The current financial crisis gripping the investment industry
in the US and other parts of the world reminds me of `passing
the parcel game' that children play at birthday parties. You probably
know the gamea parcel is passed around and whoever ends up with the
parcel in their hands when the music stops, wins a prize contained in the
parcel. However, in the case of investment industry, the parcel called Credit
Default Swaps (CDS) which were being passed by one bank to another
contained a ticking time bomb in the shape of contaminated assets that
no bank bothered to look at, since there was plenty of money to be made
from this game.
CDS provide insurance against the potential losses on the
investments in certain assets such as municipal bonds, corporate bonds,
mortgage securities, etc. CDS are similar to taking home insurance to
protect against losses from fire and other causes. The CDS market is not
regulated, and as a consequence, CDS contracts can be traded or swapped
by one investment bank to another without anyone overseeing the
trades. Thus, there is no oversight to ensure that the holder of CDS has the
required financial capital to meet losses in case of underlying security
defaults. In the last few years, CDS became very popular with
investment banks as an easy way to make money, because in the booming economic
period that we experienced in the last decade or so, the general
perception was that big corporations and/or banks whose credits were insured
via CDS markets were unlikely to fail. No wonder then that the CDS market
has grown very fast, and according to the International Swaps and
Derivative Association (ISDA), it is worth more than $60 tn, which is
approximately twice the size of the US stock
market and also dwarfs the $12 tn US mortgage market and $6 tn US
treasuries market. It is worth mentioning that the American Insurance Group
(AIG) which was recently rescued by the US Federal Reserve through a capital
injection of $85 bn had written (sold) $450 bn worth of CDS.
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