Question

(a) Describe the failure in risk management in the 2007 global financial crisis.
(b) What risk management strategies would you recommend for the stakeholders involved?
(c) Critique the Altman Z-Score model of credit risk. What improvements have been suggested by researchers?
(d) What is the CDS market? Describe the differences between hedging and speculating in the CDS market using examples

Answer 1

(a) Describe the failure in risk management in the 2007 global financial crisis.

Financial crisis of 2007–08, also called subprime mortgage crisis, severe contraction of liquidity in global financial markets that originated in the United States as a result of the collapse of the U.S. housing market. It threatened to destroy the international financial system; caused the failure (or near-failure) of several major investment and commercial banks, mortgage lenders, insurance companies, and savings and loan associations; and precipitated the Great Recession (2007–09), the worst economic downturn since the Great Depression (1929–c. 1939).

Causes Of The Crisis

Although the exact causes of the financial crisis are a matter of dispute among economists, there is general agreement regarding the factors that played a role (experts disagree about their relative importance).

First, the Federal Reserve (Fed), the central bank of the United States, having anticipated a mild recession that began in 2001, reduced the federal funds rate (the interest rate that banks charge each other for overnight loans of federal funds—i.e., balances held at a Federal Reserve bank) 11 times between May 2000 and December 2001, from 6.5 percent to 1.75 percent. That significant decrease enabled banks to extend consumer credit at a lower prime rate (the interest rate that banks charge to their “prime,” or low-risk, customers, generally three percentage points above the federal funds rate) and encouraged them to lend even to “subprime,” or high-risk, customers, though at higher interest rates (see subprime lending). Consumers took advantage of the cheap credit to purchase durable goods such as appliances, automobiles, and especially houses. The result was the creation in the late 1990s of a “housing bubble” (a rapid increase in home prices to levels well beyond their fundamental, or intrinsic, value, driven by excessive speculation).

Second, owing to changes in banking laws beginning in the 1980s, banks were able to offer to subprime customers mortgage loans that were structured with balloon payments (unusually large payments that are due at or near the end of a loan period) or adjustable interest rates (rates that remain fixed at relatively low levels for an initial period and float, generally with the federal funds rate, thereafter). As long as home prices continued to increase, subprime borrowers could protect themselves against high mortgage payments by refinancing, borrowing against the increased value of their homes, or selling their homes at a profit and paying off their mortgages. In the case of default, banks could repossess the property and sell it for more than the amount of the original loan. Subprime lending thus represented a lucrative investment for many banks. Accordingly, many banks aggressively marketed subprime loans to customers with poor credit or few assets, knowing that those borrowers could not afford to repay the loans and often misleading them about the risks involved. As a result, the share of subprime mortgages among all home loans increased from about 2.5 percent to nearly 15 percent per year from the late 1990s to 2004–07.

Third, contributing to the growth of subprime lending was the widespread practice of securitization, whereby banks bundled together hundreds or even thousands of subprime mortgages and other, less-risky forms of consumer debt and sold them (or pieces of them) in capital markets as securities (bonds) to other banks and investors, including hedge funds and pension funds. Bonds consisting primarily of mortgages became known as mortgage-backed securities, or MBSs, which entitled their purchasers to a share of the interest and principal payments on the underlying loans. Selling subprime mortgages as MBSs was considered a good way for banks to increase their liquidity and reduce their exposure to risky loans, while purchasing MBSs was viewed as a good way for banks and investors to diversify their portfolios and earn money. As home prices continued their meteoric rise through the early 2000s, MBSs became widely popular, and their prices in capital markets increased accordingly.

Fourth, in 1999 the Depression-era Glass-Steagall Act (1933) was partially repealed, allowing banks, securities firms, and insurance companies to enter each other’s markets and to merge, resulting in the formation of banks that were “too big to fail” (i.e., so big that their failure would threaten to undermine the entire financial system). In addition, in 2004 the Securities and Exchange Commission (SEC) weakened the net-capital requirement (the ratio of capital, or assets, to debt, or liabilities, that banks are required to maintain as a safeguard against insolvency), which encouraged banks to invest even more money into MBSs. Although the SEC’s decision resulted in enormous profits for banks, it also exposed their portfolios to significant risk, because the asset value of MBSs was implicitly premised on the continuation of the housing bubble.

