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Weapons of Mass Destruction?--Page 2

Clearing up the confusion surrounding credit default swaps.

Counterparty Risk
The way the CDS market evolves over the next few years will depend heavily on whether swaps remain popular among institutions, whether they continue to work the same way, and whether--and to what degree--they become more regulated. There are plans in the works, for example, to create exchanges upon which these over-the-counter-traded securities could be standardized and traded. This concept would help mitigate one of the chief concerns regarding credit default swaps, that of "counterparty risk."

Counterparty risk results from the relational nature of the CDS arrangement. It was put in high relief with the dramatic rescues of Bear Stearns and AIG, both of which were huge counterparties, and the failure of Lehman Brothers. The risk stems from the fact that a financial firm usually acts as the go-between with the two parties who are "swapping" with each other. The firm standing in the middle assumes risks from both parties and, theoretically, polices their ability to pay. It becomes each side's counterparty.

Under this system, the intermediary gets to set its own margin requirements; one appeal of the swap structure is that margin requirements are typically very low. In effect, that allows swapping parties to take on market exposures without putting up much capital--the basic definition of leverage. When investors can do that in the swaps market, they can do it over and over again. Even if a manager has only $100 million in cash, he might be able to control many times that amount of market exposure via swaps.

Meanwhile, the framework of Wall Street is such that firms constantly trade with each other to fulfill the needs of clients. A customer might want to enter a swap to buy protection on a specific credit, for example, and the only way to find a willing seller might be to work through a rival dealer. So, even if a firm is only acting as the go-between and, therefore, not overtly taking on the market risks of its clients' swap positions, it is exposed to the risk that its clients, or rival firms, won't be able to follow through on their commitments. This is the essence of counterparty risk.

Exchanges an Option?
In the United States, exchange-traded markets are regulated, and "clearinghouses" are set up to mitigate systemic risk by maintaining trader capital and margin requirements. In most cases, that centralization also means transparency in terms of risk, contract specifications, and pricing. The exchanges and regulators can look through the entire system and get a handle on how much risk is concentrated in the market and among trading parties.

That level of clarity does not exist today in the current over-the-counter swaps market. Very few people and organizations are in position to assess how much volume is moving through the market, how much depth there is in terms of buyers and sellers, and how prices are set. Without this information, the broader market, public, and government policymakers are at a dramatic disadvantage.

The CDS market needs to look no further than the futures market to find a sensible model for creating a clearinghouse and exchange-traded system. A smooth functioning exchange would likely require less customization of contracts, but the model is workable and would be an improvement. In fact, there are already swaps trading on exchanges around the United States. But the idea has not taken hold because until recently the CDS market's opacity had worked in favor of Wall Street dealers, who had been able to keep large trading profits in their own coffers and had spurned almost any cooperation with exchanges.

As the need for change has become more apparent during the financial crisis, however, the industry is developing plans for a clearinghouse to function behind the scenes between dealers--if not the more transparent features of a public securities exchange. The crisis has hastened government demands for more solutions.

Bad Reputation
The image of swaps was bad enough in the years after 1994's mortgage derivative mess that bankrupted Orange County, Calif. But their reputation sunk even lower when Warren Buffett famously slammed swaps as "financial weapons of mass destruction" in a 2002 shareholder letter. Scary stuff. But was Buffett right?

Like nuclear technology, swaps can be used and abused, but they have tremendous utility. They perform important functions in the financial system. A savvy money manager can use swaps to break up a bond's risks into component parts--such as interest-rate and credit risk--and then to take a position on one or the other without having to address both of them. A portfolio that's carefully calibrated on the basis of its interest-rate exposure can shed a specific credit risk by purchasing default protection while still hanging on to the original bond and not disturbing the portfolio's interest-rate exposure.

Change to the swap market is needed, and plenty of steps can be taken to improve it. But in doing so, legislators and regulators shouldn't choke off the market in a fit of political rage. After all, financial life without swaps would be much more difficult.

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Larry Jones, an associate director of fund analysis with Morningstar, contributed to this article, which was originally published inMorningstar Advisormagazine.

Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.