Mar 18, 2009
Some think the exposures associated with credit derivatives are so extreme that the failure of one or two large financial institutions will ruin the nation. Could the use—or abuse—of credit default swap exposures be that dangerous?

EFF/KRF: As far as I can tell, the government bailout of AIG has gone largely to prop up its $2 trillion of credit default swaps. The fear of the Treasury and the Fed is that if AIG is forced to default on its credit default swaps, the "insurance" they provide to the value of bank assets will disappear, the value of the assets will fall, and lots of big banks will be insolvent. I agree that this is likely to be the eventual outcome, in other words, the Fed and the Treasury will eventually say "uncle" and let AIG and the bad banks fail. I think this is what they should have done from the beginning, and if they had we would be in better shape now. The stockholders and the bondholders of AIG and the failed banks will lose big time, but this will allow the banking sector as a whole to emerge in a stronger state. (See also my little paper "Bailouts and Stimulus Plans.")

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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