The Global Financial Crisis: Analysis and Policy Implications Page: 31 of 116
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The Global Financial Crisis: Analysis and Policy Implications
In 2007, the notional value (face value of underlying assets) of credit default swaps had reached
$62 trillion, more than the combined gross domestic product of the entire world ($54 trillion),62
although the actual amount at risk was only a fraction of that amount (approximately 3.5%). By
July 2008, the notional value of CDSs had declined to $54.6 trillion and by October 2008 to an
estimated $46.95 trillion.63 The system of CDSs generated large profits for the companies
involved until the default rate, particularly on subprime mortgages, and the number of
bankruptcies began to rise. Soon the leverage that generated outsized profits began to generate
outsized losses, and in October 2008, the exposures became too great for companies such as AIG..
Risk
The origins of the financial crisis point toward three developments that increased risk in financial
markets. The first was the originate-to-distribute model for mortgages. The originator of
mortgages passed them on to the provider of funds or to a bundler who then securitized them and
sold the collateralized debt obligation to investors. This recycled funds back to the mortgage
market and made mortgages more available. However, the originator was not penalized, for
example, for not ensuring that the borrower was actually qualified for the loan, and the buyer of
the securitized debt had little detailed information about the underlying quality of the loans.
Investors depended heavily on ratings by credit agencies.
The second development was a rise of perverse incentives and complexity for credit rating
agencies. Credit rating firms received fees to rate securities based on information provided by the
issuing firm using their models for determining risk. Credit raters, however, had little experience
with credit default swaps at the "systemic failure" tail of the probability distribution. The models
seemed to work under normal economic conditions but had not been tested in crisis conditions.
Credit rating agencies also may have advised clients on how to structure securities in order to
receive higher ratings. In addition, the large fees offered to credit rating firms for providing credit
ratings were difficult for them to refuse in spite of doubts they might have had about the
underlying quality of the securities. The perception existed that if one credit rating agency did not
do it, another would.
The third development was the blurring of lines between issuers of credit default swaps and
traditional insurers. In essence, financial entities were writing a type of insurance contract without
regard for insurance regulations and requirements for capital adequacy (hence, the use of the term
"credit default swaps" instead of "credit default insurance"). Much risk was hedged rather than
backed by sufficient capital to pay claims in case of default. Under a systemic crisis, hedges also
may fail. However, although the CDS market was largely unregulated by government, more than
850 institutions in 56 countries that deal in derivatives and swaps belong to the ISDA
(International Swaps and Derivatives Association). The ISDA members subscribe to a master
agreement and several protocols/amendments, some of which require that in certain
circumstances companies purchasing CDSs require counterparties (sellers) to post collateral to
back their exposures.64 It was this requirement to post collateral that pushed some companies
62 Notional value is the face value of bonds and loans on which participants have written protection. World GDP is
from World Bank. Development Indicators.
63 International Swaps and Derivatives Association, ISDA Applauds $25 Trn Reductions in CDS Notionals, Industry
Efforts to Improve CDS Operations. News Release, October 27, 2008.
For information on the International Swaps and Derivatives Association, see http://www.isda.org. In 2008, credit
derivatives had collateralized exposure of 74%. See ISDA, Margin Survey 2008. Collateral calls have been a major
(continued...)Congressional Research Service
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Nanto, Dick K. The Global Financial Crisis: Analysis and Policy Implications, report, May 12, 2009; Washington D.C.. (https://digital.library.unt.edu/ark:/67531/metadc818085/m1/31/: accessed April 18, 2024), University of North Texas Libraries, UNT Digital Library, https://digital.library.unt.edu; crediting UNT Libraries Government Documents Department.