Credit Default Swaps: The Future of America
This paper explores three books and over ten published articles that report on results from research conducted online (internet) and off-line (non-internet) of the effect of credit default swaps on the network infrastructure of which the central basis of the economy is based. Furthermore, it explores the hyper-active relationship between the common user and the business entities that provide a reassurance that the credit worthiness of individual CDO’s (Collateralized Debt Obligations) fulfill basic requirements for measurement. The articles vary in their exploration of the common good from CDO’s Credit Default Swaps: An Introduction which describes the function of credit default swaps as “A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract” (Pinsent, 2013). Which delivers a shorthanded description of an otherwise complicated topic more clearly defined in Credit Default Swaps: Your Complete, Step-by-Step Guide to Trading Credit Default Swaps as “an agreement where the one person will compensate the other in the event of a default, or other credit event” (Adams, 2013). This paper is broken down into chapter sections while interjecting additional research materials within the sections.
Keywords: credit, default, Credit Default Swaps, Risk, Collateralized debt obligations
In 1933 a bill was passed that separated investment and commercial banks. The Glass-Steagall Act called for the complete separation of the risk associated with investments and the holding of assets associated with commercial banks. Essentially it has been credited with steering the United States into the most prosperous years in recent history. However, much like during any period of success the rich wanted to get richer thus starting in the 1980’s a group of bank leaders began lobbying Congress to repeal the act. In 1999 led by U.S. Senate member Phil Gramm (Texas) a superseding bill was passed called the Gramm-Leach-Bliley Act.
How is this important to how Credit Default Swaps originated? Why would an Act force such a reaction of “The Republicans made me do it” (Chittum, 2013) from President Bill Clinton in 2013?
It wasn’t just President Clinton who thought it was a good idea. In order for it to be signed into law it had to be passed by both Congress and the Senate.
To understand the way in which the economy works we must first incorporate a certain ground rule structure. To establish this structure we must first examine the hypothesis and what are assumptions are. The overall hypothesis pre-research from the group included such statements as “credit default swaps ruined the economy” and “they must make it impossible to establish real credit.” Additionally, why choose a topic that has a reputation as porous as that of credit default swaps?
When we initially chose the topic we established a thorough game plan that included chucks of work being separated by person. For example, the history of credit default swaps was assigned to an individual in order to not invalidate the research of another individual. We carefully examined all of the sections in question, assigned them buy importance and allowed for research to take place without an agenda.
What we present to you now is an unbiased account of what credit default swaps are and what opportunities there are for the economy of not just the United States but the world.
A credit default swap (CDS) is a means to transfer credit exposure for commercial loans and to free up regulatory capital in commercial banks. Credit default swaps allow the risk to transfer to a third party if default were to occur. It is similar to insurance because it provides the buyer of the contract, who often (but not always) owns the underlying credit, with protection against default, a credit rating downgrade, or another negative “credit event”. The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event happens. The buyer of a credit default swap will gain protection or earn a profit when the issuer has a negative credit event. If this happens the party that sold the credit protection and who has assumed all the risk must deliver the value principal and interest payments that would have been paid to the protection buyer (Pinsent, Credit Default Swaps: An Introduction).
Credit default swaps were first created in the early 1990’s. In 1989 Exxon was faced with the Valdez oil spill and wanted a five billion dollar line of credit to cover potential damages, for this five billion dollar line of credit they turned to J.P. Morgan. J.P. Morgan did not want to turn down Exxon because they were an old client that was in good standing but knew the amount requested was quite large and did not want to risk all of their reserve cash if they would default. In 1994 a J.P. Morgan swaps team member suggested the idea of selling the credit risk to the European Bank of Reconstruction and Development so if Exxon were to default, the European Bank of Reconstruction and Development would be on the hook for it and in return would receive a fee from J.P. Morgan. Exxon would get its credit line and J.P. Morgan could keep their relationship with Exxon. (Romm, JP Morgan Invented Credit Default Swaps).
