Blaming Credit Default Swaps
In the retelling of the saga of the 2008 financial crash, perhaps one of the most maligned “villains” is an innovative and esoteric financial product called a Credit Default Swap (CDS). Around since the 1990s, these “insurance policies” were invented to allow investors to backstop their bets on bonds created from collateralized consumer loans. Fast forward 15 years, and some institutional investors, alerted to the extremely risky nature of then-hot subprime mortgage-backed securities, began buying CDSs to bet against the subprime housing market, and in doing so, against the American dream as a whole.
Those few prescient purchasers of CDSs on subprime mortgage bonds made out like bandits—although thankfully private contracts are still completely legal. For every buyer of a CDS, there is a seller. In fact, their only “crime” was their ability to look with a cold eye at the likelihood that hundreds of thousands of borrowers who signed onto no-down-payment, zero-interest teaser rate, adjustable-rate home loans, backed by false or non-existent income and credit rating documentation, would default, and decide that likelihood was pretty nigh certain. But in the aftermath of the crash, as the rest of the world looked around in wonder at the carnage, the forensic commentators seized on the CDSs that made a few insightful investors rich as the instruments of evil. Now there is a global movement to outlaw what is in reality another early warning system for consumers that has evolved in response to market demand.
So let’s take a
Eventually, a few quants and other smart investors began to recognize that these bad and extremely bad loans were certain to default. They needed a way to bet against the sub-prime mortgage market—CDS were perfect. When the crash came, they and their clients got rich—and the pundits and government regulators cried foul.