Credit default swaps and the credit crisis

Question 1

Two sides of CDS

Answer 1

On one side, they make it easier for credit risks to be borne by those who are in the best position to bear them, enabling financial institutions to make loans they wouldn’t otherwise be able to make, and revealing useful information about credit risk in their prices. On the other side, CDS are prominent villains -> “worst Wall Street invention” George Sorus, a hedge fund manager, wants most or all trading in CDS to be banned.

Question 2

CDS

Answer 2

– an insurance contract against the default of a particular company

Question 3

Advantages for CDS

Answer 3

• Market efficiency: risk transfer → cost of capital ↓ , liquidity ↑
• Information: CDS price purely based on credit risk
• Implicitly allows short-selling
=>Better allocation of risks; easier for you to pay fixed amounts than to calculate all the risks yourself
• Transparency (improving price discovery)

Question 4

Drawbacks of CDS

Answer 4

• Remove incentives for monitoring

* Perverse incentives to cause bankruptcy (good for you if someone defaults)

Question 5

• True reasons behind the crisis

Answer 5

– No one (investors & financial institutions) expected real estate prices to fall dramatically
– too high leverage & too much investment in real estate

Question 6

Some argue, CDS made the credit crisis worse:

Answer 6

• Derivatives lead to a huge web of exposures across financial institutions. If one fails, it may drag others to fall with it.
• CDS value jumps (usually by large amount) in case of default  collateral might not be enough to protect buyers of insurance in case of counterparty default  additional failures of financial institutions.

Question 7

Reforms for CDS market

Answer 7

• Limit or ban the “naked” position, because it enables investors to short-sell debt.
• Move trading from OTC to exchange
• Move trading from OTC to exchange

Question 8

Why Limit of the naked CDS is not the best idea

Answer 8

• Financial economists believe short-selling helps efficiency;
• Prohibiting naked position would destroy CDS market;
• Then there would be only hedgers (no speculators) => hedgers won’t find counterparties for trade because no liquidity => prices cannot be efficient if investors who see profit opportunities, cannot exploit them.

Question 9

Reasons for moving trading from OTC to exchange

Answer 9

• Reduce counterparty risk;

* Create greater transparency and order in the market.

Question 10

 Difference between CDS and insurance

Answer 10

o You don’t need to have a bond/underlying to buy a CDS (naked positions)
o CDS are traded over the counter, while insurance contracts are not traded.
o May insure default risk of many firms (single-name vs multi-name contracts)

Question 11

 Potential costs of CDS

Answer 11

• Separation of risk bearing and funding decreases incentives for monitoring.
• Perverse incentives to drive a firm into a bankruptcy.

Question 12

Clearing process

Answer 12

all the steps that take place from the trade to completion of the settlement.

Question 13

OTC vs. Exchange-traded

Answer 13

OTC: 
• custom	made
• disorganized	clearing	houses
• unknown	exposure
• provide	market	for	less	liquid CDSs
Exchange-traded: 
• standardized	(size	&	maturity	time)
• counterparty	– clearing	house
• transparency
• not	flexible

Question 14

Reasons why CDS did not cause the crisis

Answer 14

Lehman Brothers & Bear Sterns failed not because of CDS
No one (investors & financial institutions) expected real estate prices to fall dramatically
Too high leverage & too much investment in real estate