1990’s– CDS were created via the reversal of the Glass-Steagall Act (1999)
Late 1990’s-CDS were starting to be sold for corporate and municipal bonds.
2000– CDS market was about $900 billion with limited number of parties involved.
Early 2000s– More and more parties joined the CDS market for both sellers and buyers which made it more difficult to determine the financial strength of the sellers of protection. CDS were starting to be issued for Structured Investment Vehicles. Speculation became rampant, such that seller and buys of CDS were not owners of the underlying asset and were actually betting on the possibility of a credit event of an asset.
2007- Credit default swaps had a notional value of $45 trillion where corporate bonds, municipal bonds and structured investment vehicles market were less than $25 trillion. Which means that at least $20 trillion were bets and were not owned by either party of the CDS contract.
In 2007 subprime mortgage problems had started to expose the problems in the CDS market. When the subprime mortgages and other CDOs had valuation issues and many defaults, the CDS seller of protection realized that the CDS tied to them would require substantial payments.
Insurance companies would enter into a CDS as a seller of protection, however the risk of payment unknowingly increases when the CDS were related to securities such as CDOs. ABS and MBS, which are full of structural problems, but were offered as secure investments.
Speculation entered the credit default swap market in three forms, using structured investment vehicles (ABS, CSDO, MBS, SIV) securities as the underlying asset, CDS were created for parties without and connection to the underlying asset and the development of a secondary market for the credit default swaps (Zabel, Credit Default Swaps).
In 2007 many large financial institutions that were greatly invested in mortgage-backed securities began to fall apart, a high number of the institutions owned credit default swaps on their subprime securities. The swaps that did not payout forced the financial institutions to lower their asset values, which caused it all to fail even more. The subprime mortgages problems had started to expose the problems in the CDS market. When the subprime mortgages and other CDOs had all of the valuation issues and many defaults, the credit default swap seller of protection realized that the CDS tied to them would require substantial payments. What makes the mortgage crisis different from a potential credit default swap crisis is that you can follow a mortgage deep enough and you will come to a house. If the borrower defaults on the loan the bank is still able to possess the house and regain some of the funds lost by selling the house. With credit default swaps, they are based on actions, such as a bank failing, not a tangible asset like a house. Because of this, if they fail to pay, finding a source of capital to cover the credit default swap is very difficult.
The speculators would try to improve their own returns by either buying a credit default swap on bonds that they do not own, or selling the credit default swaps to others. An investment firm is able to go out and buy a credit default swap on corporate bonds that it does not own and then if the company defaults, the investment firm can collect the value of the credit default swap without the risk of losing money on the bonds. As an example, it is like buying life insurance on a man that lives down the block whom you have never met. You receive the payout if he dies but you are not directly impacted by his death. If you are a seller of a credit default swap you are guaranteed to receive money every year because they buyer has to pay you a premium (Speculating with Credit Default Swaps, 2012).
The speculators would use leverage with credit default swaps too. They would do this because they would want a steady income but do not have much to put out. For example, a hedge fund manager wants to boost the fund’s returns for its investors and he decides that selling credit default swaps is they right way to go to bring in the steady money. The hedge fund manager only has $1,000,000 in assets and the manager decides to sell credit default swaps to investors who are looking to hedge $100,000,000 worth of bonds. In the credit default swap agreement, the bond investor agrees to pay a spread of 3 percent ($3,000,000) every year to buy the credit default swaps. This gives the hedge fund manager a great return because the fund will receive $300,000,000 each year, which is a 300% return on investment. The big problem is that if the company on which the credit default swaps is written defaults, the hedge fund manager will owe the buyer of the credit defaults $100,000,000 and he only has $1,000,000. So if the company defaults, the hedge fund manager would also end up defaulting. With that leverage the hedge fund manager is able to make profits off of $100,000,000 while only having $1,000,000 in the fund (Speculating with Credit Default Swaps, 2012).
