Question

1- Discuss the role of Credit Default Swaps in the U.S.’s subprime crisis and its regulation.

2- “Advanced banking systems are unlikely to experience episodes of banking crisis as banks in these systems are capable of effectively managing various inherent risks associated with their operations.” Discuss.

Answer 1

1. A credit default swap (CDS) is a type of credit derivative that provides the buyer with protection against default and other risks. The buyer of a CDS makes periodic payments to the seller until the credit maturity date. In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interest that would’ve been paid up to the date of maturity. Through a credit swap, a buyer can take risk control measures by shifting the risk to an insurance company in exchange for periodic payments. Just like an insurance policy, a CDS allows purchasers to buy protection against an unlikely event that may affect the investment.

Credit default swaps came into existence in 1994 when they were invented by Blythe Masters from JP Morgan. They became popular in the early 2000s, and by 2007, the outstanding credit default swaps value stood at $62.2 trillion. During the financial crisis of 2008, the value of CDS was hit hard, and it dropped to $26.3 trillion by 2010 and $25.5 trillion in 2012. There was no legal framework to regulate swaps, and the lack of transparency in the market became a concern among regulators.

Before the financial crisis of 2008, there was more money invested in credit default swaps than in other pools. The value of credit default swaps stood at $45 trillion compared to $22 trillion invested in the stock market, $7.1 trillion in mortgages and $4.4 trillion in U.S. Treasuries. In mid-2010, the value of outstanding CDS was $26.3 trillion.

Many investment banks were involved, but the biggest casualty was Lehman Brothers investment bank, which owed $600 billion in debt, out of which $400 billion was covered by CDS. The bank’s insurer, American Insurance Group, lacked sufficient funds to clear the debt, and the Federal Reserve of the United States needed to intervene to bail it out.

Companies that traded in swaps were battered during the financial crisis. Since the market was unregulated, banks used swaps to insure complex financial products. Investors were no longer interested in buying swaps and banks began holding more capital and becoming risk-averse in granting loans.

The Dodd-Frank Wall Street Report Act of 2009 was introduced to regulate the credit default swap market. It phased out the riskiest swaps and prohibited banks from using customer deposits to invest in swaps and other derivatives. The act also required the setting up of a clearinghouse to trade and price swaps.

The case of AIG is an example of credit risk adversely impacting on counterparty risk. Before September 2008, AIG had the fourth-highest rating (AA-) and according to ISDA standards had to post relatively little collateral. During that time AIG had sold CDS referenced to a huge variety of different assets, among them, CDS on CDO that mostly consisted of US mortgage debt including subprime mortgages. When the US subprime crisis unfolded, AIG had to mark down its assets at the same time as it was incurring more liabilities to fulfil collateral claims. In September 2008, the rating agencies cut its credit rating and, as a consequence, AIG’s counterparties demanded even more collateral. At one point, the collateral calls on CDS exceeded AIG’s ability to pay, with the company not being able to honour its contractual commitments to other financial firms. Since AIG was not able to raise additional liquidity by itself, it had to turn to the US Federal Reserve for assistance. Finally, AIG was bailed out by the U.S Government as its failure would spark a contagion.

b.Various private-led measures are being put in place that help enhance market transparency and mitigate operational and systemic risk. In particular, central counterparties have started to operate, which will eventually lead to an improved management of individual as well as system-wide risks.

Over the years, CDSs have become increasingly standardised thanks to voluntary industry initiatives. The standardisation of OTC contracts aims at reducing operational risks and increasing fungibility of these instruments. As far back as 1999, the central industry body, the International Swaps and Derivatives Association (ISDA), introduced a Master Agreement which established the terms and conditions of standard CDS contracts. Clear definitions of the credit events and settlement procedures were meant to avoid disputes as to whether a credit event had actually occurred or how a contract should best be settled. The latest amendments to this Master Agreement were introduced in 2009 with the so called “big bang” and “small bang” protocols, respectively. Both protocols “hard-wire” specific auction settlement terms to standard CDS documentation. While the “big bang” protocol refers to the default or bankruptcy of the underlying entity the “small bang” protocol refers to a restructuring credit event. Both help to determine a fair settlement value in case of a credit event by means of an auction. Before the new measures came into effect, settlement protocols were established on a case-by-case basis only after a credit event was identified. In addition to the settlement standards, market participants agreed on using only a handful of standardised coupon values for European- as well as US-referenced CDSs. Although standardisation will help facilitate central netting and clearing, it is generally not seen as a prerequisite for ensuring systemic stability.