CREDIT DEFAULT ‘SWAP‘ (CDS)AKA

CREDIT DERIVATIVE CONTRACT

Charlie Mudrick BA 543

FLOW OF PRESENTATION Definition (background context) Mechanics of a CDS

Examples Historical Context

Examples

Checkpoint Questions Throughout

Questions Work Cited Useful Links

DEFINITIONS Swap: is a derivative where counterparties

exchange cash flows of one party’s financial instrument (seller – mortgage %) for those of the other party’s financial instrument (buyer – cash payments). cash flows = ‘legs’ of the CDS

Credit Default Swap: bi-lateral OTC derivative contract. (swap based on credit defaulting) Protection seller (investment bank) will compensate

the Protection buyer (original lender) if the event of a loan default (or other credit event) occurs.

PURPOSE CDS were designed to shift risk from

primary lender to an ‘insurance’ entity debt holders enabled to hedge

MECHANICS EXAMPLE: Corporate credit instruments

We are swapping for asset quality issues (ratings)

TRADITIONAL CDSCorp A

need 50Mhave BBmay defaul

tgive 10%

Ratings Agency

Independent

Pension Fund

have 50Mwant 10%need AAgive 1%

Investment Bank

have AAwant 1%give insuranc

e

QualityMatch

RiskTaker

Not Regulated like insurance• Enter: greed, speculation,

mismanagement

CHECKPOINT 1 (DEEP THOUGHTS) How would AIG manage their CDS risk? ABCDS (asset backed CDS)

Use an asset (house) to ensure some payment

aka MBS (mortgage backed securities)

MBS & CDSCorp A

need 50Mhave BBmay defaul

tgive 10%

Ratings Agency

Independent

Pension Fund

have 50Mwant 10%need AAgive 1%

Investment Bank

have AAwant 1%give insuranc

e

QualityMatch

RiskTaker

PURPOSE (PERVERSED) CDS were designed to shift risk from

primary lender to an ‘insurance’ entity debt holders enabled to hedge

Speculators used CDS to profit from defaults Investment banks = ‘the prey’

EXAMPLE: FOURTH MARKET This is were the gambling begins Speculative CDS (binomial options)

MARKET

SPECULATIVE CDSCorp A

need 50Mhave BBmay defaul

tgive 10%

Ratings Agency

Independent

Pension Fund

have 50Mwant 10%need AAgive 1%

Investment Bankhave AAwant 1% & $give Insurance &

default value

bet No default

QualityMatch

RiskTaker

Asset managershave $

paymentswant Default

valuebet default

CHECKPOINT 2 (DEEP THOUGHTS) How can we prevent the CDS

speculation? Set mandatory disclosing of ‘secret

liens’ & identify complex financial instruments Investment bank disclose debt claims in

exchange for payment priority (not just their books)

Essentially Investment banks’ leverage disclosure

HOW WE BE (NO PROTECTION)

HISTORICAL CONTEXT Goldman Sachs Group Inc. (GS)

bet against (shorted) the U.S. Sub-Prime Mortgage housing market crash

made Billions of $$$ Donald R. Mullen Jr.: ex-head of

global credit and mortgages then currently into single family rentals REO LLC CEO now stands to profit again

HISTORICAL CONTEXT Did GS ‘bet against’ the market failing

Or ‘make the market’ fail…

HISTORICAL CONTEXT

HISTORICAL CONTEXT Sub-primed mortgage market

Welcome Sub-Prime Mortgage Crash

WOLF-VISION EXAMPLE How GS purportedly ‘played’ the

market

SUMMARY CDS are financial instruments (swaps)

Can become very complex (2nd , 3rd , etc. swaps) Can be traded in private (4th ) market Simplest form: shift loan default risk between parties

Speculation creates an unregulated market If mismanaged, financial crises could ensue E.g. Sub-Prime Mortgage Crash

CDS can be high stacks corporate gambling Zero sum game (GS ‘won’; AIG & others ‘lost’) Don’t be a player!

CDS are ‘safer’ if backed by collateralized assets ABCDS offer protection when legitimate

QUESTIONS CDS are a:

A. Derivative B. 1980’s digital media formatC. financial instrumentD. bi-lateral contractE. All of the above

True/False: Credit Default Swaps May match parties’ underlying asset quality needs Were designed to shift risk Are traded on the 4th market

USEFUL LINKS Kahn Academy Series: 1, 2, 3, 4, 5 Investopedia: video as well Wikipedia: general info GS: CDS 101 (pdf)

WORK CITED Derivative definition Swap definition Corporate Credit Ratings

Asset Quality Rating ABCDS definition Credit Default Contract Secret Liens article Goldman Sachs profit Donald Mullen Jr. Interesting MBS and CDS slideshare