Credit default swaps were not regulated until 2010 when the Dodd–Frank Wall Street Reform and Consumer Protection Act was put into place. Title VII of the act states that, “The Dodd-Frank Act divides regulatory authority over swap agreements between the CFTC and SEC. The SEC has regulatory authority over “security-based swaps,” which are defined as swaps based on a single security or loan or a narrow-based group or index of, or events relating to a single issuer or issuers of securities in a narrow-based security index…The CFTC has primary regulatory authority over all other swaps, such as energy and agricultural swaps. The CFTC and SEC share authority over “mixed swaps,” which are security-based swaps that also have a commodity component.”
For credit default swaps that means, “CDS are now subject to clearing, trading, and reporting requirements with exemptions based on the nature of the parties themselves and the purpose of the trade. One of the most controversial provisions of the legislation, the so-called swaps “push-out” rule, which requires systemically significant financial institutions to transfer their swap trading into separately capitalized affiliates, does not apply to centrally cleared CDS”(Koszeg, The Evolution of Credit Default Swaps).
Probably the most noted name in the credit default swap industry is that of American International Group Inc. (AIG) No doubt that name muttered in the same sentence as credit default swaps sends chills up most people’s spine. But, is it the term credit default swap that harbors the bad taste or actually AIG.
The business of credit default swaps did not start with AIG, in fact it is actually very hard to pin-point when the first CDS was issued. On February 6, 2012 in a PBS Frontline interview, Martin Smith interviewed former JP Morgan investor Terri Duhon. During the interview Duhon reveals information about JP Morgan’s role in credit default swaps that started in the 1990’s.
Duhon started in 1994 working at the Interest Rate Swaps trading desk before being beckoned to run/start-up Morgan’s Exotic Credit Derivative Trading Book. Morgan broke ground in this new market after receiving approval from the Feds to move full steam ahead with these over the counter transactions. Prior to taking the plunge in the exotic credit derivative market, JP Morgan tested the water via single name swaps, “…in which the underlying instrument is a reference obligation, or a bond of a particular issuer or reference entity”(Brown, 2014). Some of their names included IBM, Walmart, and Exon. Both methods allowed JP Morgan to assume more risk by transferring some of it off their books.
In her interview Duhon details the struggle JP Morgan experienced with federal regulators in the 1990’s. She points out the difference between regulatory capital and economic capital. One of the key drivers of this question of change was the mandate that regulators required a flat amount of capital to be held without looking at the credit worthiness of the portfolio. This mandate cultivated in JP Morgan the belief the banks could do more with the capital they had if they could change the amount of risk on their books. In order do this and be competitive banks would need to assume more risk, but credit default swaps would allow them to transfer some of the risk off their books.
This would then leave room for less capital holding requirements and more ability to approve loans. Eventually credit default swaps became a hot market and the risks that banks, specifically JP Morgan, were being asked to assume were too great. With this knowledge it was in 2001 per Duhon that JP Morgan chase noticed questionable portfolio’s specifically those that were subprime. Based on the realization JP Morgan revamped how it dealt with transferring risk but it did not leave the credit swap market. In fact, in 2012 JP Morgan chase released a statement “…that the bank could lose $3 billion or more from bad bets on credit derivatives” (Businessweek, 2013). Facing this threat JP Morgan turned to Blue Mountain Capital.
Blue Mountain Capital was founded in 2003 by Andrew Feldstein (form managing director and head of structured credit at JP Morgan), “…JPMorgan hired him in 1992 to help the bank develop a business in credit default swaps”, and Stephen Siderow (Harrington, 2012). In fact many of Blue Mountains key employees have ties to JP Morgan. Blue Mountain Capital came to rescue of JP Morgan in 2012 when JP Morgan found itself deeply invested in the IG9 Index. Because of JP Morgan’s saturation on this index, prices were driven down and other investment groups such as Saba Capital Management, and BlueCrest Capital Management acted upon the depressed price.
