Credit Default Swaps

stockexchange2_2For those who watched 60 Minutes’ segment Sunday on “credit default swaps,” were you enraged to hear about these financial explosive devices? Were you embarrassed to find out that our economy, the financial pioneer, has been taken advantage of by champagne drinking, shrimp cocktail eating Wall Street titans? I was, and I had trouble sleeping last night because of it!

If you did not catch this week’s edition of 60 Minutes, the show laid out the following horror story: Mortgage lenders sold loans with low introductory “teaser” interest rates. The lenders then sold the huge volume of loans to Wall Street banks, like Bear Stearns, Lehman Brothers and Merrill Lynch, who then bundled them into bonds known as “mortgage backed securities.” To entice investors, the investment houses created and sold a “credit default swap” that was marketed to protect the investors against losses if the investments went bad.

And this is where it gets bad. In essence, a “credit default swap” is an insurance contract. However, the banks were very careful not to classify it as “insurance” and used a magic word, “swap,” as a substitute. If it were insurance, the person who sold the policy would have to have capital reserves able to pay in the case the insurance was called upon or triggered. But because it was a “swap,” and not insurance, there was no requirement that adequate capital reserves be put to the side. When homeowners began defaulting on their mortgages, and Wall Street’s high-risk mortgage backed securities also began to fail, the big investment houses had not set aside the money they needed to pay off their obligations. And this is where we are today.

Thomas Friedman, the Pulitzer Prize author on foreign-affairs, says that there have only been a few times in his life when he has truly been frightened for this country: the Cuban missile crisis in 1962; when J.F.K was assassinated in 1963; on September 11, 2001; and today, the scariest moment of them all. While the first three attacks on the U.S. were by outsiders, today’s financial crisis was a result of our own failure to regulate our financial system. In other words: we let greed take over.

Look at us now. On Monday morning, the Fed announced that the system will receive yet another enormous injection of liquidity, saying it would make as much as $900 billion available. But what is especially frightening is that even with action of this magnitude, confidence does not seem to be restored. By Monday, the Dow dropped 370 points. European markets are falling. Russia and Brazil shut down trading. Not exactly confidence-boosters.

About one hundred years ago, in response to the creation of the Federal Reserve, Charles Lindbergh, a Congressman from Minnesota, made this comment: “From now on depressions will be scientifically created. Like two con men working a mark, the Fed made credit easy while…newspapers hyped what riches could be made in the stock market.” Well said Congressman Lindbergh. Nothing seems to have changed.

For a complete transcript from last Sunday’s 60 Minutes, visit: http://www.cbsnews.com/stories/2008/10/05/60minutes/main4502454.shtml

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One response to “Credit Default Swaps

  1. You neglected to state that there is some form of “insurance” built into a CDS — collateral. Now, if you want to state that the collateral was insufficient or that collateral calls weren’t triggered frequently enough (due to poor contracting and oversight), that would be a little more accurate and much more exciting. Overall, however, I liked the article.

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