Called the Financial Weapons of Mass Destruction by Warren Buffett, a Credit Default Swap is simply an over the counter credit derivative (bet) between two parties about the financial solvency or outcome of something else.
Even though politicians and the media try and blame the housing bubble on speculative home investors and sub-prime borrowers, the United States Government’s approval of legalized gambling on Wall Street is in fact the cause of a much larger $60 trillion financial crisis.
Companies who issued Credit Default Swaps are very similar to the homeowners with good credit who purchased properties that they could never really afford, with zero money down, and without having to prove income or assets.
Everything from major companies, financial markets, to mortgage backed securities were “Insured” or bet against. For example, investors could purchase a derivative on whether or not sub-prime mortgage borrowers would default on their mortgages.
While a CDS sounds like an actual insurance product, it technically was called a “Swap” so that the banking and investment firms selling them wouldn’t fall under insurance or SEC regulations.
Actually, a little bill called the Commodity Futures Modernization Act of 2000 on the heals of the Financial Services Modernization Act of 1999 reversed a 67 year-old law that made it illegal for banks, investment firms, and insurance companies to participate in this form of gambling.
Unfortunately, CDS’s were too complex for many CEOs to understand, which is why AIG could rack up $440 Billion in debt before anyone knew what hit them.
Here are the key components and history of the Credit Default Swap:
- Invented in 1997 by a few physics and math wizards at JP Morgan Chase
- Sellers of CDS aren’t regulated
- Transactions are conducted by two entities in an over the counter environment
- Sellers are not required to have cash reserves to cover the losses they are insuring
- Purchasers of CDS don’t have to own the securities being insured
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How Credit Default Swaps Destroyed US
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