Economics, 3rd Edition

CASE STUDY

The South Sea Scheme a 

caricature by William Hogarth, 

an 18th-century sociocritical 

English painter and graphic 

artist.

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CHAPTER 37  THE FINANCIAL CRISIS AND SOVEREIGN DEBT  787

The Bubble Bursts

The use of credit default swaps (CDS) represent sound business principles when the risk of default is 

very low which was the case when these were first developed in the late 1990s and when the bonds 

being insured were corporate bonds with a low risk attached to them. The expansion of CDS presented 

a different challenge to the financial markets when the collapse came. It must be remembered that 

not only were these contracts taken out in relation to bonds linked to sub-prime loans but the trade of 

these contracts might mean that banks and other financial institutions might be buying the contract 

whilst not possessing the asset (the bond). Contracts could also be bought and sold as part of spec-

ulative deals which means the web of financial interdependence grows – all based, remember, on a 

collection of sub-prime mortgages. Traders might, therefore, deliberately buy CDS on the expectation 

that the bond associated with it would fail. If it did then the trader stands to gain a return in the form 

of the bond value which has been insured or the collateral which has been set aside. The market pro-

gressed from being one which insured bond holders against risk to one where accurate speculation 

could generate large returns for dealers. Those buying these derivatives (so called because their value 

is based on something else) may have little if any idea of the strength of the underlying assets associ-

ated with their trade.

The CDS market was also not subject to any form of regulation. It is referred to as an ‘over-the-counter’ 

market, a private financial transaction between two parties. There is no official record, therefore, of 

who has made a trade and whether the seller can actually meet the obligations it is entering into. The  

precise value of the CDS market by 2007 is difficult to pinpoint for this reason but it has been estimated 

at between 

$45 and $60 trillion. To put this into some sort of perspective, $60 trillion is more than global 

GDP which is estimated at around 

$55 trillion! The number of CDS trades, the number of derivative trades 

and precisely who owns all these trades are not easy to identify. A number of major banks had exposure 

to CDS including Lehman Bros, Icelandic banks, Barclays and RBS, and in addition insurance companies 

like AIG were also heavily committed.

In 2006–2007 the prevailing concern among central banks was over the development of inflationary 

 pressure. In the UK, for example, inflation as measured by the Consumer Prices Index rose to a high