When things started to awry Blue Mount Capital stepped in to save the bank and its investments. JP Morgan turned to Blue Mountain Capital because of its “arbitrage strategy” it uses when trading credit swaps. Thus Blue Capital Management was in a better position in 2012 than most firms. Blue Mountain Capital was able to “…take the bank out of a large chunk of its losing bets without tipping off other investors” (Harrington, 2012). In more recent news BlueCrest Capital Management, started by another former JP Morgan employee in 2000, has fallen on hard time. It is currently losing investors and managing partners.
The most recent managing partner Leda Braga left in September 2014 to start her own firm as reported by Bloomberg in September 2014. Braga publicly states that BlueTrend, the hedge fund she managed “…saw assets plunge by half in the past year, suffered investment losses of 11.5 percent last year and had its management fee cut in August by 50 basis points to 1.5 percent” (Westbrook, 2014). Above details how credit default swaps are subjective. Are they truly bad for the economy or are they only trouble when banks and investment firm mismanage them? As we continue our research into the good and the bad of credit default swaps, we have to touch on AIG and their impact on these swaps.
We cannot address credit default swaps without discussing AIG. With a name synonymous with greed, in 2008 AIG became will know by tax payers and consumers. In 2008 the US Government took control over AIG with an $85 billion bailout. Before the 2008 crisis and bail out “…AIG was considered a financial fortress: it boasted a high stock valuation, an AAA credit rating (heavily used in the firm’s marketing which suggested that it would stand behind its commitments to customers) and was led by a chief executive, Hank Greenberg”(T.E., 2013). It was with this reputation that AIG was able to amass such a huge stake in credit derivatives. No one batted an eye. That is until AIG was unable to meet the payout demands. But concerns of AIG and its investments seem to have started prior to 2008. A 2005 Businessweek article reports that on March 30, 2005, “…AIG acknowledged that it had improperly accounted for the reinsurance transaction to bolster reserves, and detailed numerous other examples of problematic accounting” (AIG, 2005). Additionally it was found that AIG inflated its net worth by nearly $1.7 billion. Now keep in mind that this was in 2005, before tax payers funded its bailout.
Furthermore, in 2005 it was unearthed that transactions one thought to be independent were in fact deals that were made with companies that were owned by AIG. These transactions allowed [AIG] to claim gains without actually selling the bonds, misclassified losses; and questionable estimates on deferred acquisition costs (AIG, 2005). There were also glaring conflicts of interest as many companies that AIG dealt with were companies in which executive sat on the boards or owned large percentage of AIG stock. Two examples are Starr International Co. and C.V Starr and Co. This led to executive decisions on who received bonuses and how much to managing AIG earnings. There were also transactions in the form of charitable donations that enticed powerful influencers to sit on the board, as well as strategic placing of executives and board members. Corruption was deeply imbedded at AIG.
Revealing AIG as a corrupted entity makes their inability to payout claims less about their role in credits derivative, but more about the greed the exuded from the firm. After receiving billions on bailout from the American tax payers, AIG continues to operate. In 2013 AIG had fully repaid its bailout and returned to a private sector firm. The once assumed hedge fund attached to an insurance firm is not operating without its “…buccaneering financial-products unit” (America’s, 2013). Since 2009 AIG has worked to cut staff, sell off units to fund its bailout, and to rebuild its reputation and rebrand itself. In return AIG is seeing low margins of return, but is in the right position to once again thrive per its CEO Bob Benmosche who took over the company in 2009.
Mr. Benmosche has boasted hefty goals of doubling that margin to 10% by 2015. AIG still finds itself with a chunk of credit derivatives so it would appear as if they have not completely exited the market. The difference this go around is the removal of conflicts of interest and greedy executives. The company seems to be working more above the board.
