The Time To Police OTC Credit Default Swaps Is Now
The market for credit default swaps - complex derivative instruments invented by JP Morgan Chase & Co. in 1992 and today believed to be a key contributor to the onset of the nation’s financial meltdown - is sorely in need of a major overhaul. The trouble is the big participants in the market, including financial institutions and other special interest groups, apparently don’t want that to happen.
Credit default swaps initially emerged as a way for financial institutions to buy insurance against defaults on their corporate debt. Similar to an insurance contract, a credit default swap involves one party paying another party to protect it from the potential risk of default on a bond, loan, or other types of debt. If the loan or bond defaults, the insurer, or seller, compensates the buyer for the loss. Sellers of credit default swaps typically are banks, hedge funds or investment firms.
The market for credit default swaps is unregulated. Contracts for the swaps trade over the counter versus through the New York Stock Exchange. Lacking any oversight or regulation, the potential for financial disaster is great. As reported May 18 by Bloomberg, lax oversight of credit derivative instruments played a leading role behind the financial failures of powerhouse firms like Lehman Brother Holdings and American International Group (AIG), not to mention the $1.4 trillion in writedowns that banks have taken in the past year.
For more than a decade, however, these same investment banks have fought tooth and nail against government regulation of OTC credit default swaps. Why? Because credit default swaps contracts translate into huge profits for them. In 2008, JPMorgan reportedly took in $5 billion in profits from trading in fixed-income over the counter derivatives, according to the Bloomberg article.
Meanwhile, the rest of us are forced to wait out what appears to be an unrelenting and merciless financial crisis - a crisis largely triggered by the ticking time bomb known as credit default swaps. Defusing this ticking bomb with improved regulation and transparency is long overdue.
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