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Credit default swaps contributed to the crisis in all the following reasons except: a. Financial...

Question:

Credit default swaps contributed to the crisis in all the following reasons except:

a. Financial institutions relied heavily on credit default swaps to protect themselves from default risk.

b. Credit defaults swaps relaxed the lending standards of banks.

c. Banks used credit default swaps and securitization to shift risks off their balance sheet.

d. All of the above are true.

Moral Hazard & Risk:

Moral hazard is a term used in many situations. In economics, it refers to a situation in which one party takes on additional risk knowing that they are protected against the risk that some other party will have to pay. Due to the risk/reward nature of finance, the ability to take on unusual risks is generally rewarded with profit. This is why the financial industry likes to use insurance.

Answer and Explanation:

The answer is: d. All of the above are true. A credit default swap is a financial contract that insures the buyer against the risk of default, but in this crisis, nobody asked who was insuring the insurer. In the financial crisis, the buyer was the financial industry and the insurer was AIG. Credit default swaps created a moral hazard in the financial industry by helping it to obfuscate risk. In the end, banks were deemed "too big to fail", which doubled down on the moral hazard within the industry, and U.S. taxpayers had to step in as insurer.


Learn more about this topic:

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Financial Risk: Types, Examples & Management Methods

from Finance 305: Risk Management

Chapter 1 / Lesson 4
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