Sound and Fury Signifying Nothing

The CDS (Credit Default Swap Market) was one of the precipitating factors of this financial crisis. A CDS is an insurance policy on corporate bonds. If a company defaults on its bonds then the CDS pays off. This sounds like a good idea and a conservative strategy if you own lots of bonds. However, the CDS market was unregulated and institutions could buy a CDS even if they did not own the bonds that were being insured. That is like buying an insurance policy on someone elses house. More so, it's like having many people buy a policy for the same house. If the house burns down, then the insurance company is on the hook for many times the value of the house. Not a good thing. Additionally, there was and is no public market for these contracts so no one knew who owned what.

Lehman was the tipping point in this market. At the time Lehman went down there was $400 billion in outstanding CDS contracts. AIG was a big seller of these contracts and was on the hook for a good chunk of this money. This partially led to the government bail out of AIG.

One more thing and this is important. Many companies both bought and sold CDS contracts netting out their exposure and pocketing the difference between the selling and buying costs. This, apparently was done a lot and is reflected in the final settlement.

Yesterday, all the CDS contracts settled. Here are the results: a total of $5.2 billion (vs. $400 billion in CDS contracts) was paid out and AIG only paid out $6.2 million.

Is it possible that if transparent markets existed for CDS contracts that some of the current pain could have been avoided?