of Financial Institution ( part 1)

Philippe Grégoire

Luc Henrard

Credit Default Swap

“Are you advocating a ban on the holding of open position of CDS related to sovereign counterparties?”.

, Loïc Sarton and Cédric Percy

RecoveryCDS Premium

“Are you advocating a ban on the holding of open position of CDS related to sovereign counterparties?”

Introduction : Credit default swap are subject of considerable analysis. On one hand, they seems like a high liquid derivative product that serve for securization of our bond or others debt. In addition, it help some financial institution to make loans they would not otherwise be able to make.1

On the other one, a lot of observers and analysis have pointed out the role of the CDS in the financial crisis. Searching the internet on Google, a search under “worst wall street invention” come up with the credit default swap as the first entry.2

Many risk managers and hedge fund manager want to ban the CDS. “Are you advocating a ban on the holding of open position of CDS related to sovereign counterparties?”. This report will put light off this question, first this report will describe the processes of the CDS then we will see what was the role of the CDS in the present crisis. In the third part, we will come-up with PRO’s and CON’s of the CDS. Finally we will end this report by given a response of the previous question.

Mechanism of Dredit Default Swap

The CDS is a bilateral contract between two parties : the seller and the buyer. The Buyer pay a fees call premium to the seller. Thus if the underlying asset goes into default the buyer will receive a payoff, the payoff depend of the recovery rate, an obligation can be reimbursed for 50% so the seller have to pay the other 50% . Such mechanism allow company to reduce their capital thank to the risk weighting asset in the Basel II regulation. But the cost of the premium depend on the quality of the reference entities.

What is an “open position”Any investment that has been entered but not closed. The fact that we held CDS without the underlying asset ( loan, obligation) so we have an open position, it mean that we are expose to the market risk.

PRO's and CON'sFirst he CDS are Off-balance sheet activities so it’s difficult for the market participant to have an idea of the size of a such market. The basel II regulation have open an arbitrage opportunity that caused an excessive off-bakance sheet leverage.

1 STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives - Volume 24, Number 1. p.12 STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives - Volume 24, Number 1. p.1

Buyer portection (Short credit risk)

Seller of protection (Long credit risk)

Secondly the banker didn’t fully understand the risk of such new complex product as the CDO. This lack of understanding and transparency lead to bad risk managing. Eg: the seller of CDS insure product that they don’t really know what was behind this CDO, they had an over reliance on the external rating.

CDS allowed some smaller companies and non-financial institution to issue bond, because these bond was covered by protection, in addition it has a positive impact on the liquidity in the bond market. On the other hand, the companies that included CDS indices must face higher bond yield spread than the other one.

CDS isn’t really a new product, like other derivatives products it appeared 20 years ago, no one really paid attention of the importance this market take and the fact that it hide the financial risks. Moreover, these products can lead to increased volatility and market overreaction, hence these characteristics probably accelerate the crisis.

The CDS market is an Over The Counter market, in other word there is not standardized product, the two part decide of the specificities of the contract. This market was too big to be not organized and he was unregulated. The macroeconomic aspect was hidden but it violently come in September 2008.

Some argues that CDS is not only an protection instrument but it become a real speculation instrument.

“Particulars problems can arise with naked short selling and CDS. Many jurisdictions are moving to ban or seriously limited naked instruments. When Greece had problems, investor rushed to buy CDS, including investors who didn’t own Greek bonds, but who would get paid in the event of a default. Greater demand for CDS means higher price for this form of insurance, making the bonds seem riskier, so forcing higher interest rate on the government and hurting the economy”i3

Some argues that the CDS like other derivative product only put light off the weakness of several companies or countries. Only reflected the real value of this bond thank to a more liquid bond market.

At the start of the CDS, it was promote as an instrument which will disperse the risk but in reality it has done the opposing effect. A major part of the risk was concentered to organism who accept to buy risk such as AIG insurance. Finally it was the money of the American taxpayer which was used.

This system is mainly based on external ratings, which have made terrible mistake in the perception of the risk.

3 uropean Parliament (08-02-2011) http://www.europarl.europa.eu/news/en/headlines/content/20110204STO13204/html/Short-selling-banking-on-others%27-misfortune-or-just-hedging-bets

Evolution of the CDS and impact of the sovereign debt

This graph gives an illustration of the cost of insuring sovereign debt against default. End 2008, the subprime crisis cause an increase of the CDS of countries with bad quality debt. Because of this there was an increase too in the return such countries has to give to have financial resources and it accelerate the sovereign debt crisis. As we can see in the begins of 2010 there was a double dip due to the fears of some European sovereign debt. The CDS accelerate the fall down of the value Greek debt because of the big number of CDS buy for this countries.

Role of CDS in the crisisFrom an insurance tool to a speculative tool…

In 2007, just before the financial crisis, the notional value of the CDS market was about 62 trillion USD whereas the total value of the assets insured was about 5 trillion USD4. We can easily understand that 80% of CDS investments were purely speculative and became, at first sight, an “efficient” tool for banks to make billions.

AIG Insurance sold alone around 500 billion USD. However, on September 2008, the FED had to make an enormous loan of 85 billion USD to AIG in order to avoid its bankruptcy…

For the financial crisis of 2008, four roles played by CDS have been highlighted5;

a) CDS created ambiguity about who eventually bears credit riskb) CDS enhanced the systemic risk by making the principal CDS sellers (AIG,…) mutually

vulnerable

4 DEMIRGUC-KUNT A., EVANOFF D., KAUFMAN G. (2011). The International Financial Crisis: Have the rules of Finance Changed ?, World Scientific, p.3745 McGrawHill Company (2008). http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CDS.pdf ( consulted on 05-11)

c) CDS fostered CDS sellers to assume risksd) CDS accelerated and played a role in economic cycles by its pro-cyclicality

Moreover, as we have previously seen, banks have largely used CDS in order to mitigate their regulatory capital requirement. This has led to an important increase in the leverage of banks (huge balance sheet) and thus, in the exposure they had.

Indeed, Yale economist has observed that “the financial crisis and recession (…) has been more violent because of the creation of the derivative credit default swap market for mortgages in 2005, just at the top of the leverage cycle”6

The CDS were also widely present during the sovereign debt crisis.

Since the beginning of 2010, the sovereign debt crisis in Europe has

ConclusionOur answer to the question is yes. We think that we should ban all speculative instrument relative to sovereign debt because countries are not like companies. The consequence of the bankruptcy of a country is much bigger than for a company. And according to a lot of survey and analysis speculative instrument increase the probability of default of a country or company.

Nevertheless it give a good view of the financial health of a country. In addition, It put political on pressure to take real measure to cope with their debt issues.

We think that we must standardized CDS this could lead to several benefit: It would improve transparency and reporting of positions boost confidence and avoid panic, it would allow the supervision of the clearing house and to limit the size of this market.

6 Geanakoplis J. (2009) Solving the Present Crisis and Managing the Leverage Cycle, Yale University, p.49

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