Credit Default Swap and its role in the 2008 financial crisis
We all have heard about the “subprime” crisis. For those who haven’t, it is simply related to credit or loan arrangements for borrowers with a poor credit history, typically having unfavourable conditions such as high interest rates. But do we really know why this phenomenon had such an impact on our economies. One aspect of the answer to this question lies in the trade of credit default swaps (CDSs). These financial products led to less transparency in the markets and to a very collectively vulnerable financial system. This created a vicious circle that had not been anticipated by our financial regulators. In this article, we will discuss how it occurred and what is the impact of these products.
Introduction
The financial crisis that occurred in 2008 is the result of bad policies that have been implemented and maintained by financial regulators. This started when lenders were incited to issue mortgages to riskier borrowers after the US government created policies to facilitate American people housing. (A mortgage is basically a legal agreement that conveys the conditional right of ownership on an asset or property by its owner (the mortgagor) to a lender (the mortgagee) as security for a loan.) Such policies, through the action of government-sponsored entities (such as Freddie Mac and Fannie Mae), were signalling that these entities would purchase mortgages with subprime characteristics. This has led to the multiplication of “subprime” mortgages, which were packed into collateralized debt obligations (CDOs) and then traded in the markets. This phenomenon was emphasized by the existence of credit default swaps, which led to less transparency and to a very vulnerable financial system. In this article, we will see what credit default swaps are and how it has influenced the spread of the financial distress.
CDO (Collateralized Debt Obligations)
First of all, what is a CDO? A collateralized debt obligation, also called CDO, is a structured financial product backed by a pool of assets that are essentially debt obligations. These assets can include mortgages, loans or bonds. Retail banks created CDOs because they were looking to sell it to investors in order to reduce their risks on the debt obligations they issued. The principal and interest payments made on the loans are redirected to the investors. The investors hedge against default thanks to the collateral, which also determines the CDO value. This is why these products are called “collateralized”.
In order to sell these packages of debt obligation; banks sliced CDOs into various risk levels, also called tranches. Senior tranches are the safest risk levels because they have the first claim on assets if some of the underlying loans default. On the other hand, junior tranches are the riskiest level. In order to attract investors and compensate the higher risk taken by investors, these tranches offer a higher level of interest.
CDS (CREDIT DEFAULT SWAP)
A CDS is a form of insurance. Blythe Masters, who works at JP Morgan bank, is the person who created the credit default swap, also called CDS. This financial product was created in 1994 and became rapidly popular across the industry, as it allows investors to avoid credit event consequences on risky investments. CDS is a credit derivative that allows lenders to insure themselves against changes in borrowers’ credit ratings. In the case of a CDS, the purchaser makes payments — like insurance premiums — while the seller agrees to pay the buyer if an underlying loan or security defaults. The CDS buyer pays a fee to transfer the risk of default — the credit risk — to the CDS seller. A CDS agreement often lasts several years and requires that the seller of the insurance provide collateral to ensure that the buyer will be paid in the event of default. The collateral for a CDS typically varies with the credit rating of the swap counterparties. The purpose of the collateral is to limit counterparty risk over the life of the swap for example, people that were good to find profitable investments but not very aware about the management of risks let this part to experts, who are the CDS sellers. The general idea of CDS was to divide the load of work into different domains of expertise in order to allocate resources more efficiently.
On September 16, 2008, the Federal Reserve Bank of New York, part of the U.S. central bank, made an extraordinary $85 billion loan to American International Group (AIG). AIG, the largest insurance company in the world, was on the verge of collapse because it had sold roughly $500 billion worth of credit default swaps (CDS).
Role in the 2008 financial crisis
During the 1990s and early 2000s, most of the CDOs were backed by a diverse pool of loans, which limited the risk of default and gave the instrument a reputation for stability. However, around 2003, the housing boom allowed a large number of banks to use subprime mortgages as their main sources of collateral. With the popularity of CDOs increasing rapidly, home lenders received a continuous stream of cash. As the result, and because of bad policies implemented and maintained by regulators, lenders expanded their offers of credits to riskier borrowers. Consequently, when the real estate market dropped and mortgage defaults started to rise, CDOs issuers and their investors suffered enormous losses.
The impact they had on the crisis was to hide who was really bearing risks. Credit default swap transactions are not visible on the balance sheet of financial institutions. This implies that investors cannot accurately assess the real risks born by financial institutions. The lack of transparency affected the whole system and made it more vulnerable because of the decrease of trust in the counterparties.
Credit default swaps on Lehman Brothers debt helped cause the 2008 financial crisis. The investment bank owed $600 billion in debt. Of that, $400 billion was “covered” by credit default swaps. That debt was only worth 8.62 cents on the dollar. The companies that sold the swaps were American International Group, Pacific Investment Management Company, and hedge fund, Citadel. They didn’t expect all the debt to come due at once. When Lehman declared bankruptcy, AIG didn’t have enough cash on hand to cover swap contracts.
The Federal Reserve had to bail it out.
Even worse, banks used swaps to insure complicated financial products. They traded swaps in unregulated markets. The buyers had no relationships to the underlying assets. They didn’t understand the risk inherent in these derivatives. When they defaulted, swap sellers like Municipal Bond Insurance Association, Ambac Financial Group Inc., and Swiss Reinsurance Co. were hit hard.
Overnight, the CDS market fell apart. No one bought them because they realized the insurance wasn’t able to cover large or widespread defaults. As a result, banks became less likely to make loans. They began holding more capital, and become more risk-averse in their lending. That cut off a source of funds for small businesses and home loans. These were both large factors that kept unemployment at record levels.
Moreover, the conflict of interest created by the Nationally Recognized Statistical Rating Organizations (NRSRO) can also explain the importance of CDS in the financial markets. The incorrect ratings issued by the Credit Rating Agencies (CRA) made CDS sellers believe they were insuring credit events of financial products that had low probability of default. In other words, they believed that the risk of credit event of their global portfolio was lower than it was in reality. Their will to always make bigger profits incited them to multiply the sale of credit default swaps but without the concern of increasing their collateral in the same way.
Conclusion
Nobody can deny the strong influence that these financial products had on the outcome of the crisis. The use of these products associated with bad policies established by the regulators led the system to nearly collapse. I think that the main policy to implement is to set strong capital requirements for investors in CDOs and CDSs in order to reduce the probability of a chain of defaults that would affect the entire system.
References
Bank for International Settlement
Michael Mirochnik — “The Financial Crisis, Financial Markets and Official Interventions”
Originally published at finecoiitg.wordpress.com on August 16, 2018.
