Morningstar Advisor - February/March 2009 - (Page 22) Gray Matters Weapons of Mass Destruction? By Eric Jacobson and Lawrence Jones A great deal of misunderstanding surrounds the risks and opportunities of credit default swaps. 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 22 Morningstar Advisor February/March 2009
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