John Lounsbury

What Went Wrong in 2008?

The stock market drop in the weeks following the Lehman collapse was due primarily to the recogition of the extent of the exposure inherent in the CDS pyramid. It took that event to bring home the risk to financial institutions around the world posed by a network of guarantees against defaults in underlying debt instruments and other financial assets. This network was perceived to be like a circle of dominos stacked on end. The perception was that, with the tipping over of the Lehman domino, the entire circle would fall.

This has not happened (at least not yet), in part because of the TARP legislation. However, there is still no transparency in this area and we can not be sure the crisis has passed. If another major financial institution fails, or is rumored near failure, the entire fear cycle could be repeated. Financial stocks would drop further and the rest of the market would follow.

One way to relieve this overhanging threat would be to broker the swapping out of CDSs in self-cancelling trades. This is something that CDS holders and issuers should welcome because it is believed that many of the CDS instruments offer guarantees by those with insufficient assets to make the "insurance payments" specified in the case of default in the "protected" securities. Government expenditure to operate this brokerage might be much less costly and far more effective than such grandiose schemes as the TARP.