Credit Default Swaps

On the Monday morning, March, 10, 2008, Bear Stearns — the Wall Street giant —had no idea what was going to hit them. The firm was going through a tough time, but nothing that could not be inherently set right, or so it was believed. And then the rumors started circulating, that Bear Stearns were running out of cash. Rumors, whether founded or unfounded, can do great harm to a company. By the middle of the week the firm found itself between the devil and the deep blue sea.

The institutional investors such as Goldman Sachs who had been investing in it were acutely reluctant to lend it more money, while the public confidence plummeted and people were getting ready to withdraw their money en masse. Bear Stearns stock price was falling with nothing to buffer it. Bear ran out of its capital reserve and had no funds to open the trading next day. If Bear could not raise some good amount of money overnight, it would go bankrupt the next day. At this juncture, the Fed kicked itself into action, because the collapse of Bear could have huge implications for the economy.

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The New York Fed’s Tim Geithner and his men invaded Bear’s Wall Street office and rummaged through the accounts. They were joined by teams from JPMorgan and SEC. As they found out, Bear was up to its neck in subprime mortgages; in addition, it also indulged in a financial instrument called credit default swap which was a form of insurance for the mortgage-based securities they sold. Bear had credit default swaps to the tune of hundreds of billions of dollars — spread all over the Wall Street.

And so it was now confirmed that if Bear Stearns went under, it would take a few other firms with it, and these firms could take down other firms associated with them, resulting in a cascade. Even if this did not happen, the repercussions of Bear’s fall on the economy would be very serious. Bear Stearns’ interconnectedness with so many firms across the Wall Street generated what is known as systemic risk (Cohan 28). In 2008, the government's bailout of Bear Stearns and then a bigger bailout of AIG, along with the bankruptcy of Lehman Brothers, brought a great deal of public attention on credit default swaps.

In this paper we will explore this form of credit insurance called credit default swaps and how they posed such a tremendous systemic risk not only to the American economy but to that of the entire world.

What is a credit default swap?

Credit default swap is the most common form of credit derivatives. Credit derivates are a way of managing credit risk and creating credit default insurance. Credit derivatives such as credit default swaps, credit linked notes and total return swaps are used to minimize the risk of loss that would result from default by an organization issuing bonds or by other types of borrowers (Colquitt, 112).

Let us try to understand credit derivatives through the illustration of a case of credit-linked note (CLN), which is a form of credit default swap (CDS). Let’s say, a company such as General Motors issues bonds in order to raise money. Let us assume that GM bonds have a ten-year maturity, yield 4. 5% interest, and are priced at par. A bank that holds the GM bonds is concerned about the risk of default. To mitigate this risk, the bank creates a 5-year note (CLN) to investors and offers to pay 5% interest. So now this is another bond the cash flows of which are contingent upon the original GM bonds.

It works this way: If GM bonds do not default, then CLN investors will receive the periodic 5% interest and the par value will be returned to them at the time of maturity. In the exceptional instance that the GM bonds default, the CLN investors will receive the GM bond, which is now valued presumably much lower than par, and the CLN is terminated. The higher interest rate, a spread of 0. 5%, is the price being paid by the bank to protect itself against the default risk associated with GM. The CLN, just like a total return swap, has a credit default swap embedded into its structure.

It simply combines a credit default swap with a regular note. Conversely, in a CDS the 0. 5% spread in the above example would be directly paid by the bank – the bondholder – to the investors without a note being created. This payment is usually called the CDS premium and can be seen as being akin to insurance premium. The bondholder would purchase protection against a ‘credit event’, such as default or bankruptcy, and the investors are the sellers of this protection. In exchange for receiving the price of the spread, the seller of the contract agrees to purchase the reference entity, i.e. , the bond, from the protection buyer at par value if a credit event occurs.

To recap, in a CDS:

• The protection buyer makes period payments till the maturity of the CDS to the protection seller.
• The protection seller promises to make a payment to the buyer upon the possible default of the reference entity. As we can see, the basic mechanism behind a credit default is very similar to normal insurance. For example, a car owner approaches an insurance company to buy protection from some "car event," such as an accident or theft.

