Friday, October 10, 2008

The CDS Problem

In my recent readings I've gleaned that the size of the CDS market (CDS = Credit Default Swap) is on the order of $60T, while the face amount of bonds being insured in this way is only on the order of $10T. So how did this happen? I guess the answer is that speculators and hedge funds started to treat these vehicles not as "insurance" against the bonds they held, but as profitable gambles should third party bonds fail.

In other words, it would be like taking out fire insurance for your neighbors house. Which must have undoubtedly had some strange effects on incentives in the system.

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