632598256894

An investor who wished to invest in a pool of subprime mortgages but did not want to bear the
default risk inherent in subprime mortgages would seek to enter a credit default swap as an insurance
guarantee. Financial institutions were willing to offer the insurance in exchange for the premiums they
expected to receive.
What went wrong in recent years in the markets for subprime mortgages and credit default swaps is
still a matter of some debate. Apparently, while credit default swaps were used to shift risk around, the
aggregate level of risk in the mortgage market was not well understood. Derivatives can spread risk
around, but they cannot eliminate it. Also, while some institutions apparently gauged the risk
embedded in subprime mortgages assuming normal real estate market conditions, they failed to
consider what would happen if the entire real estate sector declined severely. The earthquake
insurance example described earlier is again apt. A property insurance company can probably handle
losses from a fire that damages one or several insured homes, but would have difficulty satisfying its
obligations if a natural disaster devastated an entire city. Similarly, the parties bearing subprime
mortgage risk could probably have handled sporadic mortgage defaults, but a downturn in real estate
values nationwide, as did happen starting in mid-2006, was another matter altogether.
So, how did credit default swaps impact the venerable investment banks Lehman Brothers and Bear
Stearns? Were credit default swaps responsible for the Lehman bankruptcy and the Bear Stearns
collapse? These questions are still being investigated and litigated, and the verdict is not yet in.
However, it seems that the crises at Lehman and Bear Stearns were precipitated by their investments in
subprime mortgages, not their insurance of those mortgages via credit default swaps. Both Lehman
and Bear Stearns were major players in the business of selling bonds backed by subprime mortgages.
Those banks held on to the risky mortgage bonds they could not sell, so they were not only issuers of
risky mortgage bonds, but also heavy investors. When the real estate and mortgage bond markets
crashed, the value of their investments declined, wiping out the banks‟ equity. One might argue on the
one hand that the banks suffered from not engaging enough in credit default swaps. They needed
protection for their risky investments. On the other hand, the advent of credit default swaps helped
make the subprime mortgage bond market possible, fed the speculative frenzy during which the
market grew dangerously big, and brought down the banks when the speculative bubble popped.
When Bear Stearns was in trouble, the federal government feared that credit default swaps would
create a domino effect, as credit derivatives now linked the fortunes of financial institutions
throughout the system. Because of credit default swaps, a default at one bank would create financial
obligations at other banks. One bank failure could precipitate many. Acting on this concern, the
federal government orchestrated a rescue of Bear Stearns. Surprisingly, however, Lehman Brothers,
which found itself in a similar situation as Bear Stearns, was allowed to fail.
Because the credit default swap market is largely unregulated, no one knows for sure how much
money was transferred to settle the credit default swaps linked to Lehman Brothers‟ bonds. Some
estimate the amount at $6 billion, whereas others estimate over $100 billion. Similarly, there is not
enough transparency in the system to determine to what extent losses from the Lehman failure, spread
via credit default swaps, contributed to the subsequent collapses of numerous other investment banks,
commercial banks, and investment funds in 2008 and 2009.
Moral of the Story