Question

Credit default swaps (CDS) played a role in the 2008 financial crisis. Describe the following: (1) what a CDS contract is (including the counterparties and the timing and amount of cash flows between counterparties), (2) how an investor could use CDS to take short positions in RMBS, (3) and how taking short exposure via CDS differs from other methods of taking short exposure to an asset.

Answer 1

1)  Credit default swaps (CDS) are the most widely used type of credit derivative. The first CDS contract was introduced by JP Morgan in 1997 and by 2012, despite a negative reputation in the wake of the 2008 financial crisis, the value of the market has increased over time. Credit default swaps have become an extremely popular way to manage credit 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.

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 his/her 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 CDS 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 when 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.
Bonds and other debt securities have risk that the borrower will not repay the debt or its interest. Because debt securities 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. A credit default swap is a kind of insurance against non-payment.

However, it is to be noted that the credit risk isn't eliminated, it has been just shifted to the CDS seller. The risk is that the CDS seller may also default 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 can be 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. Hence, 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 in terms of the premium payment.

Credit default swap will have a minimum of 3 parties. The first party involved is the institution that issued the debt security (borrower). The debt may be bonds or other kinds of securities. 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. 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.

The notional value of a CDS refers to the face value of the underlying security. The premium that is paid by the buyer of the CDS to its seller, is expressed as a proportion of the notional value of the contract in basis points. Gross notional value refers to the total amount of outstanding credit default swaps.

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:-

1. Bankruptcy
2. Obligation acceleration
3. Obligation default
4. Payment default
5. Repudiation/Moratorium
6. Debt restructuring (Debt restructuring refers to a change in the terms of the debt, causing the debt to be less favorable to debt holders).

The three most common credit events are bankruptcies, payment defaults, and debt restructuring.

3) While a CDS is similar to an insurance contract between the insurance company and the insurance policyhoder, a fundamental difference between a CDS and a traditional insurance contract is that a CDS offers a payment from the protection seller to the protection buyer even when the buyer is not a holder of debt referenced in the CDS contract. In contrast, a traditional insurance contract typically offers coverage only for damages incurred (the insuree must have "insurable interest"). In other words, in contrast to traditional insurance, a CDS contract can be "naked" (i.e., it provides payment in case of a credit event even without any underlying credit exposure on behalf of the insuree).

Hence we can say, that although credit default swaps are often compared to insurance contracts, one important difference is that with an insurance policy, the policyholder must also own the property being insured. In contrast, the buyer of a credit default swap need not be the owner of the financial instrument for which the swap is providing a financial guarantee. Thus, credit default swaps facilitate speculation (by buyers) as to whether a certain credit instrument will default.

Another key difference from insurance is that the seller of a credit default swap—unlike an insurance company—is not required to maintain a specific level of reserves in the event that the subject instrument (e.g., a mortgage-backed security) defaults, and the seller must pay the buyer of the credit default swap. For example, In 2008, AIG Insurance Company's failure to maintain adequate reserves on the billions of dollars in credit default swaps it sold was the major cause of the company's near-collapse.

The differences between CDS and other methods of taking short exposure to an asset also arise from the applicability of the credit events and the process of settlement.