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Home > Cases > Structured Investment Products > Credit-Default Swaps: A Market In Desperate Need Of Transparency, Regulation

Credit-Default Swaps: A Market In Desperate Need Of Transparency, Regulation

Credit-default swaps - they're supposed to provide insurance for losses on securities in the event of default. The operative words, of course, are “supposed to.” In recent years, swap contracts have entered into dangerous investing territory, insuring the most risky of financial instruments, including pools of subprime mortgage securities.

And therein is the problem. According to the Depository Trust & Clearing Corp., which operates a central registry of credit swaps trades, about $34 trillion in swap contracts is outstanding on government debt, corporate bonds and asset-backed securities worldwide. Unlike traditional insurance, credit-default swaps are unregulated; they also do not trade on an exchange.

Essentially, credit-default swaps are insurance contracts that allow investors to protect themselves against the risk of default on a government or corporate issuer's debt. Swaps can be used in other ways, as well, such as to speculate on a default. Credit-default swaps also represent the same market that billionaire investor Warren Buffett labeled as “weapons of financial mass destruction.”

Originally, the purpose of swaps contracts was to make it easier for banking institutions to issue complex debt securities by reducing the risk to purchasers. That hasn't happened, however. When the mortgage-backed securities that many credit-default swaps were supporting began to plummet in value in the summer of 2007, investors found their swaps to be a liability as opposed to insurance against risk.

Credit-default swaps also are to blame for many Wall Street banking firms losing billions of dollars hand over fist in recent months. One of those firms, Lehman Brothers, filed for bankruptcy on Sept. 15. Lehman isn't the only company to suffer from problems linked to credit-default swaps; others include Bear Stearns, American International Group (AIG), Washington Mutual, Fannie Mae, Freddie Mac and Morgan Stanley.

In recent days, the veil of secrecy has been lifted somewhat on the credit-default swaps market, with the Depository Trust & Clearing Corp. releasing for the first time specific data on what companies and countries investors are hedging against. The most active buyers of swaps are financial services companies. The DTCC made the unprecedented decision to release its data as a way to calm fears by lawmakers and regulators who contend - and with good reason - that the sheer size and volume of the credit-default swaps market could put the nation's entire financial system at risk.

Last month, federal prosecutors teamed up with New York Attorney General Andrew Cuomo to investigate the credit-default swaps market and, specifically, whether Wall Street investment firms manipulated the instruments for their own financial gain.

Among other things, regulators want to determine if traders used the credit swaps to artificially lower share prices of various financial companies, which then resulted in large sell-offs and a downward spiral of company stock.

The bottom line: Credit-default swaps are miles apart from standard insurance. When Wall Street came up with the idea of credit-default swaps, it neglected to address one all-important question. What happens in instances of default where the parties on the other side of the swap are unable to honor their financial obligations and come up with the money to pay investors? One needs only to look at Lehman Brothers for the answer.

Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.


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