Describe the general framework of a typical CDS contract and the cash flows between counterparties in the contract. (15 points) What are the key differences between a CDS contract and a conventional insurance contract? Are any of these differences contributing factors to the 2008 crisis? How? (25 points)

QUESTION

ANSWER

Understanding Credit Default Swaps (CDS) and their Impact on the 2008 Financial Crisis

Introduction

Credit Default Swaps (CDS) are complex financial instruments that played a significant role in the 2008 financial crisis. This essay aims to provide a comprehensive overview of CDS contracts, highlighting their framework, differences from conventional insurance contracts, associated risks for buyers and sellers, the liquidity of CDS markets, the concept of CDS basis trades, their impact on interconnectedness among financial institutions, and the role of AIG in the crisis. By examining these aspects, we can gain a deeper understanding of the factors that contributed to the financial turmoil.

Part 1: General Framework of a Typical CDS Contract and Cash Flows (15 points)

A credit default swap (CDS) is a derivative contract between two counterparties, namely the protection buyer and the protection seller. The general framework of a CDS contract involves the following elements:

 Reference Entity: The underlying entity whose credit risk is being transferred.

 Reference Obligation: The specific debt instrument or bond issued by the reference entity.

 Notional Amount: The predetermined face value of the reference obligation (Blessing, 2022).

Premium: The regular payments made by the protection buyer to the protection seller.

Spread: The basis point premium paid annually as a percentage of the notional amount.

Credit Event: Defined events that trigger a payout, such as default, bankruptcy, or restructuring.

Settlement: The process through which the protection seller compensates the protection buyer in the event of a credit event.

Cash Flows between counterparties

– In exchange for receiving protection against a credit event, the protection buyer pays periodic premiums to the protection seller.

– If a credit event occurs (e.g., default), the protection buyer delivers the reference obligation to the protection seller, who pays the notional amount minus the recovery value.

Part 2: Key Differences between CDS and Conventional Insurance Contracts and Their Role in the 2008 Crisis (25 points)

While CDS contracts share similarities with conventional insurance contracts, several key differences contributed to the 2008 financial crisis:

 Insurable Interest: CDS contracts do not require the protection buyer to hold a direct interest in the underlying reference obligation. This created a speculative environment, enabling market participants to bet on the failure of entities without any exposure to the referenced debt.

Regulatory Oversight: Unlike traditional insurance, CDS contracts were largely unregulated, leading to a lack of transparency and risk management practices. This allowed for excessive leverage and the accumulation of systemic risk.

Payout without Loss: CDS contracts allowed investors to purchase protection on bonds they did not own. Consequently, some market participants bought CDS contracts solely for speculative purposes, potentially amplifying market volatility and incentivizing risky behavior.

Risk: CDS contracts are bilateral agreements, and the failure of a protection seller to honor its obligations could expose the protection buyer to significant counterparty risk. This interconnectedness among financial institutions heightened the systemic risk during the crisis.

Part 3: Risks for CDS Protection Buyers and Sellers (25 points)

CDS Protection Buyers

Credit Risk: Protection buyers are exposed to the risk that the reference entity may default on its debt obligations, triggering a credit event.

Basis Risk: There is a possibility that the reference obligation and the CDS contract do not perfectly align, leading to a potential mismatch in payouts.

Counterparty Risk: In the event of a credit event, the protection buyer relies on the protection seller’s ability to fulfill their obligations. If the protection seller defaults, the protection buyer faces significant counterparty risk.

 Liquidity Risk: The protection buyer may face challenges in selling or unwinding the CDS contract due to illiquidity in the market, potentially resulting in losses.

CDS Protection Sellers

Credit Risk: Protection sellers are exposed to the risk of the reference entity defaulting, which would require them to make substantial payments to the protection buyer.

Market Risk: Changes in market conditions, such as credit spreads or interest rates, can impact the value of the CDS contract and potentially lead to losses.

 Liquidity Risk: Protection sellers may face challenges in finding buyers for the CDS contracts they have sold, especially during times of market stress.

