We don’t expect to win any friends by defending credit default swaps but we’re going to do it anyway. Although the CDS market has been heavily demonized, it’s clear that credit default swaps have been filling a very valuable role in the broader financial markets and the damage they’ve done has been largely overstated.
This demonization may have seriously dangerous consequences if it encourages regulators to hamper the market or investors to expect too much from the creation of CDS exchanges. We certainly don’t need another round of building phony investor confidence over misbegotten reforms.
In an effort to prevent another round of confused regulating and over-confident investing, over the next few days we’ll run through the top five myths about credit default swaps.
Myth Number 1: Credit Default Swaps Brought Down Lehman Brothers and Bear Stearns. This myth actually comes in two versions. The first version says that hedge funds that had shorted the common shares of Lehman and Bear started buying up credit default swaps on their debt in order to create the impression of a financial panic. When the prices of the swaps shot up, the stock would tank, delivering the short sellers a nice profit, according to the myth.
This makes for a nice just-so story but there’s no evidence for it. What evidence we do have about the market for insurance on Lehman and Bear debt tells a different story. Holders of the debt and those exposed to Lehman and Bear through more complex counter-party arrangements bought credit default swaps to hedge this debt. When it became apparent that Lehman and Bear were in trouble, they covered themselves by buying more credit default swaps.
Much the same thing happened with AIG. As AIG’s counterparties—those who had bought insurance from AIG—began to worry about AIG’s health they sought protection from AIG’s failure by demanding more collateral for the contracts and buying credit default swaps on AIG. The alternative would have been to wipe out AIG immediately by demanding even more collateral to back the contracts.
In reality, the credit default swap market probably allowed Lehman and Bear to continue operating for longer than they would have otherwise. If creditors and counterparties couldn’t hedge against their failure through swaps, they would have immediately been forced to cease providing credit, sell bonds and stop doing business with the firms.
Next up: The Alternative Theory Of How Credit Default Swaps Brought Down Lehman and Bear.
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