Credit Default Swaps

Based on the importance of CDS, Mehrling argues in his paper that the current crisis is best seen as the first test of the new system of structured finance. That test has revealed the crucial role played by credit insurance of various kinds, including CDS, for supporting both valuation and liquidity of even the top tranches of structured finance products. The various government interventions of the last year amount, in his view, to the public sector going into the credit insurance business in response to crisis—by either writing credit insurance or taking over insurance contracts written by others. The author calls this the “Paulson-Bernanke CDS put.” In his view, a basic lesson of the crisis is that the government must be in the credit insurance business in normal times as well.