Credit default swaps and the 2008 global financial crisis

¶ … Credit Default Swaps Impact Individual Companies

Counter-party risks

Credit default swaps and government debts

Manipulation of financial derivatives

Credit Default Swaps and Their Role in Global Financial Crisis

Credit default swaps are bilateral contracts between two parts. The credit default swaps are subject to collateral and margin agreed to by contract. They are normally traded over the counter using a telephone. The CDSs can be resold to another party willing to enter into another contract. Credit default is; however, subject to counter-party risk

Once the party providing the insurance protection has collected its upfront payment and premiums it remains with no money to pay the insured buyer incase of a default event affecting the referenced bond or loan. CDSs are not standardized instruments neither are they true securities. They are never traded on any exchange, are not subject to security laws, and are not regulated. Credit default swaps serve pertinent functions within any given economy some of which include: making it easier for credit risk to be borne by those who are in best position to bear them, enabling financial institutions to make loan they would not otherwise make if there were no credit swaps, and revealing crucial information about credit price in their prices. Credit swaps; nevertheless, have some undesirable characteristics. The woes that were visited on the Wall Street at the height of economic meltdown in the United States in the year 2008 are attributed to these undesirable characteristics (Stulz, 2010). This paper explores ways in which credit default swaps might have contributed to global financial crisis.

Counter-party risks

It is not disputed that the credit default swap market performed remarkably well during much of the credit crisis. The huge and expected losses that characterized engagements in the mortgage security and financial sector did not extend to credit default swap market which remained fairly liquid. The markets efficiently handled large defaults and this is exemplified in the processing of Lehman's default. However, through credit default swaps, banks and financial institutions held mortgage securities on which they made large unexpected losses

. Financial institutions held less regulatory capital after packaging loans on securities and holding them on their balance sheet. Some financial institutions held super-senior tranches of secularization on their books by insuring them with credit default swaps. Regulators allowed financial institutions to set aside less capital just because they had bought protection through credit default swaps. This resulted into large demand for insurance of super-senior tranches. The losses on credit default swap referencing sub-prime mortgage securitizations was as a result of defaults on subprime mortgages and the disappearance of liquidity for such securitizations. Derivatives and credit default swaps fuelled global financial crisis. Derivatives led to a huge web of exposures in the financial sector such that if a financial institution failed due to this web of exposure, it could lead other institutions to fail as they make losses on their exposures. The web of exposures led to the collapse of the financial system and considerable uncertainty about the solvency of financial institutions in the event of failure of a major financial institution. Credit default swap heightened the credit crisis because of the jumping of their value by large amounts in case of defaults. Let's interrogate this in the context of the Lehman and Brothers

. When it failed, it had close to one million derivative contracts on its books with hundreds of financial firms. Some of these firms expected payments on derivatives from Lehman something that it was not in a position to do since it had become bankrupt. It is expected that these firms subsequently became weaker financially adding to Lehman's woes through losses on derivatives contracts because of failures of counterparty. Typical derivative transactions; however, use protection against the risks of counterparty not meeting its obligations

. Because a default is a discrete event, it leads to large jumps in the value of credit default swap contracts.

Buchanan

attributed the woes of the European sovereign debt crisis to credit default swap. He lists Argentina, Russia, and Mexico as having suffered similar experiences in 2001, 1998, and 1994, respectively. He likens debt crisis to natural disasters like earthquakes. However, natural disasters are not as dangerous as debt crisis. European nations are linked in a hidden network where institutions buy and sell unregulated credit-default swaps which are not traded on any exchange or recorded by any central information repository. The existence of the hidden linkages were the reason the United States government made an undertaking to intervene in 2008 to prevent the collapse of insurance giant American International Group Inc. The AIG ignored the looming trouble with subprime mortgages and blithely sold CDS contracts insuring mortgage backed securities to Goldman Sachs Group Inc., Deutsche Bank AG and other firms. Had the AIG group signed CDS contracts, it could have spread distress throughout the global financial system

. Just like insurance contracts, credit default swaps offer a way to spread risks otherwise known as risk sharing that makes individual banks safer and the entire banking system stable. However, too much sharing of risks has its inherent disadvantages. A firm's ability to withstand shocks that stems from loans made to failed businesses reflects its financial resilience. An institution's stability also depends on the resilience of its trading partners because if one of them stumbles, its distress spreads to others

. When connectivity is relatively low and one bank goes bankrupt, the repercussions may not be that serious. The failure may nevertheless cause problems for a few institutions. In such case the risk sharing is beneficial. This is one of the benefits of credit default swap. However, under circumstances where there is rising connectivity between institutions because of the dense nature of the webs of CDS, attempts to share risk increase the likelihood that a bank will go under. International banks making loans to banks or corporations are in order to protect themselves from systematic economic turmoil by buying swaps on sovereign debt but there are limits to this because what reduces risks for individual institutions in small quantities spells doom for larger institutions when pushed too far. This can be detrimental considering that the number of CDS contracts outstanding on European sovereign debt doubled in the past three years after the AIG setback. Actions have unanticipated consequences

