Can We Expect A Regulated CDS Market?
Xilin Yang (Celine)
The article introduces credit default swaps and explores the problems of the credit derivatives. By analyzing the AIG’s bailout, the article describes the regulation gap in the CDS market and states the regulation reform after the crisis. Part I is background, generally introduces the Wall Street crisis. How it happened? What consequence it has? Part II is mainly about AIG’s CDS business: how AIG got involved in the crisis and why the biggest world insurance company suddenly collapsed. Part III is about credit default swaps: definition, construction, and problems. Part IV is concerned on the regulation reform after AIG’s failure.
Wall Street Crisis
Speaking of the Wall Street crisis, people all know it proceed from subprime crisis. The relatively low interest rate prompts banks to issue large amount of housing loans. To transfer default risk embedded in those loans, investment banks package those loans and mortgages into student loans, car loans and credit card debt, which form the so-called collateralized debt obligation (CDOs). All these derivatives depend on the housing loans. In the era of low interest rates, house prices rise rapidly and promote the rapid development of the housing loans business. With steady stream of housing loans into financial derivatives products, different ranks of products are packaged to sale out. The good view of economy makes those potentially risky CDOs popular with retirement funds. Lenders didn’t care anymore about whether a borrower could repay; the investment banks earned more money on selling more CDOs; the rating agencies had no liability if their ratings of CDOs prove wrong. Everyone in this securitization food chain made money. Ever one was happy until the market for CDOs collapsed. By 2008, home foreclosures were skyrocketing, and the securitization food chain imploded. In March 2008, the investment bank Bear Stearns ran out of cash, and was acquired for $2 a share by JPMorgan Chase. On September 7, 2008, Treasury Secretary Henry Paulson announced the federal takeover of Fannie Mas and Freddie Mac, giant lenders on the brink of collapse. On September 12, 2008, Lehman Brothers had run out of cash, and the entire investment-banking industry was sinking fast. Merrill Lynch was also on the brink of failure. Several major financial institutions failed during this tragedy. AIG is the only one insurance company. AIG’s CDS Business
How AIG involved in financial crisis?
There is no problem with AIG’s insurance business. What pull AIG into the abyss is its subsidiary—AIG Financial Products Corporation (AIGFP). AIGFP issue a large number of credit default swaps (CDSs) on super senior tranches of multi-sector collateralized debt obligations (CDOs.) For investors who own CDOs, credit default swaps work like an insurance policy. An investor who purchased a credit default swap pays AIG a quarterly premium. If no credit event occurs the protection seller retains the premium payment, while when the CDOs goes bad, AIG promises to pay the investor for their losses. Selling CDS became a significant and profitable business for AIG. AIG’s Financial Products division in London issued $533 billion worth of credit default swaps at the year-end 2007, many of them for CDOs backed by subprime mortgages. Investors welcome CDS, since they didn’t need to worry about counterparty credit risk any more. Eventually they would get compensation no matter what happened. Banks are also interested in buying CDS to convert their assets into triple-A rate assets. Approximately $379 billion of AIGFP’s CDS were written to provide European financial institutions. Under regulation, European lenders, especially banks, have to set aside reserve to cover the potential losses on their loans. By owning CDS, they off-loaded the risk to AIG. The so-called “free money” CDS turns out to be a nightmare of AIG. Due to the...
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