Fifth, and finally, the long period of global economic stability and growth that immediately preceded the crisis, beginning in the mid- to late 1980s and since known as the “Great Moderation,” had convinced many U.S. banking executives, government officials, and economists that extreme economic volatility was a thing of the past. That confident attitude—together with an ideological climate emphasizing deregulation and the ability of financial firms to police themselves—led almost all of them to ignore or discount clear signs of an impending crisis and, in the case of bankers, to continue reckless lending, borrowing, and securitization practices.

Financial crisis of 2007–08

Key Events Of The Crisis

Beginning in 2004 a series of developments portended the coming crisis, though very few economists anticipated its vast scale. Over a two-year period (June 2004 to June 2006) the Fed raised the federal funds rate from 1.25 to 5.25 percent, inevitably resulting in more defaults from subprime borrowers holding adjustable-rate mortgages (ARMs). Partly because of the rate increase, but also because the housing market had reached a saturation point, home sales, and thus home prices, began to fall in 2005. Many subprime mortgage holders were unable to rescue themselves by borrowing, refinancing, or selling their homes, because there were fewer buyers and because many mortgage holders now owed more on their loans than their homes were worth (they were “underwater”)—an increasingly common phenomenon as the crisis developed. As more and more subprime borrowers defaulted and as home prices continued to slide, MBSs based on subprime mortgages lost value, with dire consequences for the portfolios of many banks and investment firms. Indeed, because MBSs generated from the U.S. housing market had also been bought and sold in other countries (notably in western Europe), many of which had experienced their own housing bubbles, it quickly became apparent that the trouble in the United States would have global implications, though most experts insisted that the problems were not as serious as they appeared and that damage to financial markets could be contained.

By 2007 the steep decline in the value of MBSs had caused major losses at many banks, hedge funds, and mortgage lenders and forced even some large and prominent firms to liquidate hedge funds that were invested in MBSs, to appeal to the government for loans, to seek mergers with healthier companies, or to declare bankruptcy. Even firms that were not immediately threatened sustained losses in the billions of dollars, as the MBSs in which they had invested so heavily were now downgraded by credit-rating agencies, becoming “toxic” (essentially worthless) assets. (Such agencies were later accused of a severe conflict of interest, because their services were paid for by the same banks whose debt securities they rated. That financial relationship initially created an incentive for agencies to assign deceptively high ratings to some MBSs, according to critics.) In April 2007 New Century Financial Corp., one of the largest subprime lenders, filed for bankruptcy, and soon afterward many other subprime lenders ceased operations. Because they could no longer fund subprime loans through the sale of MBSs, banks stopped lending to subprime customers, causing home sales and home prices to decline further, which discouraged home buying even among consumers with prime credit ratings, further depressing sales and prices. In August, France’s largest bank, BNP Paribas, announced billions of dollars in losses, and another large U.S. firm, American Home Mortgage Investment Corp., declared bankruptcy.

In part because it was difficult to determine the extent of subprime debt in any given MBS (because MBSs were typically sold in pieces, mixed with other debt, and resold in capital markets as new securities in a process that could continue indefinitely), it was also difficult to assess the strength of bank portfolios containing MBSs as assets, even for the bank that owned them. Consequently, banks began to doubt one another’s solvency, which led to a freeze in the federal funds market with potentially disastrous consequences. In early August the Fed began purchasing federal funds (in the form of government securities) to provide banks with more liquidity and thereby reduce the federal funds rate, which had briefly exceeded the Fed’s target of 5.25 percent. Central banks in other parts of the world—notably in the European Union, Australia, Canada, and Japan—conducted similar open-market operations. The Fed’s intervention, however, ultimately failed to stabilize the U.S. financial market, forcing the Fed to directly reduce the federal funds rate three times between September and December, to 4.25 percent. During the same period, the fifth largest mortgage lender in the United Kingdom, Northern Rock, ran out of liquid assets and appealed to the Bank of England for a loan. News of the bailout created panic among depositors and resulted in the first bank runs in the United Kingdom in 150 years. Northern Rock was nationalized by the British government in February 2008.

