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CREDIT DEFAULT SWAPS : IMPACT ON THE PRESENT FINANCIALCRISISA/ CDS’s mechanism1- DefinitionBank B bought a $10 million bond from company A ( referenceentity). If B doesn’t want to keep the risk, it has 2 choices:-sell the bond-transfer the credit risk B can eliminate most of credit risk of A by entering a CDS.A CDS is a contract by which 1 party( protection seller), agrees toreimburse another party( protection buyer) in case of default on afinancial obligation by a 3
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party( reference entity).B can purchase protection against its entire loan to A or for aportion of the principal amount of $10 million bond. Amount of protection purchased by B is called: notionalamount.CDS market is a dealer market: transactions take place OTC. B’sswap is with C, a dealer that operates on this market.2- Structure of the CDSC agrees to pay $10 million if A defaults and B agrees to pay apremium annually to C. Size of this payment will reflect risk thatCbelieves it’s assuming in protecting B against A’s default.B will require a collateral from C in order to assure C’sperformance.As a dealer, C wants to keep a matched book and will require anoffsetting hedge. So, C will enter a CDS with D and D postscollateral.Risk of B is transfered to C and then to D and eventually to E.Each transaction between counterparties is a separatetransaction: B can look only to C if A defaults and C must look toD.
 
3- Does this string of transactions create more risks?Each of the parties in the chain has 2 distinct risks: that itscounterparty will be unable to perform its obligations before orafter A defaults.If C is bankrupt before A defaults, B will have to find a newprotection seller.If C defaults after A default, B will lose its protection.Premiums are negociated based on current views of A’s defaultrisk. Premiums, also known as spreads would be more costly thanoriginal premium.Either buyer or seller in a CDS transaction may be in the money atany point. CDS spreads may be rising or falling depending on themarket’s judgement of the reference entity credit:
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if the credit of the reference entity begins to decline, CDSspread will rise. The buyer is then in the money and will paya lower premium than risk would warrant. The seller,then,may have to post new collaterlal.
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if reference entity credit improves, CDS spread will fall andthe seller is in the money. The buyer may have to put up newcollateral to ensure it will continue to make premiumpayments.Assuming no other defaults among the parties, there is asettlement among them, in which E is the ultimate obligor.Failure of a large participant can be at the origin of a cascade of losses.But CDS move the risk from B to C, D or E. They don’t increase therisk created when B made its loan to A.No matter how many defaults occur in the series of transactions,ther is still only one $10 million loss.Only question is who ultimately will pay it.A month after Lehman Brothers bankruptcy, swapsin whichLehman was an intermediary dealer were settled bilaterally, andswaps written on Lehman itself ($72 billion notionally) weresettled by Depositary Trust and Cleaning Corp. With a total cashexchange among all counterparties of $5.2 billion.
 
This illustrate the fact that gross notional value is much greaterthan net notional value, as many sellers of CDS have purchasedCDS on the same reference entity to hedge their risk. According toestimates, net notional value of all outstanding CDS contracts liesbetween $3 trillion and $15 trillion vs a gross notional value of $55 trillion.B/ How CDS create systemic risk 
 
1- CDS could help to create asset bubblesWhen a bank has purchased a CDS on a loan, it is no longerconcerned about the risk of borrower’s default.As a result, banks have incentives to extend as much credit todefault-prone borrowers as legally possible, as this category willpay higher interest rates than investment grade borrwers.2- CDS could cause the collapse of an institution too big orinterconnected to failCDS transactions are essentially in the OTC market. This market isnot transparent and pricing information is not available. Due tothis lack of relevant information, at least some CDS are pricedincorrectly when sold, or should not have been sold at all.If a large financial institution buys or sells too many CDS withoutproperly anticipating the amount of collateral it will need to pay,or the risk its counterparties would be unable to pay, then it couldsuddenly be driven into insolvency.Goldman Sachs, for instance, has 9875 outstanding CDS contractsreferenced to it, with a net notional value of $6.5 billion and agross notional value of $94 billion. This means the average CDSreferenced to Goldman has been offset 14 times. So, 14 firms arelinked in this chain of transactions.3- CDS are at the origin of a debt decouplingThey separate the economic interests of creditors from theircontrol rights. While the creditor maintains control rights over thedebt, the CDS seller takes the economic interest in the debt.This can create systemic risks by:-subjecting contractual creditors to moral hazard. Moral hazardbeing defined as the tendancy of insurance to alter the insured’sbehavior. Actually, a creditor who has hedged with CDS hasn’t anyinterest in wasting time and resources monitoring the borrower.-giving debtholders a negative economic interest to destroy value,if their ownership of debt is less than their ownership of CDSinsuring underlying debt.
 
C/ Role of CDS in the current financial crisis1- The subprime mortgage crisisBetween 2001 and 2006, excessive lending led to a large numberof default-prone home mortgages. Billions of dollar of these highrisk loans were securitized in the form of Collateralized DebtObligations (CDOs). A lot of investors of subprime CDOs werefinancial institutions, and they hedged their risk by purchasingCDS on their underlying debt.
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