First American Bank: Credit Default Swaps Case Analysis Rozell Moore Lisa King Sunday Ogunkola Salvatore Spampinato 8/06/2011

Introduction

The scope of this paper is to discuss Credit Default Swaps (CDS), what these instruments represent and

how they are used in the market today. We will also discuss briefly the historical foundation of CDS,

market growth over the past decade and ultimately their role if any in the financial crisis of 2008.

Credit Default Swaps – What they are, how they work and major players

From a definitional perspective, CDS are a major type of derivative, and more specifically they are a

credit derivative. The term credit derivative is tied to the fact that the derivative itself stands on the

credit worthiness of one of more companies (or countries), while the instrument is set up as a transfer

of risk from one party to the other. The most common way of defining a CDS is that I represents an

insurance policy agreement, whereby the buyer of the insurance seeks protection against credit default

events by companies in which the buyer has invested funds, whether through the purchase of bonds,

mortgage backed securities or corporate debt.

The existence of this transaction (and therefore its attractiveness) is to protect the investor from credit

downgrades or any other negative events that could affect the company (called the reference company),

and it consists of periodic payments (similar to insurance payments) to the seller of protection, priced in

accordance (or proportionally) with the notional amount of the assets. If no default takes place, the

periodic payments continue until maturity date, which can range from one to ten years, with five years

being the most common. If there is a default, according to a carefully defined triggering event (e.g. the

reference company fails to make a required coupon payment on bonds), the insurer would step in and

make payments to the buyer according to agreed upon terms, tied to the market value of the swap at

the time of default. The interesting aspect of a CDS is that unlike an insurance contract, the investor

does not necessarily have to own the underlying assets (bonds or securities), the so called “necked”

position in the swap, and speculative in nature.

Pricing of a CDS can be somewhat cumbersome and complex but essentially, the pricing model, takes

into account the present value of the series of cash flows from the underlying investment (e.g. bond

coupon payments) and applies a discount based on the probability of non default and recovery rate

among other factors. The market value of a CDS decreases as default becomes less likely and vice versa.

These instruments have been in existence since the early 90s but J.P Morgan is widely credited with

creating the modern credit default swap in 1994, extending a $4.8 billion credit line to Exxon, which

faced a threat of $5 billion in punitive damages for the Exxon Valdez Oil Spill. A team of J.P. bankers sold

the credit risk to the European Bank of Reconstruction and Development (EBRD) and was able this way

to cut its reserves for loans defaults and improve the balance sheet presentation.1

The International Swaps and Derivatives Association (ISDA) has published a market survey showing the

explosive growth of the CDS market over the past decade, from over $600 billion in the first half of 2001

to over $62 trillion by the second half of 2007, slightly higher than the size of the World Stock Market

(according to data from Bloomberg), valued at $61.3 trillion in October of 2007. After the recent global

crisis the CDS market experienced a decline, but was still very sizeable with the gross notional amount of

all CDS contracts outstanding at $26.3 trillion by the first half of 2010.2

As mentioned above, the CDS market is made up of buyers and sellers of protection; from the buyers

perspective, not surprisingly, banks and financial institutions are the most active in this market, while

from the sellers’ perspective we often see insurers, hedge funds or other types of funds seeking

exposure to credit markets. Main risk from this perspective is most often referred to as “adverse

selection” meaning that buyers will seek protection for bad loans and will lack monitoring such loans.3

1 Wikipedia – Credit Default Swap - http://en.wikipedia.org/wiki/Credit_default_swap 2 ISDA Market Surveys - http://www2.isda.org/functional-areas/research/surveys/market-surveys 3 International Finance 16th edition– Hal S. Scott – credit derivatives p.779

Contribution to the 2008 Financial Crisis

We do not believe that CDS instruments per se would have caused the crisis blow up in 2008, but rather

it was the misuse of such instruments by some major players, coupled with greed and intent to

speculate as much as possible.

