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Throughout the past several months the financial news has been talking about credit default swaps and the adverse impact they have had on the financial community. A credit default swap is basically a form of insurance, with the intention to cover losses to banks and bondholders when companies fail to pay their debts.

These instruments are similar to a homeowner’s policy that protects against losses incurred from fire and theft. In the case of a credit default swap the buyer pays a premium to a seller in exchange for the promise to cover losses in the event of a credit default. However, what has happened is that major Wall Street firms used their simplicity and converted this market into a huge gambling house.

The credit default swap vehicle provided a means for major risk speculators like investment companies, hedge funds, and insurance companies to easily speculate on various bonds and loans or security pools such as residential and commercial mortgage backed securities.

In an environment of easy credit guidelines and loose lending terms, the credit default swap market skyrocketed over the past six years. For instance, according to the International and Derivatives Swap Association the credit default swap market in 2000 was around $900 billion compared to today where it is over $54 trillion. To put in perspective this makes it bigger than the equities market, Treasuries market and mortgage markets combined.

It’s easy to see given the enormity of this market that its failure would have horrific impact on the economy. The reason regulations could not stop the collapse is because there are none.  The credit default swap market is completely unregulated. No standard contracts are out there. They are not traded on exchanges and nobody guarantees them. No capital requirements are in place and no self-regulatory body exists to police them.

In a very large part the tremendous volatility we have been seeing in equities and the credit market is due to what has transpired in the credit default swap market. Consider that the Federal government was forced to bail out Bear Stearns to ensure the trillions of dollars credit default swaps on its books would not be obliterated or wiped out.

The same goes for AIG as this company had about $441 billion worth of swaps on corporate bonds and mortgage-backed securities. Of course, as the portfolio’s value severely declined, the Fed again was forced to rescue the insurance giant or let it default on the credit swaps, which would have had a devastating impact on the financial markets.

Given the huge size of the market, the lack of regulation, the uncertainty over prices and credit worthiness, it appears that Federal government’s intervention was the right thing to do. Going forward, let’s hope we have learned a lot from this painful experience and that the proper regulation will be put in place to oversee the credit default swap market.

Happy Trading.

Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
Visit Jeff’s Forum
Listen to Jeff at www.ProfitStrategiesRadio.com

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