The crisis in the United States deepened in January 2008 as Bank of America agreed to purchase Countrywide Financial, once the country’s leading mortgage lender, for $4 billion in stock, a fraction of the company’s former value. In March the prestigious Wall Street investment firm Bear Stearns, having exhausted its liquid assets, was purchased by JPMorgan Chase, which itself had sustained billions of dollars in losses. Fearing that Bear Stearns’s bankruptcy would threaten other major banks from which it had borrowed, the Fed facilitated the sale by assuming $30 billion of the firm’s high-risk assets. Meanwhile, the Fed initiated another round of reductions in the federal funds rate, from 4.25 percent in early January to only 2 percent in April (the rate was reduced again later in the year, to 1 percent by the end of October and to effectively 0 percent in December). Although the rate cuts and other interventions during the first half of the year had some stabilizing effect, they did not end the crisis; indeed, the worst was yet to come.

By the summer of 2008 Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), the federally chartered corporations that dominated the secondary mortgage market (the market for buying and selling mortgage loans) were in serious trouble. Both institutions had been established to provide liquidity to mortgage lenders by buying mortgage loans and either holding them or selling them—with a guarantee of principal and interest payments—to other banks and investors. Both were authorized to sell mortgage loans as MBSs. As the share of subprime mortgages among all home loans began to increase in the early 2000s (partly because of policy changes designed to boost home ownership among low-income and minority groups), the portfolios of Fannie Mae and Freddie Mac became more risky, as their liabilities would be huge should large numbers of mortgage holders default on their loans. Once MBSs created from subprime loans lost value and eventually became toxic, Fannie Mae and Freddie Mac suffered enormous losses and faced bankruptcy. To prevent their collapse, the U.S. Treasury Department nationalized both corporations in September, replacing their directors and pledging to cover their debts, which then amounted to some $1.6 trillion.

Later that month the 168-year-old investment bank Lehman Brothers, with $639 billion in assets, filed the largest bankruptcy in U.S. history. Its failure created lasting turmoil in financial markets worldwide, severely weakened the portfolios of the banks that had loaned it money, and fostered new distrust among banks, leading them to further reduce interbank lending. Although Lehman had tried to find partners or buyers and had hoped for government assistance to facilitate a deal, the Treasury Department refused to intervene, citing “moral hazard” (in this case, the risk that rescuing Lehman would encourage future reckless behaviour by other banks, which would assume that they could rely on government assistance as a last resort). Only one day later, however, the Fed agreed to loan American International Group (AIG), the country’s largest insurance company, $85 billion to cover losses related to its sale of credit default swaps (CDSs), a financial contract that protects holders of various debt instruments, including MBSs, in the event of default on the underlying loans. Unlike Lehman, AIG was deemed “too big to fail,” because its collapse would likely cause the failure of many banks that had bought CDSs to insure their purchases of MBSs, which were now worthless. Less than two weeks after Lehman’s demise, Washington Mutual, the country’s largest savings and loan, was seized by federal regulators and sold the next day to JPMorgan Chase.

By this time there was general agreement among economists and Treasury Department officials that a more forceful government response was necessary to prevent a complete breakdown of the financial system and lasting damage to the U.S. economy. In September the George W. Bush administration proposed legislation, the Emergency Economic Stabilization Act (EESA), which would establish a Troubled Asset Relief Program (TARP), under which the Secretary of the Treasury, Henry Paulson, would be authorized to purchase from U.S. banks up to $700 billion in MBSs and other “troubled assets.” After the legislation was initially rejected by the House of Representatives, a majority of whose members perceived it as an unfair bailout of Wall Street banks, it was amended and passed in the Senate. As the country’s financial system continued to deteriorate, several representatives changed their minds, and the House passed the legislation on October 3, 2008; President Bush signed it the same day.

It soon became apparent, however, that the government’s purchase of MBSs would not provide sufficient liquidity in time to avert the failure of several more banks. Paulson was therefore authorized to use up to $250 billion in TARP funds to purchase preferred stock in troubled financial institutions, making the federal government a part-owner of more than 200 banks by the end of the year. The Fed thereafter undertook a variety of extraordinary quantitative-easing (QE) measures, under several overlapping but differently named programs, which were designed to use money created by the Fed to inject liquidity into capital markets and thereby to stimulate economic growth. Similar interventions were undertaken by central banks in other countries. The Fed’s measures included the purchase of long-term U.S. Treasury bonds and MBSs for prime mortgage loans, loan facilities for holders of high-rated securities, and the purchase of MBSs and other debt held by Fannie Mae and Freddie Mac. By the time the QE programs were officially ended in 2014, the Fed had by such means pumped more than $4 trillion into the U.S. economy. Despite warnings from some economists that the creation of trillions of dollars of new money would lead to hyperinflation, the U.S. inflation rate remained below the Fed’s target rate of 2 percent through the end of 2014.