We have looked at how credit default swaps were used to simply not transfer risk from books of lenders, but used to the point where credit ratings and risk were no longer a factor. Firms were looking to make a quick buck on both sides of the aisle. Firms such as AIG were wagering that borrowers would not default and lenders were wagering the same. This misuse of credit swaps aided in subprime lending. Suddenly firms were assuming more risk than they would have and judgment went out the window. On the flip side, credit default swaps can be used to encourage more lending and stimulate the economy when used responsibility. It is not the actual swap that is bad, but rather how they are overused and exploited.
Sovereign Credit Default Swaps
Credit default swaps not only insure debt that is held in the private sector, but also in the public sector. Credit default swaps that are backing countries debt are called sovereign credit default swaps, or shortened to Sovereign CDS or SCDS. Just like credit default spreads and the price of CDS is an indicator of an investments riskiness, the credit default swap spreads between counties is a huge indicator of the riskiness of different countries debt, and therefore also of the financial stability of the country. Essentially every country has SCDS insuring its debt. Individuals, private companies and other countries can hold debt of sovereign nations and it is the investors’ decision, not the borrowing country, to choose to insure that debt with sovereign credit default swaps. So despite the controversy over CDS and SCDS any country with debt has the potential to have SCDS insuring their debt. This can be a good thing for investors and economists because it allows the many SCDSs to be compared and for investment decisions to be made accordingly.
Europe’s Financial Crisis
For the most part SCDS have been used successfully by investors with very few noteworthy incidences. However they played a major role in the current European Financial Crisis. There are many factors that lead to the recent financial crisis in Europe; however, credit default swaps played the largest roll in the fall of Greece’s Economy and the financial stability of Greece’s investors. Europe’s economy was already facing hardships throughout the continent when Greece ran into trouble, with Spain, Italy, Ireland and Portugal economies in the worst state.
When Greece decided to switched to the euro in 2001, it was expected that it would change the financial future of the country (Dellas, and Tavlas). At the time Greece was already living beyond its means, it had little growth, several exchange rate crisis, double digit inflation rates and racked up large amounts of debt in the 1980’s and 1990’s (Dellas, and Tavlas). It was hoped that many of these issues would be fixed after switching denominations and therefor required to meet a 3 % of GDP cap on borrowing (Peachey, 2012). For about eight years it appeared that the transition was mostly successful, however Greece did continued to rack up large amounts of debt. Greece failed to meet the maximum 3% debt to GDP ratio and instead concealed much of what they were borrowing. In 2009 when George Papandreou took office he and his staff quickly discovered discrepancies between previous administrations claims and the actual current state of Greece’s financial situation. George Papandreou announced in autumn of that year that the 2009 fiscal deficit would be 12.7 percent of GDP, doubling previous predictions (Dellas and Tavlas, 2013).
In addition to the large amount of debt, Greece did not have a strong monetary policy in place. When it came to light just how bad the Greece financial situation was Greece was pressured by other countries, many of which had large amounts of funds invested in Greece pressured them to take action, in the form of a debt restructuring.
After seeing the additional disaster caused by credit default swaps in the United States during our recession, Europe became concerned with what would happen if their countries that were suffering financial started to default on their loans, such as the large, risky loans owed by Greece. Investors had largely viewed these loans as very secure, because it was suspected that if they could not pay then other European countries would step in (Dellas and Tavias, 2013).
Just like the American Government stepped in with “too big to fail” companies in America during our recent recession. In response to this concern, and in an attempt to avoid defaulting and therefor having CDS called upon to pay for Greece’s debt, attempts were made to restructure the debt. This was unsuccessful and ultimately backfired, investors lost confidence because of this restructuring. Many investors viewed this attempt to avoid defaulting and avoid CDS payouts, as a sign that CDS would not be paid. This actually decreased trust in Greece’s economy even further. Many investors thought that if Greece did default that CDS would not be paid, so investments stopped almost completely. Lack of further investments created the tipping point that finally caused Greece to default on its loans.
