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CREDIT DEFAULT ‘SWAP‘ (CDS)AKA
CREDIT DERIVATIVE CONTRACT
Charlie Mudrick BA 543
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FLOW OF PRESENTATION Definition (background context) Mechanics of a CDS
Examples Historical Context
Examples
Checkpoint Questions Throughout
Questions Work Cited Useful Links
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DEFINITIONS Swap: is a derivative where counterparties
exchange cash flows of one party’s financial instrument (seller – mortgage %) for those of the other party’s financial instrument (buyer – cash payments). cash flows = ‘legs’ of the CDS
Credit Default Swap: bi-lateral OTC derivative contract. (swap based on credit defaulting) Protection seller (investment bank) will compensate
the Protection buyer (original lender) if the event of a loan default (or other credit event) occurs.
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PURPOSE CDS were designed to shift risk from
primary lender to an ‘insurance’ entity debt holders enabled to hedge
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MECHANICS EXAMPLE: Corporate credit instruments
We are swapping for asset quality issues (ratings)
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TRADITIONAL CDSCorp A
need 50Mhave BBmay defaul
tgive 10%
Ratings Agency
Independent
Pension Fund
have 50Mwant 10%need AAgive 1%
Investment Bank
have AAwant 1%give insuranc
e
QualityMatch
RiskTaker
Not Regulated like insurance• Enter: greed, speculation,
mismanagement
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CHECKPOINT 1 (DEEP THOUGHTS) How would AIG manage their CDS risk? ABCDS (asset backed CDS)
Use an asset (house) to ensure some payment
aka MBS (mortgage backed securities)
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MBS & CDSCorp A
need 50Mhave BBmay defaul
tgive 10%
Ratings Agency
Independent
Pension Fund
have 50Mwant 10%need AAgive 1%
Investment Bank
have AAwant 1%give insuranc
e
QualityMatch
RiskTaker
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PURPOSE (PERVERSED) CDS were designed to shift risk from
primary lender to an ‘insurance’ entity debt holders enabled to hedge
Speculators used CDS to profit from defaults Investment banks = ‘the prey’
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EXAMPLE: FOURTH MARKET This is were the gambling begins Speculative CDS (binomial options)
MARKET
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SPECULATIVE CDSCorp A
need 50Mhave BBmay defaul
tgive 10%
Ratings Agency
Independent
Pension Fund
have 50Mwant 10%need AAgive 1%
Investment Bankhave AAwant 1% & $give Insurance &
default value
bet No default
QualityMatch
RiskTaker
Asset managershave $
paymentswant Default
valuebet default
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CHECKPOINT 2 (DEEP THOUGHTS) How can we prevent the CDS
speculation? Set mandatory disclosing of ‘secret
liens’ & identify complex financial instruments Investment bank disclose debt claims in
exchange for payment priority (not just their books)
Essentially Investment banks’ leverage disclosure
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HOW WE BE (NO PROTECTION)
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HISTORICAL CONTEXT Goldman Sachs Group Inc. (GS)
bet against (shorted) the U.S. Sub-Prime Mortgage housing market crash
made Billions of $$$ Donald R. Mullen Jr.: ex-head of
global credit and mortgages then currently into single family rentals REO LLC CEO now stands to profit again
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HISTORICAL CONTEXT Did GS ‘bet against’ the market failing
Or ‘make the market’ fail…
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HISTORICAL CONTEXT
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HISTORICAL CONTEXT Sub-primed mortgage market
Welcome Sub-Prime Mortgage Crash
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WOLF-VISION EXAMPLE How GS purportedly ‘played’ the
market
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SUMMARY CDS are financial instruments (swaps)
Can become very complex (2nd , 3rd , etc. swaps) Can be traded in private (4th ) market Simplest form: shift loan default risk between parties
Speculation creates an unregulated market If mismanaged, financial crises could ensue E.g. Sub-Prime Mortgage Crash
CDS can be high stacks corporate gambling Zero sum game (GS ‘won’; AIG & others ‘lost’) Don’t be a player!
CDS are ‘safer’ if backed by collateralized assets ABCDS offer protection when legitimate
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QUESTIONS CDS are a:
A. Derivative B. 1980’s digital media formatC. financial instrumentD. bi-lateral contractE. All of the above
True/False: Credit Default Swaps May match parties’ underlying asset quality needs Were designed to shift risk Are traded on the 4th market
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USEFUL LINKS Kahn Academy Series: 1, 2, 3, 4, 5 Investopedia: video as well Wikipedia: general info GS: CDS 101 (pdf)
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WORK CITED Derivative definition Swap definition Corporate Credit Ratings
Asset Quality Rating ABCDS definition Credit Default Contract Secret Liens article Goldman Sachs profit Donald Mullen Jr. Interesting MBS and CDS slideshare