The role of credit default swaps in precipitating the current financial crisis

In november of 2008, when the financial crisis was beginning to unfold, I was enrolled in a course called “banking, finanicial markets and systems”. This was an interesting course taught by Professor PC Narayan. One of the main thesis of professor was that lack of regulation causes high leverage and high risk taking and therefore makes financial markets unstable. I, along with a couple of my classmates, tried to investigate the role of credit default swaps, in precipitating the crisis. We started out with the following idea.

Credit default swaps is a contract in which the buyer makes a series of payments to the seller in exchange for the right to payoff if there is a default in respect of the reference party. The market for credit derivatives became larger than the underlying assets themselves1, and it is often alleged that these instruments catalyzed the meltdown2. The term paper aims at exploring the instrumentality of these instruments in precipitating the current financial crisis.

After an interesting analysis of what these financial instruments actually are and how they were used, we concluded:

Although the jury is still out on whether credit derivatives catalyzed the financial meltdown, evidence so far seems to suggest that they could indeed have played a crucial role. However, they may not deserve all the vilification that was heaped on them – from “financial WMDs” as Mr. Warren Buffet called them, to disowning of them by their former cheerleader Mr. Alan Greenspan. The genuine benefits of derivatives such as ability to hedge and price discovery of credit risk may in fact be fine-tuned in the future. However, it looks imperative that derivates be brought under the ambit of a regulator and probably a standardized and exchange traded form introduced to eliminate counterparty risk.

If you are interested in this topic, you can read our report by clicking the following link – role of Credit Default Swaps in precipitating the the current financial crisis.

References & Footnotes
  1. Demystifying the Credit Crunch: A Primer and Glossary, July 2008, Arthur D Little, Private equity council, by Jonathan Cheng, Matthew Walsh and Simon Flax of Arthur D. Little’s New York office. Pp 5. []
  2. The Monster That Ate Wall Street, How ‘credit default swaps’—an insurance against bad loans—turned from a smart bet into a killer, by Matthew Philips, newsweek, published Sep 27, 2008, from the magazine issue dated Oct 6, 2008. []

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