Credit Risk Management and the Financial Crisis - Are Credit Default Swaps to Blame?

Credit default swaps (CDS) have been widely blamed by politicians, regulators and the media for their role in the ongoing crisis. What was their original purpose, and how have they contributed to the turmoil in the economy?

A credit default swap is a credit derivative; this is a financial instrument whose value depends on an underlying or reference asset, such as a bond, bank loan, mortgage, etc. Credit derivatives enable financial institutions to hedge the risk of losses to their portfolios due to events such as bankruptcy or ratings downgrades.

Credit default swaps were introduced by Wall Street in the mid-1990s as a form of insurance against credit risk. A CDS is an agreement between a protection buyer and a protection seller in which the buyer makes a regular series of payments in exchange for a settlement in the event of a credit loss by a reference asset.

Due to their flexibility, the popularity of credit default swaps grew rapidly, giving rise to more complex variations. One of these is the credit default swap index, in which the reference asset is the average value of a set of bonds; these bonds can be chosen from a specific sector of the economy, ratings class or country. This product enables hedgers to buy protection from a broad range of assets at a relatively low cost.

STRUCTURED PRODUCTS

The explosive growth of the CDS market, whose size reached an estimated $60 trillion by 2007, inspired Wall Street to produce progressively more sophisticated credit derivatives. The most complex of these are known as structured credit products. These are created when a financial institution acquires a pool of risky assets and distributes the promised cash flows to investors through a series of classes or tranches. The tranches are segregated by credit risk, with the riskiest tranches offering the highest potential rate of return. This type of structure increases the choices available to investors, who can easily customize their exposure to credit risk.

One of the most important structured credit products is the Collateralized Debt Obligation (CDO). A CDO is typically backed by extremely risky assets, such as sub-prime mortgages, low-rated corporate bonds, even tranches of other CDOs. In order to increase the attractiveness of a CDO, the issuer may sell protection to investors through a CDS.

WHAT WENT WRONG?

In spite of the numerous benefits associated with credit default swaps and other credit derivatives, they are extremely risky products, both for buyers and sellers. Warren Buffet famously compared derivative securities to weapons of mass destruction, due to their potential for catastrophic losses. In the rush to earn profits, many financial institutions overlooked the risk stemming from their positions in credit derivatives. In particular, the CDS market enabled firms to take huge speculative positions on credit risk, since there are no legal requirements for protection sellers to own the reference asset or hold capital as a cushion against potential losses.

The tipping point came when the number of defaults among sub-prime mortgages began to surge, triggering sizable credit losses, especially among leveraged products such as CDOs. The inability of protection sellers to cover their losses further magnified the crisis; many investors who believed that they were insured against credit losses saw the value of their holdings plunge. The crisis saw the disappearance of Bear Stearns, Lehman Brothers and Merrill Lynch, while bond insurer AIG required a massive government bailout to survive.

The fallout of the crisis has led to calls for reform of the credit derivatives markets; some proposals have included the creation of a clearinghouse, which would reduce counter-party risk and increase the transparency of the market. Regardless of the reforms that are enacted, CDS and other credit derivatives will continue to be used by financial institutions as part of an overall risk management strategy. There will be less use of CDS as speculative instruments, as market participants have hopefully learned that CDS can be powerful tools when used correctly, but can wreak havoc when used for gambling purposes.

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