Investments, tenth edition

  Credit Default Swaps, Systemic Risk, and the Financial 

Crisis of 2008–2009 

 The credit crisis of 2008–2009, when lending among banks 

and other financial institutions effectively seized up, was in 

large measure a crisis of transparency. The biggest problem 

was a widespread lack of confidence in the financial stand-

ing of counterparties to a trade. If one institution could not 

be confident that another would remain solvent, it would 

understandably be reluctant to offer it a loan. When doubt 

about the credit exposure of customers and trading part-

ners spiked to levels not seen since the Great Depression, 

the market for loans dried up. 

 Credit default swaps were particularly cited for foster-

ing doubts about counterparty reliability. By August 2008, 

$63 trillion of such swaps were reportedly outstanding. 

(By comparison, U.S. gross domestic product in 2008 was 

about $14 trillion.) As the subprime mortgage market col-

lapsed and the economy entered a deep recession, the 

potential obligations on these contracts ballooned to 

levels previously considered unimaginable and the ability 

of CDS sellers to honor their commitments appeared in 

doubt. For example, the huge insurance firm AIG alone 

had sold more than $400 billion of CDS contracts on sub-

prime mortgages and other loans and was days from 

insolvency. But AIG’s insolvency could have triggered the 

insolvency of other firms that had relied on its promise of 

protection against loan defaults. These in turn might have 

triggered further defaults. In the end, the government 

felt compelled to rescue AIG to prevent a chain reaction 

of insolvencies. 

 Counterparty risk and lax reporting requirements made 

it effectively impossible to tease out firms’ exposures to 

credit risk. One problem was that CDS positions do not have 

to be accounted for on balance sheets. And the possibility 

of one default setting off a sequence of further defaults 

means that lenders may be exposed to the default of an 

institution with which they do not even directly trade. Such 

knock-on effects create  systemic risk,  in which the entire 

financial system can freeze up. With the ripple effects of 

bad debt extending in ever-widening circles, lending to 

anyone can seem imprudent. 

 In the aftermath of the credit crisis, the Dodd-Frank Act 

called for new regulation and reforms. One proposal is for 

a central clearinghouse for credit derivatives such as CDS 

contracts. Such a system would foster transparency of posi-

tions, would allow the clearinghouse to replace traders’ off-

setting long and short positions with a single net position, 

and would require daily recognition of gains or losses on 

positions through a margin or collateral account. If losses 

were to mount, positions would have to be unwound 

before growing to unsustainable levels. Allowing traders 

to accurately assess counterparty risk, and limiting such risk 

through margin accounts and the extra back-up of the clear-

inghouse, would go a long way in limiting systemic risk.  

 WORDS FROM THE STREET 

   

17

 The legal separation of the bank from the SIV allows the ownership of the loans to be conducted off the bank’s 

balance sheet, and thus avoids capital requirements the bank would otherwise encounter.  

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Final PDF to printer

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478

P A R T   I V

 Fixed-Income 

Securities

Bank

Structured

investment

vehicle, SIV

Senior tranche