregulation coupled with human greed created an explosive combination that spun completely out of control. As a result, the U.S. economy has taken a staggering blow, and no one ultimately knows just how many of these toxic assets are out there.

Yet, history has shown that out of crises often come great changes. If there is any silver lining in the great credit crisis of the 21st century, it may be that it will force lawmakers to address systemic weaknesses that have been ignored so far. In the long term, that would leave us all better off.

Published: May 22, 2009