There is now general agreement that the measures taken by the Fed to protect the U.S. financial system and to spur economic growth helped to prevent a global economic catastrophe. In the United States, recovery from the worst effects of the Great Recession was also aided by the American Recovery and Reinvestment Act, a $787 billion stimulus and relief program proposed by the Barack Obama administration and adopted by Congress in February 2009. By the middle of that year, financial markets had begun to revive, and the economy had begun to grow after nearly two years of deep recession. In 2010 Congress adopted the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which instituted banking regulations to prevent another financial crisis and created a Consumer Financial Protection Bureau, which was charged with regulating, among other things, subprime mortgage loans and other forms of consumer credit. After 2017, however, many provisions of the Dodd-Frank Act were rolled back or effectively neutered by a Republican-controlled Congress and the Donald J. Trump administration, both of which were hostile to the law’s approach.

(b) What risk management strategies would you recommend for the stakeholders involved?

So far in this series on risk management, we’ve looked at the main types of risk a business can face, and how to measure risk in your business.

The next logical step, of course, is to put together a plan for dealing with each risk you’ve identified, so that you can manage your risks on an ongoing basis. You’ll learn exactly how to do that in this tutorial.

We’ll start by seeing what a risk management plan might look like, and how you can put one together for your business. Then we’ll look at the options you have in dealing with each individual risk, and how you can decide which strategy to employ. And finally we’ll see how you can monitor risk in your business on a regular basis, and update your plan as necessary.

Putting together a solid risk management plan is one of the most important things you can do for your business. Companies fail all the time, sometimes blaming bad luck, “the economy”, or other unforeseen circumstances. Risk management is about being prepared for as many of these adverse events as possible, so that you can ride out storms that make your competitors go under.

Disaster can still wreck the best-laid plans, of course, but taking risk management seriously will certainly increase your chances of long-term success. So let’s get started.

1. Make a Plan

Every business should have a solid risk management plan. Here's a guide to putting one together.

The format can vary widely, depending on your company’s needs. A risk management plan for a large, complex business could easily run to hundreds of pages, while a small business might just have a small spreadsheet focusing on the main items.

There are a few essential items to include in a risk management plan, however. Here they are:

• a list of individual risks
• a rating of each risk based on likelihood and impact
• an assessment of current controls
• a plan of action

Let’s look at each of those in turn. If you’ve been following the series so far, you’ll notice that we already covered the first two items in the last tutorial. So we’ve got a good head-start on our plan already. Here’s the sample table we put together last time:

Risk	Likelihood	Impact	Risk Score
Key client XYZ Corp is late paying its invoice.	5	2	10
Loss of power for more than 24 hours.	1	3	3
Our COO Janet leaves the company.	4	4	16
A new competitor undercuts the price of our main product.	2	5	10
Scathing product review from an influential magazine/website.	3	2	6

Your full plan will of course have a lot more items, but this example at least illustrates the format. You can refer to the other tutorial for more details about what each score means.

So to complete our risk management plan, we just need to add two more columns to our table.

The first new column is an assessment of current controls. For each of the risks you’ve identified, what are you currently doing to control that risk, and how effective is it?

For example, let’s look at the first item on our table: “Key client XYZ Corp is late paying its invoice.” Maybe you are already controlling for that risk by having automated reminders sent out when the invoice is close to its due date, and having one of your staff members responsible for following up personally with phone calls and emails. You’d list those as existing controls on your risk management plan.

So the next step is to consider the effectiveness of those actions. How well are things working right now? If your client almost always pays on time, for example, then your controls are effective. But if XYZ Corp has been late with its payments two or three times already this year, the controls are inadequate. Again, you could use a simple five-point scale here:

1. very inadequate, or non-existent
2. inadequate
3. satisfactory
4. strong
5. very strong

Then the final element of your plan details the action you plan to take in order to manage the risk more effectively. What could you do, either to reduce the likelihood of that event happening, or to minimize its impact when it does happen?

