Question

1. Describe the sub-prime crisis in early September 2008. What is the role of CDS in the crisis? What made the CDS business special (in terms of collateral requirements) with respect to other insurance business conducted by AIG? Besides AIG, who else also sold (and are selling) CDS?

2. What is systemic risk? How does systemic risk differ from systematic risk? Why may one claim that when AIG was engaged in the CDS business it was underwriting systemic risk? Please answer the question with the discussion on AIG’s collapse.

Answer 1

1.Describe the sub-prime crisis in early September 2008.

When banks sold so many mortgages to meet the appetite for mortgage securities traded on the secondary market, the subprime mortgage crisis arose. The risk extends to the mutual funds, hedge funds and corporates holding these securities. In 2006, house values decreased and defaults were caused1. The subsequent banking crisis of 2007 and the financial crisis of 2008 led to the toughest recession since the Great Depression.

In the aftermath of the 2008 financial crisis, the Federal Reserve saved $180 billion and resumed oversight, with AIG instability associated with widespread purchases of unrestrained insurances The Financial Crisis Inquiry Commission

The events leading to the financial ciris of 2008 include -

1. The rapid rise of maotgauge housing with who had adjustable-rate mortgages.
2. Passing of the  tax rebate bill to help the struggling housing market.
3. Fed Lowers Rate and Buys More Toxic Bank Debt

4. Lehman Brothers Bankruptcy Triggered by huge rise in illiquid MBS in their portfolio

5. Economy Almost Collapses and AIG also fails

6. Fed bails out AIG .

2.What is the role of CDS in the crisis?

A credit default swap (CDS) is a form of credit instrument that offers default protection and other risk protection for the purchaser. The buyer of a CDS shall make regular payments to the seller until the date of credit maturity. The lender agrees in the deal that, if the loan owner defaults, the lender will pay the buyer all the fees and interest that will have been paid up to the maturity date.

• As the subprime mortgage market and the bond market centred on such mortgages expanded, the default insurance demand increased. That was credit default swaps (CDS's). The CDS's were a type of safety derivatives.
• The CDS was instrumental in spreading the financial crisis. The first influence on the situation they had was to cover who was actually facing the risks. Credit default swap trades are not evident on financial institutions' balance sheets. This ensures consumers are unable to reliably determine the actual risks born by financial institutions. The lack of accountability has impacted the whole structure and made it more fragile due to a loss in faith in it

Comptrollers. The perfect example of this is that there have been the "subprime" crisis. As the subprime mortgage-backed securities (MBS) began to default, everybody was worried who would suffer the loses.

3.What made the CDS business special (in terms of collateral requirements) with respect to other insurance business conducted by AIG?

AIG introducted increasingly risky mortgage-backed securities tied to subprime and Alt-A mortgages. Then there were the credit default swaps written on collateralized debt obligations, or CDOs, with huge exposures to subprime mortgages. And then there were the swaps sold to hedge the risk of CDOs made up of CDOs, and that of synthetic CDOs, where just the risk was bought and sold and there was no underlying security.

• AIG also wrote insurance for something called “multisector CDOs,” a collection of more than 100 bonds backed by everything from residential mortgages to auto-loan receivables.
• Later the investment banks had begun putting pressure on AIG to give up more collateral to cover the declining value of the mortgage securities AIG had insured.

4. Besides AIG, who else also sold (and are selling) CDS?

Besigdes aig following are the corporations who were also involved in CDS operations -

Lincoln National Corp

Principal Financial Group

Genworth Financial Inc

MBIA

Allianz

Allstate Corporation

Swiss Re

Aegon NV

ING Groep N.V.

Hartford Financial

Their relative exposure in the financailacrisis to investment banks is as follows as per the chart -

2. What is systemic risk?

Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system.

How does systemic risk differ from systematic risk?

Thanks !