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Unwinding Credit Default Swaps necessary to fixing financial markets

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Gretchen Morganson, Times Business writer, explored the necessity to unravel the CDS mess that continues to wreak havoc in the financial markets.

In the end, far too much of this insurance was written at way too cheap a cost. Now, with Wall Street and the economy in tatters, the fear that already-hobbled financial companies may have to pay off huge amounts on C.D.S. arrangements hangs like a cloud over the markets.

C.D.S.’s have already figured prominently in taxpayer bailouts. The $150 billion rescue of the American International Group, for example, came about because of swaps the insurer had written on mortgage securities. And the $100 billion taxpayer backstop handed to Bank of America on Jan. 16 had a good bit to do with soured credit-default swaps that the bank inherited when it acquired Merrill Lynch.

“Credit-default swaps written on companies that were presumed not to be in danger of collapse but that are now on the brink — that is the overhang on the financial markets,” said Sylvain R. Raynes, a mathematics professor at Baruch College in New York and an expert in structured finance at R & R Consulting. “The financial system is frozen largely because of credit-default swaps.”

C.D.S.’s have introduced other economic burdens as well. Christopher Whalen, managing partner at Institutional Risk Analytics, argues that speculators who use credit protection to bet against financial institutions add instability to the system and cause the cost of taxpayer bailouts of the banks to escalate.

In her article, Morganson cites the plans of Christopher Whalen, managing partner at Institutional Risk Analytics, [institutionalriskanalytics.com] and Sylvain R. Raynes, a mathematics professor at Baruch College in New York and an expert in structured finance at R & R Consulting [creditspectrum.com].

First, a transparent and regulated exchange must be formed where swaps can trade and regulators overseeing the transactions can set margin requirements. Too many of the problems in the derivatives market stemmed from the fact that all the transactions occurred in a black box, which regulators chose not to open.

Also, little money was required up front, as a good-faith measure of an insurer’s ability to pay.

While each differs from the other on exactly how the unwinding of CDS should occur, both agree on the need to do so immediately to prevent further deterioration of the financial markets and to control additional, potentially harmful, speculation.

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Written by Valerie Curl

January 25, 2009 at 10:55 PM

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