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Line 42: − + − + + − The effect of these risks manifested themselves in two key ways. First, when major players in the CDS market like Bear Sterns and AIG were found to be insolvent, or failed outright like Lehman Brothers, the default conditions that were tied to the risk-spreading CDS's were triggered, and many companies found themselves obligated to pay out on contracts they never expected to. These sudden exposures led to capital and liquidity shortages at scores of firms involved in the secondary credit markets, and the default pattern started repeating on itself in an echo-like manner. Since the complex, interdependent nature of the CDS market made it difficult for firms to assess their true exposure to loss in this unprecedented market, they refrained from both short-term and long-term lending to guard against further losses. This essentially led to a freezing up of credit in the marketplace, as lenders refusing to give credit to other lenders translated into businesses and consumers being unable to get short-term operating loans, or borrow for homes, autos, student loans or credit-card accounts as before. + − −
→Misuse of Credit Default Swaps: CDOs as tradeable assets
===Misuse of Credit Default Swaps===
===Misuse of Credit Default Swaps===
Another key contributing factor to the credit market meltdown was the misuse of Credit Default Swaps, or CDSs, which are contracts between entities designed to mitigate against risk of a credit default. A CDS is essentially an insurance policy designed to protect the insured party against excessive losses in a separate financial transaction. However, by structuring the contract as a derivative swap instead of a traditional insurance policy, companies other than regulated insurers could offer them. This created two critical risk exposures to the insured companies, and collectively to the overall market. First, traditional insurers are required to maintain a sufficient level of capital to pay on losses, while companies issuing CDSs were not. Since investments in pooled mortgages were viewed as unlikely to devalue or fail, major issuers of CDSs like AIG and Lehman Brothers found themselves over-exposed to losses. The second risk was that CDSs issued by one firm were typically hedged, or backed up financially, by CDSs with other companies. The strategy of minimizing risk by dividing it into collections of smaller exposures with other companies is a sound practice, but when the original risk is overexposed that overexposure is then spread across the companies that participate in the secondary risk markets.
Another key contributing factor to the credit market meltdown was the misuse of Credit Default Swaps, or CDSs, which are contracts between entities designed to mitigate against risk of a credit default. A CDS is essentially an insurance policy (and not a tradeable asset<ref>[http://www.ritholtz.com/blog/2012/03/credit-default-swaps-cds-are-insurance-products-not-tradeable-assets/ Credit Default Swaps (CDS) Are Insurance Products, Not Tradeable Assets,] Barry Ritholtz, March 2, 2012,</ref>) designed to protect the insured party against excessive losses in a separate financial transaction. However, by structuring the contract as a derivative swap instead of a traditional insurance policy, companies other than regulated insurers<ref>such as newly created [[Financial holding companies]] (FHCs)</ref> could offer them. This created two critical risk exposures to the insured companies, and collectively to the overall market. First, traditional insurers are required to maintain a sufficient level of capital reserves to pay on losses, while companies issuing CDSs were not. Since investments in pooled mortgages were viewed as unlikely to devalue or fail, major issuers of CDSs like AIG and Lehman Brothers found themselves over-exposed to losses. The second risk was that CDSs issued by one firm were typically hedged, or backed up financially, by CDSs with other companies. The strategy of minimizing risk by dividing it into collections of smaller exposures with other companies is a sound practice, but when the original risk is overexposed that overexposure is then spread across the companies that participate in the secondary risk markets.
[[AIG]], the world's largest insurance company, was a major player in the financial crisis because it sold $441 billion in unhedged and undercapitalized insurance on securitized debt, much of it tied to mortgage values. Normally an insurance company "lays off" some of the risk by taking out insurance with another company. AIG neglected to do this because it never expected the securities to turn toxic, which they did. Either someone paid the insurance or the nation's financial system would colapse, so the government stepped in, seized AIG, and paid the insurance.
[[AIG]], the world's largest insurance company, was a major player in the financial crisis because it sold $441 billion in unhedged and undercapitalized insurance on securitized debt, much of it tied to mortgage values. Normally an insurance company "lays off" some of the risk by taking out insurance with another company. AIG neglected to do this because it never expected the securities to turn toxic,<ref>or, the borrowers to default when interest rates rose on Adjustable Rate Mortgages.</ref> which they did. Either someone paid the insurance or the nation's financial system would colapse, so the government stepped in, seized AIG, and paid the insurance.
The effect of these risks manifested themselves in two key ways. First, when major players in the CDS market like Bear Sterns and AIG were found to be insolvent, or failed outright like Lehman Brothers, the default conditions that were tied to the risk-spreading CDS's were triggered, and many companies found themselves obligated to pay out on contracts they never expected to. These sudden exposures led to capital and liquidity shortages at scores of firms involved in the secondary credit markets, and the default pattern started repeating on itself in an echo-like manner. Since the complex, interdependent nature of the CDS market made it difficult for firms to assess their true exposure to loss in this unprecedented market, they refrained from both short-term and long-term lending to guard against further losses. This essentially led to a freezing up of credit in the marketplace, as lenders refusing to give credit to other lenders translated into businesses and consumers being unable to get short-term operating loans to meet payroll, or borrow for homes, autos, student loans, or credit-card accounts as before.
This freezing of the markets to avoid loss was the primary incentive for the U.S. government's Troubled Asset Relief Program (TARP), which injected billions of dollars of government-backed funds into the credit markets to restore confidence and liquidity.
This freezing of the markets to avoid loss was the primary incentive for the U.S. government's Troubled Asset Relief Program (TARP), which injected billions of dollars of government-backed funds into the credit markets to restore trust and liquidity.
==Bubble bursts==
==Bubble bursts==