Credit Default Swaps Impact Individual

¶ … 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.

How credit default swaps impact individual companies

The notion that credit default swaps are difficult to understand is neither here nor there. In fact, CDSs are as easy to understand as insurance contracts (monocline or otherwise). It is easy to understand them in the context of insurance contract against the cost of default of a company which is at times referred to as reference entity. Suppose you are holding General Electric (GE) bonds and are worried about GE's default risk. You may consider insuring your bond holdings with a credit default swap. Just like a typical insurance contract, premiums are paid over time. If GE does not default, you lose the premiums. If GE defaults, the credit default swap allows you to exchange the GE bonds you hold with depreciated value with for the principal amount of the bonds. The GE bonds can lose value even if GE does not default. The holder of the bond will only receive payment from a credit default swap in the case of an actual default

. Nevertheless, differences exist between insurance contracts and credit default swaps in the sense that one must not hold the bonds to buy a credit default swap on that bond, where as in insurance contracts one must have a direct economic exposure to obtain insurance. The notional amount that is synonymous with credit default swaps arises out of the idea that one must not hold bonds. It is the amount one insures with a credit default swap. If for instance an individual buys a credit default swap on GE for a notional amount of $100 million, s/he has insurance on $100 million of principal amount of GE bonds. Another difference between insurance contracts and credit default swaps is that where as insurance contracts are not traded, credit default swap are traded over the counter using a telephone or electronic messages

. Dealers can trade with end users and other dealers. Credit default swaps are supposed to make financial markets more efficient and improve the allocation of capital. As opposed to olden ages when investors who had funded companies through debt bore the company's credit risk, they no longer bear those risks save for credit default swaps. Credit risks now reside with investors who are better equipped to bear it. Separation of the cost of funding and the credit risk enhances transparency in the pricing of credit. Ideally, these benefits of credit default swaps are supposed to reduce the cost of capital for firms. Credit default swap market should be a better place to assess a company's credit risk instead of being a market for a company's bond. Contractual provisions are never factored when it comes to fixing the prices of credit default swaps which are purely determined by the expected default loss

. Liquidity features prominently in the pricing and trading of credit default swaps than of bonds because bonds involve funding. It is very difficult to sell a company's bond if you believe that its risk of default is just about to increase. Buying protection; however, endows economic benefit to the company in the event of a default. Separation of risk-bearing and funding creates problems and incentives. Banks that have given huge loans to firms lose their capacity to monitor these loans when they buy protection against default for these loans because the seller of the protection cannot these firms in a way in which these banks can. The seller of the protection against default has no contractual relationship with these firms

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.