Gretchen Morgenson of the New York Times sounded the alarm back in February with a long, detailed piece describing the massive credit default swaps market that is now threatening to swallow Wall Street in a swamp of toxic debt. On Feb. 17 she wrote:
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.
Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.
The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.
No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.
Morgenson went on to report that American International Group (AIG) failed to properly value it's swaps, leading to a $3.6 billion loss. Look how that turned out.
Morgenson won a Pulitzer Prize in 2002 for her coverage of Wall Street. She deserves another.
In what I still think is my best "To The Point," Morgenson came on our show to talk about the effect of the housing crisis on the economy. John Cassidy of the New Yorker was also a guest. He talked about the volatility of the free market and the inevitability of these terrible bubbles when government takes a hands-off approach.