Swap Not to Blame

Peter J. Wallison

CREDIT-DEFAULT SWAPS ARE NOT TO BLAME

Shelley.Barry@informa.com ShelleyBarry 0 2000002009 21 Criticaland Francis 2009 0891-3811 (print) 1933-8007 (online) OriginalReview Foundation ISSN 10.1080/08913810902934265 RCRI_A_393598.sgm Taylor Article

ABSTRACT:

Though accused by critics of helping to cause the current financial crisis, credit-default swaps are blameless. The accusation is understandable, however, given misunderstandings about how a credit-default swap actually works. A careful look into its mechanism shows that it is not only simpler than thought, but that it is also vital to keeping the financial system strong by enabling financial institutions to better manage their risks. The risk taken on in a credit-default swap (CDS) is no different from the risk of making the underlying loan. CDSs allow risks to be spread more widely instead of being concentrated at vulnerable points, but they do not add to the total amount of risk.

After the failure of Bear Stearns, Lehman Brothers, and A.I.G. had signaled the global financial meltdown, Securities and Exchange Commission chairman Christopher Cox was quoted in the Washington Post as telling an S.E.C. roundtable:

The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis . . . and requires immediate legislative action. . . . The over-the-counter credit-default swaps market has drawn the world’s major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system. (O’Harrow and Dennis 2008)

The chairman’s statement is puzzling for reasons both abstract and concrete.

Peter J. Wallison, pwallison@aei.org, is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, 1150 Seventeenth Street, N.W., Washington, DC 20036. Critical Review 21(2–3): 377–387 © 2009 Critical Review...