This last item is a little more complex, so we’ll look at it in some more detail in the next section of this tutorial.

2. Decide How to Handle Each Risk

So at this point in the series, we’ve identified all the main risks in our business, prioritized them based on likelihood and impact, and assessed the effectiveness of our current controls.

The next step is to decide what to do about each risk, so that we can manage them best. In the world of risk management, there are four main strategies:

1. Avoid it.
2. Reduce it.
3. Transfer it.
4. Accept it.

Each strategy has its own advantages and disadvantages, and you’ll probably end up using all four. Sometimes it may be necessary to avoid a risk, and other times you’ll want to reduce it, transfer it, or simply accept it. Let’s look at what those terms mean, and how to decide on the right classification to use for each of your own business risks.

Avoid the Risk

Sometimes, a risk will be so serious that you simply want to eliminate it, for example by avoiding the activity altogether, or using a completely different approach. If a particular type of trading is very risky, you may decide it’s not worth the potential reward, and abandon it.

The advantage of this strategy is that it’s the most effective way of dealing with a risk. By stopping the activity that’s causing the potential problems, you eliminate the chance of incurring losses. But the disadvantage is that you also lose out on any benefits too. Risky activities can be very profitable, or perhaps have other benefits for your company. So this strategy is best used as a last resort, when you’ve tried the other strategies and found that the risk level is still too high.

Reduce the Risk

If you don’t want to abandon the activity altogether, a common approach is to reduce the risk associated with it. Take steps to make the negative outcome less likely to occur, or to minimize its impact when it does occur.

With our earlier case, “Key client XYZ Corp is late paying its invoice”, for example, we could reduce the likelihood by offering an incentive to the client to pay its bills on time. Maybe a 10% discount for early payment, and a penalty for late payment. Dealing with late-paying customers can be tricky, and we covered it more in our tutorial on managing cash flow more efficiently, but these are a couple of options.

In the same example, we could reduce the impact by arranging access to a short-term credit facility. That way, even if the client does pay late, we don’t run out of money. For more on short-term borrowing options like factoring and lines of credit, see our tutorial on borrowing money to fund a business.

This is probably the most common strategy, and is appropriate for a wide range of different risks. It lets you continue with the activity, but with measures in place to make it less dangerous. If done well, you have the best of both worlds. But the danger is that your controls are ineffective, and you end up still suffering the loss that you feared.

Transfer the Risk

We’re all familiar with the concept of insurance from our everyday lives, and the same applies in business. An insurance contract is basically a transfer of risk from one party to another, with a payment in return.

When you own a home, for example, there’s a big risk of losses from fire, theft, and other damage. So you can buy a home insurance policy, and transfer that risk to the insurance company. If anything goes wrong, it’s the insurance company that bears the loss, and in return for that peace of mind, you pay a premium.

When you own a business, you have the option to transfer many of your risks to an insurance company as well. You can insure your properties and vehicles, and also take out various types of liability insurance to protect yourself from lawsuits. We’ll look at insurance in more detail in the next tutorial in the series, but it’s a good option for dealing with risks that have a large potential impact, as long as you can find an affordable policy.

Accept the Risk

As we’ve seen, risk management comes at a price. Avoiding a risk means constricting your company’s activities and missing out on potential benefits. Reducing a risk can involve costly new systems or cumbersome processes and controls. And transferring a risk also has a cost, for example an insurance premium.

So in the case of minor risks, it may be best simply to accept them. There’s no sense investing in a whole new suite of expensive software just to mitigate a risk that wouldn’t have had a very big impact anyway. For the risks that received a low score for impact and likelihood, look for a simple, low-cost solution, and if you can’t find one, it may be worth simply accepting the risk and continuing with business as usual.

The advantage of accepting a risk is pretty clear: there’s no cost, and it frees up resources to focus on more serious risks. The downside is also pretty clear: you have no controls in place. If the impact and likelihood are minor, that may be fine. But make sure you’ve assessed those things correctly, so that you don’t get a nasty surprise.

