Final answer:
Credit default swaps have disadvantages such as being largely unregulated, enabling risky investment strategies and contributing to systemic financial instability, which played a significant role during the Great Recession.
Step-by-step explanation:
The disadvantages of credit default swaps (CDS) are multiple and significantly contributed to the Great Recession of 2007. One major issue with CDS is that they are largely unregulated, which means that institutions could operate outside of the governed financial framework, allowing for higher levels of risk-taking without adequate oversight. This lack of regulation led to excessive speculation and the creation of a bubble in the housing market, exacerbated by CDS linked to mortgage-backed securities.
Moreover, because credit default swaps are a form of insurance on investments that could be used even when the holder did not own the underlying asset, they encouraged risky investment strategies. Consequently, when the crisis hit, many institutions faced massive payouts that they could not cover, leading to liquidity problems and insolvency. The misperception of risk, bolstered by high ratings from credit agencies, further inflated the confidence in these financial products, contributing to the financial system's vulnerability. As a result, when defaults on subprime mortgages increased, the CDS market contributed to the swift collapse of financial stability.