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Unregulated credit default swaps (CDS) gave shaky coverage to subprime loans.

John Paulson, a hedge fund manager, earned $20 billion for his firm and $4 billion for himself by betting against the over-heated US housing market in 2007. He bought insurance contracts that cost only $1 for every $100 covered on the riskiest slices of mortgage-backed securities. When the subprime mortgage market began to unravel in February 2007 and spread across the financial world, Paulson’s bets started to pay off.

The insurance contracts that let John Paulson and other investors bet against the housing market are known as credit default swaps (CDS). CDS are just insurance contracts to insure against the occurrence of an unpleasant event. The only difference is that it is not regulated like regular insurance contracts. Specifically, sellers are not required to have capital reserves to back up the contracts. So sellers could write an unlimited number of contracts (so-called derivatives) to rake in premiums as long as there are buyers willing to buy them.

Before 2000 when the US Congress passed a bill prohibiting all federal and most state regulation of CDS, there were no easy ways to bet against the housing market. But the explosion of mortgage-backed securities (MBS) with unfamiliar risks would not have been possible without some assurance to buyers. The ease with which CDS can be set up with little upfront costs provided just the tickets to send the volume of MBS into the stratosphere. With such covers, mortgage lenders began to go deep into subprime mortgages for borrowers who could not possibly afford to own homes before so that the mortgages could be packaged into MBS to sell to hungry investors.

CDS were also used to launch the markets for other assets with regular cash flows, such as credit-card loans and auto loans. Because an unlimited number of CDS can be written on the same asset-backed securities (ABS), the notional value of CDS exploded from nothing to $54.6 billion in the decade before 2008. This value of CDS even exceeded the world’s GDP. Many of the big financial institutions were deeply involved in buying and selling CDS. The end result was an unprecedented expansion of risky credit that ultimately crashed in late 2008.

Because some of these financial institutions such as Bear Sterns and AIG were judged to be too big to fail, they were bailed out by US taxpayers. One notable casualty was the demise of Lehman Brothers, a leading ABS (asset-backed securities) dealer. Although the CDS and ABS markets are mere shells of their former selves in late 2009, there is still lingering nostalgia for the bad old days among many big players who are reluctant to accept effective government regulation.