AT1 Bonds: the new Financial Weapons of Mass Destruction?

Abstract

Credit Default Swaps (CDS) are financial derivatives that earned the notoriety of being characterized Financial Weapons of Mass Destruction in the aftermath of the 2007-8 financial crisis, which originated in the US. CDS is a kind of insurance against credit default. It was issued by insurers like AIG and other market participants, and bought by investment banks like Goldman Sachs, to protect their investment in subprime and other securities. Speculators too can buy the contract without holding the underlying security. When the financial crisis reached its climax, AIG nearly went down the Lehman Brothers route to bankruptcy thanks to its CDS exposure. It avoided Lehman’s wretched fate with the US government’s rescue, but it was a close call. At its peak, the total outstanding CDS contracts in the market was estimated at more than 60 trillion dollars, bearing no correlation to the underlying value of the securities it sought to protect. An implosion in the CDS market, given its size, could have sounded the death knell of the financial markets, hence the tag Financial Weapons of Mass Destruction for these swap contracts.