3. Monitor

Putting measures in place isn't enough; you also need to check whether they're working, and monitor your business on a regular basis to identify and deal with new risks.

The starting point is the plan you’ve been putting together. You should now have a list of all the risks in your business, an assessment of their likelihood and impact, an evaluation of your current controls, and an action plan for dealing with them. Here’s an example of how it could look when you put it all together (click the Risk management plan and register button at the bottom of the page).

The danger with a document like this is that you spend lots of time preparing it initially, but then never go back and update it later. A good risk management plan must be a living document, constantly referred to and updated to reflect new situations, new risks, and the effectiveness of your actions.

First of all, each action you define should have a target date for completion, and a person who’s primarily responsible for it. For example, with our late-paying client, we could decide that our salesperson, Tina, will be responsible for renegotiating payment terms with XYZ Corp. to create incentives for timely payment, and that this will be completed by March 1st.

When Tina’s finished doing this, you’d move that from the “actions” column to the “current controls” column. Then over the following months, you’d assess how effective the new payment terms are at reducing the risk. If they’re still not effective, you could look at the short-term financing option to reduce the impact of the late payments.

If neither of those options work, then you could look for other alternatives. If you’ve tried everything and the client still pays late, then you may decide to accept the risk if the client’s business is really important to you, or you could go for the nuclear option of eliminating the risk altogether by avoiding doing business with that client.

The situation will evolve constantly over time, as the risks change and your responses to them have their own effect. Some of the controls you put in place may reduce the likelihood of the client paying late, making it less important to deal with. Or you may take on so many other clients that XYZ Corp. accounts for a smaller share of your revenue, so the impact of late payment is smaller. All of this needs to be accounted for.

There’s no hard and fast rule about how often to update your risk management plan. Large companies have whole departments dedicated to full-time risk management, whereas in a small company the resources you can devote to it will probably be more limited. The key is to make a commitment to update your plan regularly, whether that’s on a monthly basis, quarterly, or even annually.

One of the best approaches is to make small changes to individual items on an ongoing basis, as the changes occur, and then to carry out a more comprehensive review of the document on a less frequent, but still regular schedule. The comprehensive review would include going back to the steps we covered in the earlier parts of this series, brainstorming about all the risks your business is subject to, adding new items to the list, and ranking them by importance. Then do the same with your existing risks, noting any changes.

Next Steps

If you take all of the steps outlined in this tutorial and the earlier parts of the series, you’ll be in a good position to protect your business from many of the pitfalls that will come your way.

You now have a comprehensive risk management plan that outlines all the risks your business faces, and ranks them according to how likely they are to occur and how serious their impact would be.

You’ve evaluated the effectiveness of the controls you currently have in place, and come up with an action plan for either avoiding, reducing, transferring or accepting the risk.

Your action plan has a clear timeline and a person responsible for implementing it, and you’ve made a commitment to monitoring the success of your actions and updating the plan as necessary.

Congratulations! You’re in a better position than many other business owners. Truly unforeseeable events can still crop up and pose challenges, but you’ve done your best to plan for likely risks and to protect yourself as far as possible.

The final tutorial in this series will look in more detail at the option of transferring risk. There are quite a few different types of business insurance, and the categories are different from those you might be used to from your personal life. So stay tuned for a look at the main types of insurance that your business needs.

(c) Critique the Altman Z-Score model of credit risk. What improvements have been suggested by researchers?

The Altman Z-score is the output of a credit-strength test that gauges a publicly-traded manufacturing company's likelihood of bankruptcy. The Altman Z-score is based on five financial ratios that can calculate from data found on a company's annual 10-K report. It uses profitability, leverage, liquidity, solvency, and activity to predict whether a company has a high probability of becoming insolvent.

How the Altman Z-Score Works

One can calculate the Altman Z-score as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

• A = working capital / total assets
• B = retained earnings / total assets
• C = earnings before interest and tax / total assets
• D = market value of equity / total liabilities
• E = sales / total assets

A score below 1.8 means it's likely the company is headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. Investors can use Altman Z-scores to determine whether they should buy or sell a stock if they're concerned about the company's underlying financial strength. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to 1.8.