. The financial deregulation in 2000 led to the mushrooming of unregulated and largely hidden CDS contracts. This had made the financial marker riskier than ever. With the deregulation of the CDS market a bank can sell as many CDS as it wishes and invest the money whenever it wants. When the bonds started going bad in 2008, CDS were introduced for traditional corporate debt, mortgage backed securities, CDOs, and secondary CDOs. When optimism fell, the CDS for exotic products shot up. The CDS was a way in which losses on subprime mortgages triggered write-downs at other financial institutions. When banks like Lehman and Bear Stearns started failing the situation became dire as people who had sold these swaps were looking at losses on them. Insurers and a host of companies that were selling CDS sold them at extremely low prices that made them incur major losses. The companies that were selling the CDS many of which were not insurance companies had the risk that the insurance companies were not able to pay. Had AIG, for instance, sold a lot of CDS based on debt it owes say Lehman, it couldn't have honored all the swap contracts. Their counterparties had to incur losses they were insured against. If bank X bought a CDS from bank Y on the company Z, and the company Z. defaults, bank X thinks it has payment coming to it from bank Y; but if bank Y doesn't have the cash, bank X cannot get its payment. This example helps explain how CDS create uncertainty in the banking sector. Banks may appear healthy but are in essence counting on CDS payouts from other banks that cannot be seen. The CDS spreads risks in unpredictable and invisible ways. Perhaps the United States government refusal to let AIG fail after Lehman had failed best explains this. The AIG was a large net seller of CDS. Had it defaulted on these swaps the implications could have had far reaching ramifications for the financial sector

. Its failure could have amplified and spread the uncertainty as to reduce confidence in the financial sector.

Uncertainties in the unregulated credit default swap markets are also caused by the fact that investors who have purchased these swaps normally have trouble tracking down those who are supposed to pay their claims

. Contracts are sold and resold among financial institutions. Original buyers cannot therefore know that a new, potentially weaker entity has taken over the obligation to pay the claim. This makes potential buyers of such swaps and investors to be wary of such markets because of fear of losing their monies.

Credit default swaps and government debts

The International Monetary Fund avers that credit default swaps are an effective tool that investors use to check against hedging. Investors also use them to express an opinion about the credit worthiness of a government

. It helps the investors to cushion themselves against losses attributed to debt restructuring by the borrowing governments. However, speculative use of sovereign credit default swaps in advanced economies has been associated with destabilizing effects on the financial system. This has occasioned the European Union to burn the purchase of protection using CDS contracts if the buyer is not hedging.

Fig 1. Five-Year credit default swap spreads within the United States

Adopted from the Economist

Sovereign credit default swaps at not effective at representing the credit risk of governments because credit default swaps on government debts are just but a fraction of a country's outstanding debt market. The IMF

finds little evidence to support the negative publicity that credit default swap has received relating to its destabilizing ability. In fact, it decries the EU's ban on naked selling of credit default swaps, averring that such action can potentially harm the hedging role of the markets as market liquidity and depth deteriorate. This can potentially spill to other markets. The hedgers can subsequently migrate their hedges to the next best markets. This can stress and make the markets more volatile. This can in long-term lead to increase in sovereign funding costs. It is also not very clear whether credit default swap markets are more likely to propagate shocks than other markets bearing in mind that there are inherent risks in credit default swap market and the larger financial system.

Manipulation of financial derivatives

In as much as it has been argued that credit default swaps enables the trading of specific risks there have been arguments to the effect that the market for credit default swaps was being manipulated. Because at the fall of 2008 many financial markets were not always liquid, few well placed trades in credit default swaps gave impression that the name was in trouble. The manipulator benefited by establishing short stock and debt positions. Financial institutions can be very vulnerable to such actions because they are susceptible to runs. By the fall of 2008 there were extreme movements in credit default swap premiums. The peak cost of insuring Morgan Stanley's debt was 1500 basis points a year

. Firms like Berkshire Hathaway experienced sharp increase in the cost of protection. Its debts increased from 140 basis points a year to 415 basis points a year on rumors that a particular derivatives bet that the company had made could turn out to be hugely expensive. Manipulations through short-sales make the credit default market so inefficient.

Conclusion

Financial derivatives like the credit default swaps increase the economic welfare as it leads to risk-sharing in the financial markets. However, because of legitimate concerns that have been raised in the recent past about exposures to credit default swaps, it is imperative that we mention that this derivative has far reaching implications in the global financial market. The CDS have become the tool of choice for betting on the likelihood of a company going bankrupt. If for instances you have a feeling that accompany may go bankrupt you may buy the company's CDS and after a couple of months when everybody else has realized that the company is actually on the verge of collapse you can sell your CDS to somebody else at a higher price or sell a new CDS at a higher price. This increases the number of the CDS within the public domain. Because CDSs are not regulated they do not have to maintain a specific capital level based on the amount of swaps they have sold. This allows them to sell as many CDS as they want and invest the money accrued in anything they want. The CDS are one way through which losses on subprime mortgages trigger write-downs on other financial institutions. The insurers who were selling CDS at the fall of 2008 sold them at excessively low prices and subsequently suffered major losses. In as much as derivatives like the CDS are thought of as spreading risks synonymous with the financial markets too much sharing creates bigger problems. Because of the dense web of risk-sharing connections there is a likelihood of system-wide collapse.

No progress has been made in moving CDS trading from OTC to exchanges because they are standardized instruments. They are not true securities owing to the fact that they are not transparent. They are subject to present securities laws and are not regulated. CDS are private contracts between two parties subject to collateral and margin agreed to by contract. However, propositions have since been made to move trading away from OTC and use exchange-based trading. It is believed that exchange-based trading could greatly reduce the problem of counterparty risk and create greater transparency.