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It was a combination of factors. First of all, credit default swaps were an extremely lucrative business when everything was going ok. Who would have thought that Lehman Brothers or Bear Stearns would fail? AIG and others were allowed to sell trillions of CDS contracts because it made them (and us, shareholders in the stock market) huge amounts of money. And it seemed like there was very little risk.
The second factor was that this was an entirely unregulated market. These are extremely complex financial instruments, and even the regulators did not seem to comprehend the threat that these swaps posed to our economy. That will likely change in the next year or two in Congress.
The second factor was that this was an entirely unregulated market. These are extremely complex financial instruments, and even the regulators did not seem to comprehend the threat that these swaps posed to our economy. That will likely change in the next year or two in Congress.
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Don't forget David X. Li, the CDS Wizard illusionist
Greed. They were unregulated and extremely profitable.
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2. Structured credit and Collateralized Debt Obligations which use CDS for credit enhancement slowed considering in 2007. The increase in CDS growth catches the attention. Companies adjust their risk exposure by trading into CDS contracts. International Swaps and Derivatives Association celebrated Over-the-counter derivatives equaling $455 trillion at the end of 2007. ISDA claimed 2% exposure to risk then Bear Stearn implosion, a top ten actor in the CDS market.
3. The emphasis was playing down dangers and playing up volumes.
4. In 1990s, CDS were viewed as way to speculate on the likelihood of a firm going but without have to trade its underlying bonds. The risk was spread around the financial system.
5. Enter David X. Li , a mathematician from China (Masters at Nankai, MBA in Quebec, Masters in actuarial science and Phd in statistics). In 2004, Li secures a job at Barclay’s Capital. Li enters the market in the quant era.
6. Li came up with an ingenious way to model default correlation without even looking at historical default data. The correlation was the credit default swap. In the 1990s, investors began selling CDS, insurance against borrowers defaulting.
7. Investors liked CDS investment because they received a premium payment from the companies.
8. An unlimited number of CDS can be sold against each borrower, the supply of swaps is not constrainted, the way bonds are. Li paper was published and soon CDS market grew rapidly. Risk was being spread like wildfire through the financial system. The assumption was the CDS markets could price default risk correctly. One number that sums up all the positive and negative correlations in the pool, the correlation number.
9. A tranche safety and risk was measured by the correlation number. Agencies like Moody’s started using the correlation number to rate the Triple A securities. As a consequence corporate bonds and mortgage backed securities could be turned into Triple-A bonds and considered safe investment devices. The pools were known as collateralized debt obligations.
10. By the end of 2001 there was $920 billion of CDS outstanding and by 2007 the number reached $62 trillion CDS outstanding on top of $455 trillion in derivate contracts, a pyramid of money; CDS at the top and derivates at the bottom.