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Saturday, October 11, 2008

Credit Default Swaps and the Financial Crisis

A couple months ago, most of us never heard about credit default swaps (CDS), but now we learn that they may be at the heart of the financial crisis. This is primarily because many banks and financial institutions have credit default swaps on their books and no one knows how to value them or how much these financial institutions may owe.

According to Wikipedia (

A credit default swap (CDS) is a swap contract in which a buyer makes a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default or on the occurrence of a specified credit event, for example bankruptcy or restructuring. The associated instrument does not need to be associated with the buyer or the seller of this contract.

Estimates of the credit default swap market has grown to the tens of trillions, (yes, that’s trillions), of dollars. It is now estimated to be larger than the world’s GDP. This has caused many institutions to hoard cash and not lend to others for fear that many have these “toxic debts” on their books.

Why don’t we make credit default swaps illegal? They will always remain as a source of doubt about financial institutions. Those who’ve engaged in these unregulated practices will just have to eat their loses, which they appear to be doing now. Just look at the recent auction of Lehman Brother’s credit default swaps, which yielded about 8 cents on the dollar. Wouldn’t we be better off legislating them all away and starting again from zero?

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