Legal Risk: Protection sellers are exposed to legal risks, such as disputes over the occurrence of credit events or the validity of the contract itself.

Part 4: Factors Contributing to the Liquidity of CDS Markets (40 points)

The CDS market on corporate bonds tends to be more liquid compared to the market for the underlying bonds due to several reasons:

Accessibility: CDS contracts allow investors to gain exposure to credit risk without owning the underlying bonds, providing a more accessible and flexible investment vehicle.

Ease of Trading: CDS contracts are standardized and traded over-the-counter (OTC), enabling easier and faster trading compared to the underlying bonds, which often require negotiation and settlement procedures.

Short-Selling Opportunities: CDS contracts enable market participants to take short positions on credit risk, providing an avenue for hedging and speculation, which enhances overall market liquidity.

Diversification: The CDS market covers a broader range of reference entities and obligations than the underlying bond market, allowing investors to diversify their exposure and manage risk more efficiently.

Part 5: Understanding CDS Basis Trades and the 2008 Crisis (40 points)

CDS basis trades involve exploiting pricing discrepancies between CDS contracts and the underlying bonds. This strategy seeks to profit from the relative mispricing by taking offsetting positions in both instruments (Banton, 2022). The profitability of CDS basis trades depends on various factors, including interest rates, credit spreads, liquidity, and market conditions.

In late 2008, negative CDS basis trades experienced significant problems. This occurred due to the dislocation in the market caused by the financial crisis. As the crisis intensified, market participants rushed to purchase CDS protection, driving up demand and causing a significant increase in CDS premiums. However, the prices of the underlying bonds did not reflect this increased risk, leading to a widening of the CDS basis (i.e., the price difference between CDS contracts and bonds). Investors who held negative basis positions incurred substantial losses as the CDS market seized up and liquidity vanished.

Part 6: Interconnectedness of Financial Institutions through CDS Trades (15 points)

CDS trades played a crucial role in increasing the interconnectedness of financial institutions. The use of CDS contracts allowed market participants to transfer and concentrate credit risk among different entities, leading to a web of interconnected relationships. Financial institutions became linked through their positions as protection buyers and sellers, creating complex networks of obligations. This interconnectedness heightened systemic risk, as the failure of one institution could quickly spread throughout the network, contributing to the rapid transmission of financial distress during the 2008 crisis.

Part 7: Role of AIG in CDS Trades and Opinion on the Bailout (40 points)

AIG, the American International Group, was a major player in the CDS market and faced severe financial distress during the 2008 crisis. AIG provided credit protection through CDS contracts, insuring against the default of various entities and their associated bonds. However, AIG had not adequately accounted for the risks associated with these contracts and lacked sufficient capital reserves to meet their obligations (Davidson, 2008). Given the systemic importance of AIG and the potential domino effect its failure could have on the financial system, it was deemed necessary to bail out the company. The government intervention aimed to prevent further destabilization of the financial markets and mitigate the contagion risks associated with AIG’s massive exposure to CDS contracts. While the decision to bail out AIG was highly contentious, it was driven by the need to protect the overall stability of the financial system.

In conclusion, understanding the framework of CDS contracts, their differences from conventional insurance, associated risks, liquidity factors, basis trades, and the role of AIG sheds light on the intricate nature of these instruments and their impact on the 2008 financial crisis. The complex and interconnected nature of CDS trades contributed to the rapid transmission of financial distress and systemic risk, highlighting the need for enhanced regulation, risk management, and transparency in financial markets.

References

Banton, C. (2022). Get Positive Results With Negative Basis Trades. Investopedia. https://www.investopedia.com/articles/trading/08/negative-basis-trades.asp 

Blessing, E. (2022). Reference Entity. Investopedia. https://www.investopedia.com/terms/r/reference-entity.asp 

Davidson, A. (2008, September 18). How AIG fell apart. U.S. https://www.reuters.com/article/us-how-aig-fell-apart-idUSMAR85972720080918