FIN 330 CDS - Spring FIN 330 Chang - CDS Extra Credit Reading notes. Use this to construct PDF

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Spring FIN 330 Chang - CDS Extra Credit Reading notes. Use this to construct the majority of your extra credit assignment...

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FIN 330: CDS Extra Credit Presentation Guideline: I expect you to give a good summary of the article and come up with your own examples/opinion. You can just focus on the questions below. Reading the article will be enough to answer those questions. On the other hand, if you have any other related resources/reference that you would like to share, that would be great. The presentation should last 15 min. Explain the mechanics of Credit Default Swaps How does it work? Why do people want to enter a CDS? Explain the example of CDS on Companies and on Subprime Mortgage-Backed Securities. 2) Explain the background of CDS market (such as, the size and the growth) 3) What are the benefits and the costs of credit default swaps? How credit default swaps may have contributed to the crisis?

CDS Mechanics  Akin to insurance contract (with regard to CDS contract holder) a) ‘name’ or ‘reference entity’ = the company whose cost of default is being insured against b) Holder plays premiums over time c) If company defaults, CDS allows exchange of any corporate bonds owned (now worthless) for principal amount of the bonds, or Principal – current value i) *Bonds can be devalued (via rate hikes, credit rating degradation, etc.), but these aren’t ‘insured’  2 differences b/w CDS and Insurance a) CDS: No direct economic exposure required to purchase contract (you don’t have to hold the bonds) b) CDS are tradeable over-the-counter (no central exchange)  CDS Background (market size, growth)  C/B Analysis of CDS  Pros: a) Theoretically, should improve efficiency of DCM 1. Investors can shift credit risk 2. Shifts credit risk to those more able to bear it 3. Greater transparency in pricing credit, via separation of cost of funding and credit risk 4. THEREFORE, should reduce WACC b) Increases firm access to capital, by reducing capital issuer’s exposure to risk  Cons: a) Theoretical pros, practical cons 1. CDS can mimic effect of short-selling, which can make a market destabilizing and less reactive to new info 2. 3. Separation of funding and credit risk may disincentivize strong monitoring of credit because CDS takes skin out of the game (p. 76, bank has less incentive to

monitor, and CDS writer can’t monitor credit risk as well as the bank/debt issuer) b) Incentivizes investors to encourage bankruptcy, if refinancing doesn’t trigger a CDS payout

CDS role in 2008 (Subprime Mortgage-Backed Securities)  Names o “60 Minutes” called CDS on SP-MBS a “bet that blew up Wall Street” o Google search, “worst Wall Street invention” had CDS as 1st entry  CDS Mechanics on MBS o MBS = Pool of mortgages, with notes issued against them  Payouts begin in the Senior tranche with AAA ratings  Lowest tranche may not get paid completely, if defaults arise o CDS on Corporate Bond vs MBS tranche  Corporate Bond: event of default or restructuring is well-defined  MBS tranche: rising level of defaults  debt payments reduce but continue, and don’t lead to bankruptcy filing…. THEREFORE: o MBS CDS insures entirety of principal amount of AAA tranche  Ex. MBS, AAA tranche has principal amt of $100m  IF  Defaults wipe out $1m, so principal balance falls to $99m  THEN  CDS pays $1m to investor; CDS continues to pay until maturity  ABX indices = basket of CDS on subprime mortgages of the same tranche o 2007, indices fall, b/c subprime securities defaulted o Allowed investors:  Insight into subprime market w/o direct ownership  Exposure to subprime mortgages, w/o direct ownership  CDS on Subprime MBS o Benefits to invstors  Improved price discovery  Ability to hedge risks of subprime mortgages o Criticisms  Market for Subrpime MBS CDS inefficient  Bank of England, ABX overreacted to  Theoretical Benefit failed: CDS allows credit risk to shift over to those who can bear it better:  Sellers of CDS didn’t have ability to bear the risks (ex. AIG, other “monoline” insurance companies that mostly insured munis)  CDS encouraged excessive risk behavior, especially in a time when: o Mortgages to put into MBS was in high demand o Started putting subprime mortgages in, still rated AAA o Started predatory lending practices  No income verification  Adjustable rate mortgages (ex. 1-2% for 2 years, 6% thereafter)...