Of note in the European debt negotiations during October, there was particular concern that any writedown of Greek bonds and loans not trigger credit default swaps (CDS) on the debt. Credit default swaps were originally developed as a sort of insurance against debt defaults, with buyers of protection paying regular sums to the sellers of protection until an event of default occurred. If there was a default, the sellers would be obligated to offset the decline in the value of the defaulted debt covered by the swaps. The CDS market has grown rapidly in recent years, but has become increasingly a venue for speculation. Investors anticipating deteriorating financial conditions for a sovereign credit or corporation would buy protection through the CDS market, without ever having had exposure to the debt. On the other side of the transaction were institutions and funds that hoped to reap the steady flow of CDS payments, but which may or may not have the wherewithal to pay in the event that defaults actually occur.  The CDS market is truly massive, but the problem is that no one fully understands where the risks lie. The effort to avoid a technical Greek default and thereby triggering CDS’s reflects concerns that that process could trigger a credit crisis as European financial institutions would face massive obligations to offset losses on Greek debt. The failure of any institution to make good on all of its CDS obligations would trigger CDS defaults on that institution. Frustratingly, in the three years since Lehman Brothers failed and caused the global financial system to seize up, we don’t seem to have addressed some of the factors that lead to such crises.

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