Credit Default Swaps and the Financial Crisis

Abstract

This paper examines the role that credit default swaps (CDS) played in the run-up to and during the financial crisis that struck in 2007-2008. I examine the nature of CDS as well as their evolving uses preceding and during the crisis, such as in the case of synthetic collateralized debt obligations (CSOs). Through case studies, I also highlight several problems deriving from the pervasive and largely unregulated use of CDS, including counterpart and systemic risk as well as the empty creditor problem. Through these case studies and my analysis, I conclude that while CDS are meant to simply shift economic risk to those parties most willing and able to bear it without adding systemic risk to the economy, during the recent financial crisis the unregulated and pervasive CDS market actually contributed to systemic risk. Thus, I also propose possible solutions to address the problems associated with CDS