Question

Describe the sub-prime crisis in early September 2008. What caused the financial crisis? What is the key role of CDS in the crisis? Based on the credit risk valuation model we discussed in the class, what has been under-estimated by AIG when pricing CDS?

Answer 1

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 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– 1939).

Causes of Financial Crises:-
1. speculative activity in the financial markets,
2. focusing particularly on property transactions – especially in the USA and western Europe
3. availability of cheap credit,

borrowing on a huge scale to finance what appeared to be a one-way bet on rising property prices. But the boom was ultimately unsustainable because, from around 2005, the gap between incomes and debt began to widen. This was caused by rising energy prices on global markets, leading to an increase in the rate of global inflation.

“This development squeezed borrowers, many of whom struggled to repay mortgages. Property prices now started to fall, leading to a collapse in the values of the assets held by many financial institutions. The banking sectors of the USA and the UK came very close to collapse and had to be rescued by state intervention.”

“Excessive financial liberalisation from the late 20th century, accompanied by a reduction in regulation, was underpinned by confidence that markets are efficient,” says Martin Daunton, emeritus professor of economic history at the University of Cambridge.

Role of CDS in Financial Crises:

A CDS is a privately negotiated bilateral contract in which one party A, usually known as the protection buyer pays a fee or premium to another B, generally referred to as the protection seller to protect himself against the loss that may be incurred on his exposure to an individual loan or bond as a result of an unforeseen development.

The CDS played a major role in the spread of the financial crisis. The first impact they had on the crisis was to hide who was really bearing risks. Credit default swap transactions are not visible on the balance sheet of financial institutions. This implies that investors cannot accurately assess the real risks born by financial institutions. The lack of transparency affected the whole system and made it more vulnerable because of the decrease of trust in the counterparties. The best example of this is when the “subprime” crises occurred. When the subprime mortgage-backed securities. started to default, everybody was wondering about who were going to face the losses. This led to a shrink in counterparty trust, which led to the collapse of key financial markets. One key market that was affected was the interbank lending market. Banks were not willing to lend money to other banks as they did not really know if they were exposed to high risk or not. Therefore, banks were not able to borrow money to meet their liquidity needs and so were assessed as risky institutions. This was the beginning of a vicious circle.

what has been under-estimated by AIG when pricing CDS?

1. it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have been claims that CDSs exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG

2. Systemic Risk:-During the 2008 financial crisis, counterparties became subject to a risk of default, amplified with the involvement of Lehman Brothers and AIG in a very large number of CDS transactions. This is an example of systemic risk, risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.

3. Tax and accounting issues:-

The U.S federal income tax treatment of CDS is uncertain Commentators have suggested that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes,but this is not certain. There is a risk of having CDS recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event) the appropriate treatment for Naked CDS may be entirely different.