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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
A key OTC derivative in the financial crisis was the credit default swap (CDS),
which offered the seller a little potential upside at the relatively small risk of a poten-
tially large downside. The purchaser of a CDS transferred to the seller the default risk
of an underlying debt. The debt security could be any bond or loan obligation. The
CDS buyer made periodic payments to the seller during the life of the swap. In re-
turn, the seller offered protection against default or specified “credit events” such as a
partial default. If a credit event such as a default occurred, the CDS seller would typi-
cally pay the buyer the face value of the debt.
Credit default swaps were often compared to insurance: the seller was described as
insuring against a default in the underlying asset. However, while similar to insurance,
CDS escaped regulation by state insurance supervisors because they were treated as
deregulated OTC derivatives. This made CDS very different from insurance in at least
two important respects. First, only a person with an insurable interest can obtain an
insurance policy. A car owner can insure only the car she owns—not her neighbor’s.
But a CDS purchaser can use it to speculate on the default of a loan the purchaser does
not own. These are often called “naked credit default swaps” and can inflate potential
losses and corresponding gains on the default of a loan or institution.
Before the CFMA was passed, there was uncertainty about whether or not state
insurance regulators had authority over credit default swaps. In June , in re-
sponse to a letter from the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP,
the New York State Insurance Department determined that “naked” credit default
swaps did not count as insurance and were therefore not subject to regulation.
In addition, when an insurance company sells a policy, insurance regulators re-
quire that it put aside reserves in case of a loss. In the housing boom, CDS were sold
by firms that failed to put up any reserves or initial collateral or to hedge their expo-
sure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would ac-
cumulate a one-half trillion dollar position in credit risk through the OTC market
without being required to post one dollar’s worth of initial collateral or making any
other provision for loss. AIG was not alone. The value of the underlying assets for
CDS outstanding worldwide grew from . trillion at the end of to a peak of
. trillion at the end of . A significant portion was apparently speculative or
naked credit default swaps.
Much of the risk of CDS and other derivatives was concentrated in a few of the
very largest banks, investment banks, and others—such as AIG Financial Products, a
unit of AIG —that dominated dealing in OTC derivatives. Among U.S. bank holding
companies, of the notional amount of OTC derivatives, millions of contracts,
were traded by just five large institutions (in , JPMorgan Chase, Citigroup, Bank
of America, Wachovia, and HSBC)—many of the same firms that would find them-
selves in trouble during the financial crisis. The country’s five largest investment
banks were also among the world’s largest OTC derivatives dealers.
While financial institutions surveyed by the FCIC said they do not track rev-
enues and profits generated by their derivatives operations, some firms did provide
estimates. For example, Goldman Sachs estimated that between and of its
revenues from through were generated by derivatives, including to