The insurance company collects regular premiums from the customer over a period of time and in return promises to make compensatory payments to the customer should any of the covered events occur. In the case of CDS, the protection buyer gets “default insurance” on any kind of debt, for the notional amount of the debt which is issued by a third party. The notional amount in this case is equal to the amount of insurance coverage. The annualized insurance premium is referred to as the spread, which would be a percentage of the notional amount. If the notional amount is, say, $1000, and has a premium of 40 basis points, the spread would be $4.

Normally, CDS premiums are paid quarterly, so the protection buyer has to pay $1 every three months to the protection seller. If the reference entity defaults, the CDS is settled via cash or physically, according to the terms of the agreement. Physical settlement means the protection buyer hands over the defaulted assets to the protection seller and receives the par value or face value of the assets. There is a swap taking place here, and hence the name. In cash settlement, the protection seller pays the difference between the face value and the recovery value of the assets.

In the United States, physical settlement is the more common practice. The maturity of the CDS may differ from the maturity of the associated bond or other type of debt instrument issued by the reference entity. Credit default maturities typically range from 3 to 10 years, with the 5-year maturity being the most common. It is possible to terminate a credit default swap before the maturity. Unwinding, as it is called, is a common practice and requires an agreement between the two parties regarding the market value of the position.

Whichever party has a position that corresponds to a negative market value duly compensates the other party. It is also possible for a party to close out its position by naming a new counterparty to which the position is assigned. The valuation of CDS contracts is arrived at by employing various complex mathematical models; a commonly employed method is the JPMorgan model or one of its versions.

Differences between regular insurance and CDS Although CDS is considered credit insurance, there are a few crucial differences between the regular insurance business and CDS trading.

The institutions selling insurance are required to maintain stipulated fund reserves to meet any possible reimbursement claims. In the CDS sector, however, there is no requirement for the protection seller to maintain fund reserves, and nobody oversees the financial worthiness of the protection seller. A protection buyer purchases protection from the protection seller based solely on the credit rating of the seller. Ideally, the credit seller has a triple A rating, but there is no guarantee that promises will be honored in the future as they were in the past.

It is largely owing to the fact that there is no obligation for protection sellers to maintain concomitant reserves of funds as contingency measure, that the Wall Street firms could sell protection in CDS transactions indiscriminately and thus brought ruin upon themselves and the nation’s economy. Furthermore, in the case of regular insurance the protection buyer needs an insurable interest of course. However, only a segment of CDS buyers typically would have an interest in the underlying asset. The others use CDS merely to speculate, i. e. , to bet on reference obligations which they do not own.

Swaps done on a speculative basis are called ‘naked swaps’ while swaps done for regular hedging purposes are called ‘covered swaps’. Speculation and naked swaps have been conspicuously involved in the downfall of Bear Stearns, AIG and Lehman in 2008. Also, upon purchase the insurance is held with the purchaser, whereas in the case of CDS, the instruments are often traded. The CDS deals may move from hand to hand many times and the distance between the reference entity on the one side and the protection buyers and sellers on the other keeps increasing.

CDS contracts can sometimes pass through more than 10 parties. The large number of parties typically involved in the history of a CDS contract makes it complicated and difficult to “unwind” upon the occurrence of a credit event. Complexity also arises because the terms usually change from the original CDS contract to the contracts that follow it.

Uses of CDS to investors

Hedging: Credit derivatives, and particularly credit default swaps, allow the holders of credit instruments such as banks to hedge their credit risk. Hedging is the most straightforward and genuine use of credit default swaps.

While credit instruments remain in the bank's balance sheet, the risk associated with the credit is transferred to the protection seller as per the terms of the contract in a CDS. • Speculation: For the past several years, there has been an increasing shift from protection to speculation in the CDS sector. While hedging is a form of insurance, speculation is a form of betting. An investor may want to wager on the credit standing of a firm. The CDS spread will increase as the estimates of credit-worthiness of firm decrease, and vice verse, since in the capitalist framework more risk entails more reward.