Special Considerations

In 2007, the credit ratings of specific asset-related securities had been rated higher than they should have been. The Altman Z-score indicated that the companies' risks were increasing significantly and may have been heading for bankruptcy.

Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These companies' credit ratings were equivalent to a B. This indicated that 50% of the firms should have had lower ratings, were highly distressed and had a high probability of becoming bankrupt.

Altman's calculations led him to believe a crisis would occur and there would be a meltdown in the credit market. Altman believed the crisis would stem from corporate defaults, but the meltdown began with mortgage-backed securities. However, corporations soon defaulted in 2009 at the second-highest rate in history.

History of the Altman Z-Score

NYU Stern Finance Professor Edward Altman developed the Altman Z-score formula in 1967, and it was published in 1968. Over the years, Altman has continued to revaluate his Z-score over the years. From 1969 until 1975, Altman looked at 86 companies in distress, then 110 from 1976 to 1995, and finally 120 from 1996 to 1999, finding that the Z-score had an accuracy of between 82% and 94%.

In 2012, he released an updated version called the Altman Z-score Plus that one can use to evaluate public and private companies, manufacturing and non-manufacturing companies, and U.S. and non-U.S. companies. One can use Altman Z-score Plus to evaluate corporate credit risk. The Altman Z-score has become a reliable measure of calculating credit risk.

(d) What is the CDS market? Describe the differences between hedging and speculating in the CDS market using examples

A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.

A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

A credit default swap is designed to transfer the credit exposure of fixed income products between two or more parties. In a CDS, the buyer of the swap makes payments to the swap's seller until the maturity date of a contract. In return, the seller agrees that – in the event that the debt issuer (borrower) defaults or experiences another credit event – the seller will pay the buyer the security's value as well as all interest payments that would have been paid between that time and the security's maturity date. In the CDS world, a credit event is a trigger that causes the buyer of protection to terminate and settle the contract. Credit events are agreed upon when the trade is entered into and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers: reference entity bankruptcy, failure to pay, obligation acceleration, repudiation, and moratorium. A credit default swap is a type of credit derivative contract.

Bonds and other debt securities have risk that the borrower will not repay the debt or its interest. Because debt securities will often have lengthy terms to maturity, as much as 30 years, it is difficult for the investor to make reliable estimates about that risk over the entire life of the instrument.

Credit default swaps have become an extremely popular way to manage this kind of risk. The U.S. Comptroller of the Currency issues a quarterly report on credit derivatives and in a report issued in June 2018, it placed the size of the entire market at $4.2 trillion, of which CDS accounted for $3.68 trillion.

Credit Default Swap as Insurance

A credit default swap is, in effect, insurance against non-payment. Through a CDS, the buyer can avoid the consequences of a borrower's default by shifting some or all that risk onto an insurance company or other CDS seller in exchange for a fee. In this way, the buyer of a credit default swap receives credit protection, while the seller of the swap guarantees the creditworthiness of the debt security. For example, the buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, along with any unpaid interest, should the issuer default on payments.

It is important to note that the credit risk isn't eliminated – it has been shifted to the CDS seller. The risk is that the CDS seller defaults at the same time the borrower defaults. This was one of the primary causes of the 2008 credit crisis: CDS sellers like Lehman Brothers, Bear Stearns and AIG defaulted on their CDS obligations.

While credit risk hasn't been eliminated through a CDS, risk has been reduced. For example, if Lender A has made a loan to Borrower B with a mid-range credit rating, Lender A can increase the quality of the loan by buying a CDS from a seller with a better credit rating and financial backing than Borrower B. The risk hasn't gone away, but it has been reduced through the CDS.

If the debt issuer does not default and if all goes well, the CDS buyer will end up losing money through the payments on the CDS, but the buyer stands to lose a much greater proportion of its investment if the issuer defaults and if it had not bought a CDS. As such, the more the holder of a security thinks its issuer is likely to default, the more desirable a CDS is and the more it will cost.

Credit Default Swap in Context

Any situation involving a credit default swap will have a minimum of three parties. The first party involved is the institution that issued the debt security (borrower). The debt may be bonds or other kinds of securities and are essentially a loan that the debt issuer has received from the lender. If a company sells a bond with a $100 face value and a 10-year maturity to a buyer, the company is agreeing to pay back the $100 to the buyer at the end of the 10-year period as well as regular interest payments over the course of the bond's life. Yet, because the debt issuer cannot guarantee that it will be able repay the premium, the debt buyer has taken on risk.

