How to Understand Credit Derivatives

The credit derivatives market, worth $29 trillion dollars as of January 2009, has been a major cause of the recent economic crisis. Credit derivatives are a far greater danger than sub-prime mortgages. These products have encouraged banks to take on riskier loans than they should have. They have helped increase leverage in the global financial system. And they have exposed financial firms to the risk of default. Because they have made the financial world more complex and vague, they have caused panic. Merrill Lynch gave itself up for sale because investors had no confidence in the firm’s ability to handle its problems. When the federal government took over AIG. in September 2008, it was because of the company’s exposure to credit-default swaps. By mid-September 2008, Treasury Secretary Hank Paulson proposed largest bailout in U.S. history.

Difficulty: Moderately Challenging

Instructions

1. A CREDIT DERIVATIVE is a financial instrument used by hedgers and speculators to manage exposure to credit risk. It is a two-sided contract in which the buyer pays a fee to the party taking on the risk. Credit derivatives are either funded or unfunded.

2. An UNFUNDED CREDIT DERIVATIVE is a contract between two parties, where each side is responsible for making payments under the contract, and there’s no guarantee they will! The most popular unfunded credit derivative is the credit default swap.

3. A FUNDED CREDIT DERIVATIVE requires the party assuming the credit risk to make an initial payment that is used to settle any potential credit events. In this way, the buyer is not exposed to the credit risk of the seller. Transactions are commonly rated by rating agencies, which allows investors to choose their credit risk. Funded credit derivative products include credit linked notes and synthetic collateralized debt obligations.

4. CREDIT DEFAULT SWAPS (CDS) represent over thirty percent of the credit derivatives market. This product is a private contract between two parties. The buyer pays a periodic fee to the seller in return for protection against loss on an entity, such as a loan or bond. The seller agrees to make a payment to the buyer if a specific event occurs, such as failure of the entity, or bankruptcy.
   
   Credit default swaps are not standardized. They’re not transparent, aren’t traded on any exchange, and aren’t regulated. If the party providing the insurance protection doesn’t have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan, the buyer is simply out of luck.
   
   Credit default swaps that were written on sub-prime mortgage securities were bought by banks, investment banks, insurance companies, and others. They were over-rated and ended up falling sharply in value as foreclosures increased. Speculators sold and bought trillions of dollars of “insurance” that these mortgage pools would, or wouldn’t, default. The sellers, such as AIG, were hit hard as mortgage defaults escalated.
   
   What is happening in both the stock and credit markets is a result of activity in the CDS market. If Bear Stearns had entered bankruptcy, trillions of dollars of credit default swaps on its books would have been wiped out. All the banks and institutions that had insurance written by Bear would have had to write-down billions of dollars in losses. The Federal Government could not allow that to happen.
   
   AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds and mortgage-backed securities (Gilani, 2008). As the value of these entities fell, AIG had huge write-downs and had to post more collateral. When its ratings were downgraded, the company had to post even more collateral, which it didn’t have. So on September 16, 2008, the Federal Government loaned AIG $85 billion dollars in exchange for a 79.9% stake in the company.

5. A TOTAL RATE OF RETURN SWAP (TRS) is a two-party agreement where one party (buyer) owns an asset (such as a bond), and agrees to pay the other party (seller) all interest and capital gains on the asset. In exchange, the buyer receives a stream of cash flows, such as LIBOR plus spread plus any negative price changes on the asset. If the asset defaults, the market the asset is valued to zero and the seller has to pay the full initial market price of the asset.
   
   This financial contract allows the payer to gain the economic benefits of owning an asset without having to buy it and have it on its balance sheet. Also, it gives the asset owner protection against default of the asset.

6. EQUITY DEFAULT SWAPS are the same in structure as credit default swap. However, a credit default protects against an event relating to an asset, whereas an equity default swap protects against a decline in the price of a company’s stock.

7. SYNTHETIC COLLATERALIZED DEBT OBLIGATIONS are funded credit derivatives. They are a form of collateralized debt obligation that invests in credit default swaps or other non-cash assets. Synthetic CDOs are sliced into tranches of varying credit risk. All tranches receive periodic payments based on the cash flows from the credit default swaps. If a credit event occurs within the portfolio, the synthetic CDO and its investors are responsible for the losses, starting from the lowest rated tranches and working its way up.

8. 

   The PROBLEM WITH CREDIT DERIVATIVES is that greed financial institutions insured more corporate bonds than they could afford. These contracts can be bought, sold and traded like stocks, but they aren’t regulated. Even if a sound institution originated a CDS, they could sell it to a company that is unable to cover the cost of default. If a huge bank fails, the insurers of the bank’s assets are left without being able to cover the losses. This causes a domino effect, setting off a string of bankruptcies.
   
   The situation with credit derivatives is similar to mortgage backed securities. Banks kept lending money, expecting that housing prices would never fall. In the same way, insurers kept writing CDS contracts to investors and speculators, never expecting that a “too big to fail” corporation like Lehman or Bear Stearns could ever fail. Because one failure would lead to another and another, the Fed bailed out several large institutions.
   
   Complex credit derivatives have been active participants in this ongoing worldwide financial crisis. The role they will play going forward deserves careful consideration.

[lifeengineer]

on 5/8/2009 Great details on credit drivatives. This is very helpful information.

[Wasatch]

on 1/30/2009 Well written article. Unfortunately congress is close to passing a bill that will add $7,000 to every households share of the national debt. Too many pet projects that will NOT fix the banking mess or sell houses to rev things up again.

[meacham01]

on 1/27/2009 These derivatives will fall when default is certain and it is certain because of underinsured paper or over stated value.Some will fall because of the call on these issues. Great article. Very well written.

[JoyNmyHeart]

on 1/25/2009 Great detailed article on credit derivatives.