Credit Default Swaps and their Role in the Financial Crisis


Term Paper, 2011
12 Pages, Grade: A

Excerpt

Table of Content

1. What are Credit Default Swaps?

2. History

3. CDS in the Financial Crisis

4. Developments after the Financial Crisis

5. References

1. What are Credit Default Swaps?

A credit default swap is essentially an insurance contract to hedge credit risk. It is a type of derivative whose value depends on the likelihood of a company defaulting. In this type of derivative two parties enter a contract where one party agrees to pay another in the event of a company defaulting on bond payments (also known as a credit event) for a premium or spread. There are two types of payoffs if a credit event occurs. In the first type the owner returns the bond in return for a payment equal to the par value of the bond. This type of payoff is called a physical settlement. In second type of payment structure the owner of the credit default swap receives the difference between the par value and the market price of the bond as a payment and does not have to return the bond. This type of payoff is called a cash settlement. The total market for credit default swaps is currently around $60 trillion.

Credit default swaps can be used to hedge risk. In this strategy a bondholder purchases a credit default swap to eliminate the default risk of the bond for a premium. Credit default swaps can also be used to speculate on a company or country defaulting. In this application the buy or sell does not own the bond of interest. Credit defaults swaps used in this application are referred to as naked credit default swaps. Approximately 70% of all credit default swaps are naked credit default swaps.

In principal, purchasing a credit default swap is very similar to purchasing insurance because both instruments provide protection for a premium. However, there are several differences between credit default swaps and insurance. First, credit default swaps do not require the purchaser to have an insurable interest or even own the bond that corresponds to the credit default swap. Second, there are little to no regulation and no reserve requirements. Finally, mark to market account is used on credit default swaps for balance sheet purposes.

Since, there is little to no regulation of credit default swaps and no reserve requirements there is the risk that either the buyer or sell of the credit default swap will default. If there is a credit event and the seller of the credit default swaps defaults then the buyer may not receive any money. Likewise, the buyer can default resulting in the seller losing an expected revenue stream.

Credit default swaps can also be used for arbitrage. If there is additional information that is not priced into the credit default swap there is an opportunity for free money. Additionally, when both the bond and the credit default swap are owned there is the potential of large profits with little risk. In this strategy the bond payments essentially offset the credit default swap premiums and a credit event results in receiving the par value of the bond before the maturity date of the bond.

2. History

Credit Default Swaps were initially introduced as a contract between two parties as a way to mitigate the risk associated with a firm’s loans or bonds. Credit default swaps were also a mean to free up the cash reserves regulation required these firms to carry to back their debt obligations.[1] CDS were originated in 1994 by a group of JPMorgan bankers to protect their assets from default and utilize the tens of billions of dollars carried on their balance sheets as loans. To do this a contract was created with a third party who would offer protection from default. The in exchange for providing protection on the assets the seller of protetction would receive monthly payments from the buyer of protection, the bank. This protection could be provided for any type of instrument, offered to anyone, and sold by any company, insurance company or not. CDS do not undergo the same actuarial underwriting process as insurance products and is valued based on the financial strength of the institution. Additionally, since the protection is sold as a two party contract and not an insurance policy it was not subject to the strict regulator policies found in the insurance industry.[2]

Payments were made by the buyer of protection based on the riskiness and stability of the underlying assets, the more likely a firm was to remain a going concern the lower the monthly protection premium would be. At the genesis of the CDS market there were few concerns that the bond issuer would default and as long as they did not, the seller of protection would collect steady income in the form of premiums, however if the company were to default the seller of protection would cover the loss incurred by the default. As long as more companies continued to make their payments than those that defaulted the sellers of protection would remain profitable[3]. In an article by James Kwak, he uses Citi to illustrate how a CDS’s value would be assessed and sold. The spread for CDS are quoted in basis points and generally have duration of 5 years unless otherwise specified. With a spread of 255.5 basis points or 2.55% a buyer of protection would pay $2.55 in premiums for protection for every $100 in Citi debt. Based on the 5 year duration of this contract it is determined that there is a 12.775% ($2.555 x 5) chance of Citi becoming insolvent in the next five years. Throughout the duration of the contract the seller of the protection collects payments valued at $12.775 so if Citi were to default during the fourth year, the seller would be responsible to the $100 of protection they offered but could net out the $12.775 in payments they received less any residual value they can recover for the underlying assets. By monitoring the spreads for the CDS on a company’s debt the market is able to assign the relative stability for that firm.[4]

The following chart shows the development of size of the market for CDS[5].

illustration not visible in this excerpt

By the end of the 1990s the CDS market had grown to nearly $900 billion functioning in their intended manner, delivering payments for the bond defaults with Enron and WorldCom. At this point the arrangements were the parties were familiar with each other and were familiar with the terms of the agreements and in most occasions the buyer of protection also held underlying assets. It wasn’t until 2007 CDS led to CDOs becoming commoditized and speculation took off in the market that these instruments began to turn toxic. The sold portions would entitle the buyer to the monthly revenue stream associated with those assets. At this point the CDS market was valued at nearly $45 trillion with $25 trillion in underlying assets leaving roughly $20 trillion to speculation transactions on the occurrence of credit events in the market. Also, at this point the number of parties involved in the transactions grew from 1-2 to 10-12 that added several elements of convolution to the process. As the number of parties involved in the transactions and the number of transactions increase the financial strength of the companies can no longer be accurately analyzed and the riskiness of the CDS can no longer be assessed. In addition to the difficulty in identifying the parties associated in a traded CDS, when these securities are repackaged and resold, the new contract may not match the terms of the initial contract and thus prevent some parties from receiving payment in the event of a credit situation.[6]

[...]


[1] Zabel, R. Richard, Credit Default Swaps: From Protection to Speculation. 9/2008.

[2] Phillips, Matthew. The Monsters that Ate Wall Street: How Credit Default Swaps- An Insurance Against Bad Loans- Turned from a Smart Bet to a Killer. 9/27/2008.

[3] ibid.

[4] Kwak, James. Credit Default Swaps- Herald of Doom. 11/2008.

[5] Graph from: http://suddendebt.blogspot.de/2011/01/cds-hedge-or-hog.html, accessed July 13, 2011. Data from: http://www.isda.org/statistics/historical.html

[6] Zabel, R. Richard, Credit Default Swaps: From Protection to Speculation. 9/2008.

Excerpt out of 12 pages

Details

Title
Credit Default Swaps and their Role in the Financial Crisis
College
Union Graduate College
Course
Money, Markets and Banking
Grade
A
Author
Year
2011
Pages
12
Catalog Number
V198665
ISBN (eBook)
9783656253976
ISBN (Book)
9783656255123
File size
681 KB
Language
English
Series
Aus der Reihe: e-fellows.net stipendiaten-wissen
Tags
CDS, Credit Default Swaps, Derivatives, Financial Crisis, Capital Markets
Quote paper
Klaus Schütz (Author), 2011, Credit Default Swaps and their Role in the Financial Crisis, Munich, GRIN Verlag, https://www.grin.com/document/198665

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