(November 17, 2009) Although much attention has been directed at the contribution made by credit default swaps to the financial crisis, most discussion has focused on the companies, such as American International Group, that posted big losses because they sold these instruments without sufficient due diligence.
Another line of inquiry has not been pursued, however, though it is equal, and perhaps greater, significance. That line of inquiry concerns the way in which the prices of Credit Default Swaps effect the perceived value of all forms of debt — corporate bonds, commercial mortgages, home mortgages, and collateralized debt obligations — and as a result, the ability of hedge funds manipulators to use credit default swaps to enhance their bear raids on public companies.
If short sellers can manipulate the price of credit default swaps, they can disrupt those companies whose debt is insured by the credit default swaps whose prices are manipulated.
The game plan runs as follows: find a company that relies on a layer of debt that is both permanent, and which rolls over frequently (most financial firms fit this description).