Here’s the latest from the Greek debt crisis:
“Europe is seeking to avoid a default at all cost because it could also initiate payment of credit-default swaps, there with unpredictable results. There is little public information on which financial institutions have sold credit-default swaps and might have to absorb losses if Greece defaulted, there but it is likely that American banks and insurance companies have taken on the largest share. The shock to the global economy might compare to the collapse of Lehman Brothers in 2008, illness the European Central Bank has warned.” (Jack Ewing & Landon Thomas Jr., “Europe faces tough road on effort to ease Greek debt,” The New York Times, 4 July 2011)
Wait a minute! In credit default swaps the first party pays a premium to a second party in order to “insure” the value of an amount invested in corporate or government bonds made by the first, and the second party guarantees to make up the shortfall if that investment loses value, for example where the issuers of the bonds default on their debt.* Derivatives such as credit default swaps are a risk management strategy for investors, protecting them (for a price) against large losses. So how does this very sensible risk mitigation strategy, used by individual investors, end up causing or exacerbating another broad financial crisis?