Changes

===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 (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.   

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<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,<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.   

[[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.