Does the Geithner Plan Reduce Credit Default Swap Risk Too?

Credit default swaps (CDSs) are still a big issue. Estimates of how much of the market is at risk vary, but the lowest I’ve seen is about $15 trillion. If that goes bad, we’re probably talking another $3 or $4 trillion of damage.

While I agree that CDSs are an issue, I also think that taking bad assets off firm’s hands makes defaults on CDSs more unlikely, and thus reduces exposure to them.

Of course, this really depends on whether the fundamental problem lies with the economy or the financial market—or both. If the economy keeps going south, then bailout after bailout will be needed, defaults will happen anyway, and CDSs will be called. If the combination of fixing the financial sector plus the stimulus bill and military spending is enough to stop the economy’s downward spiral, on the other hand, then Geithner’s plan may well do the trick (once a couple more trillion are spent). We’ll see.

(Aside: Interest rate and currency swaps are about a 7 times larger market than CDSs. The real risk is a currency meltdown by a major economy.)