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Assess what part credit derivatives played in the 2007-2009 financial crisis and describe how the credit derivative market changed afterwards.

FRM® Part I · Foundations of Risk Management · Credit Risk Transfer Mechanisms · FRM1.FR.4.c

The idea

Credit derivatives did not create the 2007-2009 crisis, but they spread and hid its losses. Large sellers of protection, above all AIG Financial Products and the monoline insurers, wrote CDS on super-senior tranches of structured credit without holding enough capital or collateral. As market values fell and ratings were cut, collateral calls and mark-to-market losses came at once. AIG needed a government rescue in 2008. Bilateral over-the-counter trading made exposures opaque, so counterparty risk was hard to measure. Afterwards, several reforms were introduced. These were standardised contracts with fixed coupons and upfront payments, central clearing through central counterparties, and trade reporting. Higher capital and margin were also required for uncleared trades. Clearing swaps bilateral exposure for exposure to a clearing house, with multilateral netting and margin. It reduces counterparty risk but concentrates it, and it does not remove credit risk.

Formulas

Upfront payment on a standard CDS

upfront = (par spread − fixed coupon) × risky annuity × notional

par spread
the spread that would make the contract worth zero
fixed coupon
the standard coupon the contract pays
risky annuity
the present value of one unit of annual premium, allowing for default
notional
the notional amount

The buyer pays when the par spread is above the fixed coupon, because the coupon is too low for the risk; the seller pays when it is below.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature of the credit default swap positions of AIG Financial Products most directly led to its liquidity crisis in 2008?

  1. It had bought protection from monoline insurers who then defaulted before AIG could be paid.Why not: Reverses the roles; AIG was a large protection seller, not mainly a buyer from monolines.
  2. It had used CDS to speculate on sovereign defaults, and the sovereigns defaulted in 2008.Why not: Wrong cause; the losses came from structured credit tied to mortgages, not from sovereign defaults.
  3. It had cleared all its CDS through a central counterparty whose margin calls were too large.Why not: Anachronistic; AIG's positions were bilateral and uncleared, which is the transparency problem reforms later targeted.
  4. It had sold large amounts of protection on super-senior CDO tranches, with collateral calls triggered by falling values and its own downgrade. - correct

AIG Financial Products wrote protection on super-senior tranches of multi-sector CDOs. As values fell and AIG was downgraded, its counterparties made collateral calls it could not meet, leading to government support.

A harder one

After 2009, standardised single-name CDS trade with a fixed coupon (such as 500 basis points) and an upfront payment. A protection buyer takes USD 10 million notional on a name whose par spread is 800 basis points. The risky annuity (present value of one unit of annual premium) is 3.6. The upfront payment is closest to:

  1. Buyer receives USD 1.08 millionWhy not: Sign error: when the par spread exceeds the fixed coupon the buyer pays, not receives, the upfront amount.
  2. Buyer pays USD 2.88 millionWhy not: Uses the full 800 basis point spread x 3.6 x notional instead of the difference from the fixed coupon.
  3. Buyer pays USD 1.08 million - correct
  4. Buyer pays USD 0.30 millionWhy not: Uses the 300 basis point difference x notional but leaves out the risky annuity of 3.6.

Upfront = (par spread - fixed coupon) x risky annuity x notional = (0.08 - 0.05) x 3.6 x 10 = USD 1.08 million paid by the buyer, since the contract's coupon is too low for the risk.

The hardest tier

Which statement gives the most accurate assessment of the role of credit derivatives in the 2007-2009 crisis?

  1. CDS on single-name corporate debt generated most of the losses, as corporate defaults surged.Why not: Wrongly blames corporate single-name CDS; the biggest losses came from mortgage-linked structured credit.
  2. Opaque bilateral CDS on structured credit, concentrated in thinly collateralised sellers, spread losses and counterparty fears across institutions. - correct
  3. Because every CDS has a buyer and a seller, gains and losses offset, so CDS posed no systemic risk.Why not: Ignores that the seller may be unable to pay; zero-sum on paper does not remove counterparty risk.
  4. CDS caused the housing price bubble by making mortgage lending cheaper.Why not: Overstates the role; the bubble and weak lending standards are separate, and CDS amplified rather than caused it.

CDS are zero-sum between two parties only if both can pay. In 2008 concentrated, opaque positions with weak collateral meant a seller failure (AIG, monolines) threatened many buyers. CDS amplified the crisis rather than causing the housing bubble.

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