The debt buyer is the second party in this exchange and will also be the CDS buyer, if the parties decide to engage in a CDS contract. The third party, the CDS seller, is most often a large bank or insurance company that guarantees the underlying debt between the issuer and the buyer. This is very similar to an insurance policy on a home or car.

CDS are complex because they are traded over-the-counter (meaning they are non-standardized). There is a lot of speculation in the CDS market, where investors can trade the obligations of the CDS if they believe they can make a profit. For example, assume there is a CDS that earns $10,000 quarterly payments to insure a $10 million bond. The company that originally sold the CDS believes that the credit quality of the borrower has improved so the CDS payments are high. The company could sell the rights to those payments and the obligations to another buyer and potentially make a profit.

Alternatively, imagine an investor who believes that Company A is likely to default on its bonds. The investor can buy a CDS from a bank that will pay out the value of that debt if Company A defaults. A CDS can be purchased even if the buyer does not own the debt itself. This is a bit like a neighbor buying a CDS on another home in her neighborhood because she knows that the owner is out of work and may default on the mortgage.

Though credit default swaps can insure the payments of a bond through maturity, they do not necessarily need to cover the entirety of the bond's life. For example, imagine an investor is two years into a 10-year security and thinks that the issuer is in credit trouble. The bond owner may choose to buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will have faded.

It is even possible for investors to effectively switch sides on a credit default swap to which they are already a party. For example, if a CDS seller believes that the borrower is likely to default, the CDS seller can buy its own CDS from another institution or sell the contract to another bank in order to offset the risks. The chain of ownership of a CDS can become very long and convoluted, which makes tracking the size of this market difficult.

Real World Example of a Credit Default Swap

Credit default swaps were widely used during the European Sovereign Debt crisis. In September 2011, Greece government bonds had a 94% probability of default. Investors holding Greek bonds could have paid $5.7 million upfront and $100,000 each year for a credit default swap (CDS) to insure $10 million worth of bonds for five years. Many hedge funds even used CDS as a way to speculate on the likelihood that the country would default.

Hedging vs. Speculation: An Overview

Speculators and hedgers are different terms that describe traders and investors. Speculation involves trying to make a profit from a security's price change, whereas hedging attempts to reduce the amount of risk, or volatility, associated with a security's price change.

Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving.

Hedging

Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel out another.

For example, assume that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's main inputs. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. In order to protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10 percent price increase, the futures contract will lock in a price that will offset this gain.

As you can see, although hedgers are protected from any losses, they are also restricted from any gains. The portfolio is diversified but still exposed to systematic risk. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk.

To mitigate this risk, the investor hedges their portfolio by shorting futures contracts on the market and buying put options against the long positions in the portfolio. On the other hand, if a speculator notices this situation, they may look to short an exchange-traded fund (ETF) and a futures contract on the market to make a potential profit on a downside move.

Speculation

Speculators trade based on their educated guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit.

Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.

Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.

Hedging vs. Speculation Example

It's important to note that hedging is not the same as portfolio diversification. Diversification is a portfolio management strategy that investors use to smooth out specific risk in one investment, while hedging helps to decrease one's losses by taking an offsetting position. If an investor wants to reduce his overall risk, the investor shouldn't put all of his money into one investment. Investors can spread out their money into multiple investments to reduce risk.

For example, suppose an investor has $500,000 to invest. The investor can diversify and put money into multiple stocks in various sectors, real estate, and bonds. This technique helps to diversify unsystematic risk; in other words, it protects the investor from being affected by any individual event in an investment.

When an investor is worried about an adverse price decline in their investment, the investor can hedge their investment with an offsetting position to be protected. For example, suppose an investor is invested in 100 shares of stock in oil company XYZ and feels that the recent drop in oil prices will have an adverse effect on its earnings. The investor does not have enough capital to diversify their position; instead, the investor decides to hedge their position by buying options for protection. The investor can purchase one put option to protect against a drop in the stock price, and pays a small premium for the option. If XYZ misses its earnings estimates and prices fall, the investor will lose money on their long position but will make money on the put option, which limits losses.