A person who has a lower estimate of the company’s credit-worthiness will buy CDS protection if he can find a party who has a higher estimate of the company’s credit-worthiness. The buying party goes short on the underlying asset, while the selling party goes long. Since the speculators do not own the bond or the underlying asset, the long and short positions in this context are known as synthetic. • Arbitrage: Arbitrage is a way of exploiting the lack of efficiency in the markets. The traders take advantage of the price differences between two markets.

Typically, credit default swap pricing tends to be sufficiently varied from place to place so as to allow some good scope for arbitraging. Credit default swaps have given rise to new opportunities for particularly profitable arbitrage in global markets. CDS transactions play a part in the larger framework of capital structure arbitraging. Capital structure refers to the way a company is financed, and the scope for arbitraging arises from the fact that there are usually inappropriate price differences among the various kinds of stocks and bonds of a company.

History and growth of CDS

CDS have come into vogue in the mid-1990s. JP Morgan was chiefly responsible in refining the instrument, which led to its greater use in a rapid manner. In 1994, JP Morgan provided credit for Exxon when the mega oil corporation faced litigation and damage claims to the tune of $5 billion in the wake of the Exxon Valdez disaster, though Exxon did not pay any of this amount to the litigants. Subsequently, JP Morgan sold the credit risk associated with this loan to EBRD (European Bank of Reconstruction and Development), in order to protect itself from Exxon’s default.

In 1997, JP Morgan also developed a system called BISTRO which is a prototype of synthetic or speculative CDO’s. As we shall see shortly, synthetic CDO’s played an important role in exacerbating the economic crisis of 2008. What CDO’s essentially do is split up the credit risk so that takers can be easily found to assume the smaller fractions of the overall credit risk. In the early years of CDS, they were mostly used by banks to hedge risk associated with the loans they made. The size of CDS market in 1996 in the US when mostly national banks were trading in CDS, was already as large as tens of billions of dollars.

In the next few years many more players entered the arena. CDS began to be sold for corporate and municipal bonds. In 1999, ISDA (International Swaps and Derivatives Association) standardized the procedures for trading in CDS. This helped in expanding the market. In the year 2000, the CDS market in the US was worth $900 billion. In the early 2000’s the growth in popularity of CDS was spurred by the fact that Alan Greenp’s economic policy decided to keep the CDS sector outside the purview of SEC regulation. This provided ample opportunity for carrying out speculation.

By 2002, speculation-related activities superseded the hedging-related activities in the CDS sector. With speculation running rampant, the outstanding amount in the CDS market soared to 2 trillion dollars, by the end of 2002. Beginning from 2003, CDS were issued in the form of MBS, CDO and other structured investment vehicles. From 2003 onward, the CDS market in the US began to grow exponentially. The size of the market was $3. 7 trillion by the end of 2003, but by the end of 2007, it was an incredible $62. 2 trillion. Almost half of this notional amount is owing to speculation.

Speculation can cause the outstanding amounts to rise to huge proportions. For example, if a person buys insurance for his house, the outstanding amount would be, say, $300,000, which would be given to the insurance buyer if the house was burnt down in flames or washed away in floods. However, in speculation, even if the person does not own the underlying asset, he can still take insurance on it. Let’s say, some 10 people in the neighborhood also purchased insurance on this same house. Now, while the value of the underlying asset remains the same, the outstanding amount has grown from $300,000 to $3 million.

And it can happen overnight. We must note that in the case of CDS the outstanding amount indicating the size of the market is the sum of money that would be needed to pay should all the debtor organizations default at once. However, as it was an extremely rare occurrence for investment grade organizations to default prior to 2007, the actual amounts that were exchanging hands were only the premiums and they amounted to only 1 or 2% of the outstanding notionals. In 2008 the financial crisis began, and by the end of that year the CDS market fell to $38. 6 trillion.

The role of CDS in the financial crisis of 2008

In 2008, credit default swaps triggered a world-wide financial market meltdown. The US and other governments had to go to extreme lengths to preserve the integrity of capital markets, even so far as to abandon some of the fundamental principles of capitalism. Credit default swaps had such an impact because they were tied to subprime mortgages. Subprime mortgages, MBS, CDOs, and CDS —these four elements acted in concert to wreak havoc on the global economy. Let us now take a closer look at how the subprime mortgages and credit default swap disaster unfolded in 2008.

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