The role of the CDS was that of a hedging tool against credit risk4. In 2008, the condition of the financial

markets in the U.S. continued to deteriorate. As of December 2007 the economy was in the beginning

of what would be and 18 month long recession, the longest since the Great Depression in 1929. Prior to

the recession the economy experienced a long period of growth in the housing market. This growth was

fueled by low interest rates and Wall Street’s appetite for earning underwriting fees through the

securitization of mortgage loans. Mortgage lenders were able to deliver loans to Wall Street in

wholesale fashion to be repackaged into AAA mortgage backed securities and subdivided into tranches

and sold to investors seeking to get the returns from the booming U.S. housing market. A large portion

of the mortgage loans generated to please Wall Street’s appetite were subprime loans initiated through

a reduction of lending standards such as, no credit check, no income requirements and no

documentation necessary in order to obtain the loan to purchase a home. These were High risk loans

with adjustable rates that would reset if the market rate of interest was to rise or if the price of the

home was to decline. These loans were being shipped off to Wall Street to become new securitized

tranches; the banks failed at conducting due diligence in checking to insure that the borrower was credit

worthy and financially able to repay the mortgage. The investment banks were relying on Moody’s

Standard and Poor’s and Fitch to provide rating advice; subprime junk was being collateralized and

graded as triple AAA rated investment grade securities while ignoring the underlying issue of the ability

of the borrower to repay the loan.

4 Introduction to The Global Financial Markets and The Real Cause Of The Financial Crisis, Dr. Yoon S. Park The George Washington University

It is clear that the credit default swap did not create the financial crisis in 2008. The CDS became the

poster child of what can happen when lending standards are relaxed and a product initially created to

hedge risk receives the blame for creating the risk. The street was using CDS protection to hedge

against possible losses from mortgage backed securities. It is quite clear that at least some of the

market participants were quite clear of what could possibly happened if the underlying mortgages

began to unravel and the default rate of subprime mortgages were to increase. Apparently, the vision

of AIG was not quite as clear as other participants in the market. It appears that AIG was blinded by the

ability to collect CDS premiums from investors and speculators while focusing on statistics which

indicated that there was less than a 1% chance of a default occurring on AAA rated securities. AIG was

overly reliant on the credit reporting agencies; the firm continued to underwrite credit protection

coverage without taking adequate hedges against its positions5. The continued process of underwriting

CDS was creating an underlying problem of systematic risk which would lead to the company becoming

too big to fail6. The unregulated activity of AIG underwriting CDS protection in the OTC market became

a threat to the entire financial system. The rating agencies graded the MBS securities as triple AAA

investment grade instruments. AIG believed in the rating system. Once the default rate began to

increase on AAA subprime mortgage backed securities, the credit reporting agencies lowered the credit

rating of AIG and required a posting of collateral. The unraveling of the investment grade rated

securities forced AIG to continue posting collateral until the company ran out of cash.

In conclusion, there are multiple factors which played a part in the financial crisis. Low interest rates,

subprime lending standards, rating agency conflict of interest, highly leveraged financial institutions and

a lack of government regulations in some areas are all contributing factors. The credit default swap is

5 Credit Default Swaps and The Credit Crisis, Rene M. Stulz Journal Of Economic Prespectives Vol 24 No 1 Winter 2010 PP 73-92 6 Systematic Risk and The Financial Crisis: A Primer, James Bullard, Christopher J. Neely, David C Wheelock, Federal Reserve Bank Of St. Louis Review sept / Oct 2009 pp 403-417

not the product which created the financial crisis. Based upon the terms of the loans, the reset criteria

on the loans and the probability that the loans would eventually fail, the people at the bottom were

eligible to receive loans without any documentations, income or credit history, should have been made

eligible for CDS protection.

To better regulate the CDS market, in 2009 central clearing houses were introduced, one based in the US

and one based in Europe, acting as the central counterparty to both sides of the transaction, reducing

the risk of default by both the buyer and seller’s perspective. The US clearing house is operated by the

InterContinental Exchange (ICE), appointed by the Securities and Exchange Commission (SEC) based in

Atlanta, while the European subsidiary ICE Clear Europe, based in the U.K. The clearing house allows the

market to essentially trade against a central body, mitigating risk of failures by one of the parties; the

presence of this element in and of itself helped refuel confidence among investors.

Conclusion

We have seen a classic scenario in the Harvard case, where Charles Bank International (CBI) was in need

to serve a client (CapEx Unlimited) which needed to borrow extra funds, but because of the existing

level of loans, CBI would be unable to make the additional loans without the help of First American

Bank, whom would offer protection against in this transaction. As in this case, credit derivatives have

helped facilitate many loans that could probably never have been executed, which has brought a benefit

to the overall markets. The fundamental concept of a credit swap is very simple and inherent with the

existence of lenders and borrowers; it intends to mitigate banks’ risk when loaning money to borrowers;

for this reason we don’t believe that use of CDS should be banned from the market, but a much tighter

regulation is a must, as it is the only way to contain the speculative nature on these instruments that

contributed to fueling the crisis.

Charts

Fig. 1

Fig. 2

-

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

70,000.00

Credit Default Swaps Outstanding