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Weapons of Mass Destruction?

A great deal of misunderstanding surrounds the risks and opportunities of credit default swaps.

Eric Jacobson and Lawrence Jones, 01/30/2009

During times of financial distress, it's not surprising to see the media search for a culprit on which to pin the blame. In many recent reports, enemy number one has become a particularly important type of derivative--the credit default swap. Like many reports on complicated issues, the stories are partly correct, but they contain misunderstandings and misinformation.

There's no denying that the drawbacks of swaps placed additional risk burdens on the financial system and threatened to magnify its troubles. Bear Stearns, Lehman Brothers, and AIG AIG were big players in the swaps market. Each of those firms was a counterparty to untold numbers of contracts. In effect, they each were acting as substitutes for the role of an exchange. Had a more disorderly collapse of any of them or other firms been allowed to occur, it's unclear just how badly and how far the damage would have stretched.

But the suggestion that the financial crisis was triggered by a specific failure in the swaps market is incorrect. Out-of-control leverage--which was taken on through many different methods, including but not limited to swaps--and lax lending standards have been rampant across the market. Failures in the mortgage finance system arguably deserve the lion's share of blame.

Lost in all the hubbub has been a more nuanced look at what the risks to our financial system actually are and what can be done to address them--without throwing the baby out with the bath water. That's important because the fact is that derivatives, and especially swaps, have made a valuable contribution to the expansion, efficiency, and utility of our financial markets.

What's a Swap?
In its most basic form, a swap is a contract between two parties to exchange one thing or another. In the case of a plain-vanilla interest-rate swap, for example, two parties might have mismatched assets and liabilities. Assume that Party A has taken out a loan and must pay a fixed rate of interest, but it also receives a stream of income that pays a floating rate to Party A. Party B, by contrast, owes money on a floating-rate loan, but it has an income stream that pays a fixed rate. Each party would prefer to swap its payment stream, so that both its assets and liabilities are matched--either fixed to fixed or floating to floating. With a swap, each party can eliminate the risk that its income may not be sufficient to meet its payment obligations. Assume that both parties choose the same dollar amount upon which to base the swap, called the "notional" value. One party agrees to make a fixed interest payment based on the notional value, while the other agrees to pay a floating rate.

What makes things interesting is that, while the notional value is important as a reference point, the actual amount almost never changes hands. Rather, it's only the interest payments based on that number that flow back and forth. In fact, the contract can be structured in a way that those interest payments will offset each other to some degree. For example, take a swap with a notional value of $10 million, where the fixed rate is 6% and the floating rate is at 5% at the time payments are due. The payments are "netted" (6% minus 5%); the fixed-rate payer owes 1% of $10 million to the floating-rate payer, a payment of $100,000.PAGEBREAK

Often, the only other money involved is margin collateral that the parties put up to cover the risk that they will fail to live up to the contract. That's why it's worth taking numbers you hear about the size of the swap markets with a grain of salt. A $60 trillion notional amount of swaps may represent plenty of risk being transferred or embedded in the financial system, but it doesn't mean that 60 trillion actual dollars ever traded hands.

There are all kinds of reasons that an investor would want to use an interest-rate swap, and they run the gamut from saving money to hedging risk and speculating. In many cases, investors can get similar results from futures or options, but they may turn to customizable swaps to negotiate a longer maturity, or for other needs.

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