In May of 2010, the International Monetary Fund, or IMF, agreed to a 143 billion dollar (110€) bailout plan. In 2012 a second bail out of 130€ was needed (Peachey, 2012). This large amount was not enough and in March of 2012, in the largest default in history, Greece finally defaulted on its bonds (“The Wait is Over,” 2012). The majority of investors agreed to trade in their short term bonds for longer term ones with less than half of the face value, and in addition this triggered costly CDS payouts. “Holders of €152 billion of the €177 billion of sovereign bonds issued under Greek law signed up to the swap” (“The Wait is Over,” 2012). Those remaining investors that were against the bond-swap, amount €9 billion and the remaining investors that did not respond will be forced to except the swap (“The Wait is Over,” 2012). The Economist (2012) reported in their article “The Wait is Over” the following figures for the CDS Payouts:
“The national value of Greek sovereign bonds insured by CDSs [was] around $69 billion, according to DTCC, a data repository. But banks and hedge funds have offsetting exposures, having issued some CDS insurance contracts and bought others. Once these wash out, the net exposure to a Greek default is a more modest €3.2 billion.”
Because defaults on sovereign debt are relatively rare officials and investors considered Greece’s default on its debt the first test of Sovereign credit default swaps on sovereign bonds. This is really a test of the resilience of the financial system and to see how effective SCDS are in creating increased stability and recovery.
Naked Credit Default Swaps
Credit default swaps can be either naked or covered. Naked credit default swaps are a type of speculation where an investor bets on the likelihood of a default on a debt that he does not own. In the paper thus far we have mostly talked about covered credit default swaps, where an investor holds the bonds that they are insuring against default. For example, leading up to Greece’s default speculators betting on Greece defaulting increased, these bets took the form of naked credit default swaps, because the speculators did not hold Grecian bonds.
It is important to make the distinction at this time because policy-makers attempted to restructure in a way that would not cause payouts on naked credit default swaps as well as the previously mentioned covered credit default swaps. Policy-makers were mostly successful because the default was considered voluntary.
In December of 2011, the European Union voted to ban naked credit default swaps for sovereign debt. The new ban has been controversial. Some say that naked credit default swaps are an effective hedging tool and others say that it spreads risk un-necessarily. The latter uses Greece as an example, as it is believed that financial situation would have been made considerably worse if SCDS payouts increased by billions of dollars because they were made to both covered and naked credit default swap holders.
The roll of credit default swaps in Greece’s crisis closely mimicked what happened during the American recession. Because so much of Greece’s debt was owned by other countries, when they started to default on their loans other countries’ economies was affected as well. This domino effect between countries was very similar to the domino effect between large finical businesses that we saw in the US. The bailouts to Greece also mimicked the bailouts made to large companies by the American Government, however this time the bailouts were coming from the IMF through which the whole world paid for Greece’s debt.
Where Greece is now
The Debt Crisis is still not really over, but there are signs that Greece has started to recover. For example, they minted billions of euros worth of bonds in April of 2014, with a 4.75% yield, that investors quickly grabbed up (Sanati, 2014). However, while this should have been a sign that the crisis was coming to an end Greece, and much of Europe, is still dangerously massive amounts of debt. Only time will tell if Europe is out of the clear, or if this is just a breathing point before another economic.
Fortune magazine reporter Cyrus Sanati summarized the state of the Greek economy in April of 2014 as:
“The Greek economy is in shambles, and the only reason it hasn’t defaulted on its debt for a third time is the European Central Bank’s low interest rate policy and the 240 billion euros in aid that have flowed into the nation’s coffers from the International Monetary Fund and the European Union over the last four years.”
Sovereign CDS Summary
While the crisis in Greece too many may seem like an example that CDS are not good for the economy, that is not the case, there were many other problems with Greece’s finances all of which can be boiled down into two major categories, a lack of transparency and too much debt. Greece hid so much of their debt for so long that investors were unaware of how risky the debt that they were buying was. In addition they believed that Greece would be bailed out by the IMF and other European nations, which it was but Greece’s investors still took massive losses on their investments.
