On Wednesday, the White House released its plan for reviving financial regulatory reform. And the plan nicely sums up how credit default swaps--complex financial instruments traded between financial firms to cover possible losses--helped grease the way to the current economic disaster:
One of the most significant changes in the world of finance in recent decades has been the explosive growth and rapid innovation in the market for financial derivatives. Much of this development has occurred in the market for OTC derivatives, which are not executed on regulated exchanges. In 2000, the Commodity Futures Modernization Act (CFMA) explicitly exempted OTC derivatives, to a large extent, from regulation by the Commodity Futures Trading Commission. In addition, the law limited the SEC’s authority to regulate certain types of OTC derivatives. As a result, the market for OTC derivatives has largely gone unregulated.
The downside of this lax regulatory regime for OTC derivatives – and, in particular, for credit default swaps (CDS) – became disastrously clear during the recent financial crisis. In the years prior to the crisis, many institutions and investors had substantial positions in CDS – particularly CDS that were tied to asset backed securities (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated of market participants. At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against declines in the value of such ABS, as well as poor counterparty credit risk management by many banks, saddled our financial system with an enormous – and largely unrecognized – level of risk.
When the value of the ABS fell, the danger became clear. Individual institutions believed that these derivatives would protect their investments and provide return, even if the market went down. But, during the crisis, the sheer volume of these contracts overwhelmed some firms that had promised to provide payment on the CDS and left institutions with losses that they believed they had been protected against. Lacking authority to regulate the OTC derivatives market, regulators were unable to identify or mitigate the enormous systemic threat that had developed.