What Really Caused the Financial Crisis: Credit Default Swaps
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Bad loans were a problem, but there was much, much more.
Many people think that “bad mortgages and housing loans” invoked our current financial crisis. It is true that these were a large part of the problem, but there was an equally large, and much more disturbing component: Credit Default Swaps. This financial instrument spawned tens of trillions of dollars worth of debt in a variety of corporations.
It began as a type of insurance policy. When one bank, company or person bought bonds from an enterprise, they could pay a small percentage of the money to a third party. In exchange, the outside party would guarantee to pay the full price of the bonds to the investor in the rare event that the company selling bonds failed to pay them back.
For example, if Company A wants cash for an endeavor, and Company B has money to lend, then Co B might loan Co A $50 billion, and Co A would agree to pay back the money, and 10% interest in a year. However, just in case Co A went bankrupt, and could never follow through on the agreement, Co B may pay a third corporation (in this case called Company C) a small percentage of the loan value, such as $1-1.5 Billion. If Co A did in fact fail to produce the money, Co C would pay it instead to Co B.
Eventually, people arranged Credit Default Swaps as a sort of “bet” that an enterprise would fail. If an investor predicted that a company would crash, they could pay someone to insure them as though they had a bond in the company. Even though they would never need to buy the bond, the investor would receive the full bond price from the insurance party for only paying a small percentage of its value. According to NPR, because of this betting, at one point different companies throughout the world were guaranteeing to pay each other a total of 60 trillion dollars through Credit Default Swaps if certain bonds defaulted, when there was only 5 trillion dollars in the whole bond market.
This still could have worked out fine, except for the fact that corporations insured bonds that they could never possibly pay off. They just assumed that companies like Lehman brothers were too trustworthy to crash. Once a few banks started to fail, Credit Default Swaps brought many more down with them.