This is very similar to what happed in the US with CDSs, except in the U.S. investors were unaware because companies were not required to report CDSs. CDS were a major motivating factor to restructuring the Greece’s debt because many people believed that they could not be paid and would therefore shatter investor confidence throughout Europe, or that paying such a large sum would equally damage the economy.
No one can say what would have happened if different actions were taken in this situation, but we can conclude that CDS were not a contributor to the original problem. In the end CDS worked just the way that they are supposed to, they spread out the risk, and when cashed in the spread out the cost.
The role in the economy that credit default swaps played cannot be overstated. The market is saturated with a movable blocks of CDO’s that have been bundled by banks to sell to Wall Street. Without a real rating assigned to the CDO the risk could outweigh the reward to the traders and the market could be frozen in an asset versus liabilities quandary. At their basic structure the market in question is based on a faith much like that of religion. Using the religious analogy we can use the symbolic bible as a way of affirming our belief.
Some people believe that every word written in the bible is fact just like in market when Moody’s or Standard and Poor grade a CDO at AAA. The concept reaffirms our faith in the religion of money. It indicates to the buyer that there is validity to their assumption. Now when we introduce the ability to hedge a bet, also known as a credit default swap against the rating we are essentially stating that while the CDO is AAA rated we also want to have a set of protections if it does fail. Once again this provides the buyer with a level of security to their investment. A level of security that is only allowed when you are awarded the opportunity to purchase a set of protections against your investment.
While the insurance companies that sell credit default swaps are only selling a policy on insurance it is extremely important that they hold the money from the insurance policy for the lifetime of the policy. Much like a bank there can be a run on the policy which could decimate the liquidity of an insurance company. Much like what occurred with AIG. When CDO’s were bundled and the well was poisoned they did not have enough liquidity to pay the promised amounts for the policy.
As a society we should not allow companies to hedge bets and then when they lose and cannot pay they get rewarded from the government in terms of a bailout. When this kind of response is made to companies they are encouraged to continue the activities of earnestly acquiring contracts while leaving pennies on the dollar in regards to holding in case the policy is needed to be paid on.
In an ideal scenario the Company (AIG) would have been allowed to fail but when the Stock Market drops as drastically as on September 29, 2008 (777 points) too big to fail enters the frame. Unfortunately for the American people decisions were made that they might not have agreed with but in the world today too big to fail ends with a bailout not a bankruptcy.
However, when we include the interconnection of U.S. Companies to the international market we begin to see the infrastructure of a world economy that nearly dilutes politics due to its ability to affect every aspect of the way people live. For example, when a large corporation decides to exit a market (internationally) due to its lack of ability to shore up credit from U.S. banks it could potentially leave a large number of unemployed within the host country. Statistically when people are employed crime is lowered. In 2003 in a research paper called The Relationship between Crime and Employment author Matthew D. Melick defines the correlation within the context of argument as that of “common theory in public policymaking is that
higher unemployment causes higher (crime) rates” (Melick, 2013).
So we aren’t just talking about the ability for Company A to hedge a bet, we are talking about the ability for CDO’s to be traded with all of the faith that can be found within the rating system that is respected by the U.S. and subsequently the trader/ buyer of the CDO itself.
Unless we (United States citizens) defiantly argue against the ability for banks to bundle our home loans into CDO’s we will continue to see the complete dismantling of wealth distribution throughout society. Where the top 1% are awarded a vast majority of the wealth available and the rest of us are fighting for the crumbs that they have left over.
Credit default swaps are not the enemy. Credit default swaps allow for an investor to purchase insurance on their investment. The real enemy here is the companies that were allowed to continue within the framework of using the money that they should have held from the policy itself and awarded large sums of money in the shape of bonuses to CEO’s that dealt in predatory lending. Essentially, do not lump a solid policy within the system with poorly run companies because they are not the same thing and should not be categorized as such.
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