NATIONAL ECONOMICS UNIVERSITY

SCHOOL OF ADVANCED PROGRAMS

CREDIT DEFAULT SWAPS

A brief introduction about Credit Default Swap and its contribution to financial
crisis 2008

Name: Vũ Mạnh Việt

Class: Advanced Finance 60B
No. 53
ID: 11185592
Course: Principles of Investment
Intructor: Dr. Trần Tất Thành

Hanoi, May 2021

Contents
I. Introduction.........................................................................................................................................2
II. What is a CDS.......................................................................................................................................3
III. How CDS works?..............................................................................................................................4
IV. Benefits............................................................................................................................................4
V. Shortcomings.......................................................................................................................................4
VI. What has CDS contributed to the financial crisis of 2008-2009.......................................................5
VII. Bibliography.....................................................................................................................................6
 I. Introduction

Credit default swaps (CDS) were introduced by J.P. Morgan in 1994. Morgan Inc. would offload
credit risk to defense dealers from its balance sheet. At that time, no one had imagined that CDS
would play such an important part in the everyday lives of brokers, policymakers, and financial
economists in the twenty-first century. Although there were quite plenty of research and papers
related to this topic, some internal issues are still hotly debated.
The controversy about CDS is underscored in an early survey by Stulz (2010). CDS have been a
factor in recent financial scandals, for example in the subprime crisis of 2007–2008, in instances
of trading losses by the London Whale at J. P. Morgan Chase in 2012, and in the $1.86 billion
settlement between a group of plaintiffs and a number of Wall Street banks, which were accused
of violating US antitrust laws through anticompetitive practices in the CDS market. Some hedge
funds, such as Napier Park and BlueMountain Capital, have profited from the CDS industry,
including the latter, which profited from the popular London Whale event. Similarly, CDS plays
a role in a significant portion of the hedging and trading operations of the world's largest banks.
For example, J. P. Morgan has several trillions of dollars of CDS notional outstanding (Off.
Comptrol. Curr. 2015). CDS occupy a prominent position in global financial regulation,
including in the Basel III guidelines of the Bank for International Settlements, the Dodd–Frank
Wall Street Reform and Consumer Protection Act in the United States, and the Markets in
Financial Instruments Directive (MiFID II) in the European Economic Area (the European Union
plus Iceland, Liechtenstein, and Norway). Indeed, the role played by the purchase of naked (i.e.,
uncovered) sovereign CDS in shaping pan-European securities regulations clearly demonstrates
that the controversy surrounding CDS cannot be reduced to the exchange of sound bites between
the prominent investor, Warren Buffett, who has denounced derivatives as weapons of mass
destruction (Buffett 2003), and the former Chairman of the Federal Reserve System, Alan
Greenspan, who has argued in favor of CDS as efficient vehicles of credit risk transfer
(Greenspan 2004).
 II. What is a CDS

According to Bodie, Kane and Marcus, co-author of Essentials of Investments, a credit default
swap is in effect an insurance policy on the default risk of a corporate bond or loan. To illustrate,
in July 2011, the annual premium on a five-year Citigroup CDS was about 1.3 percent, implying
that the CDS buyer must pay the seller $1.30 per $100 of bond principle. The lender receives
these annual fees for the duration of the deal, but in the case of a default, the buyer must be
compensated for the reduction of bond value.
In other words, they work similarly to insurance policies. Insurance, on the other hand,
guarantees against physical harm that occurred prior to the deal and only pays out in the event of
an event, while CDS involves regular collateral reporting. It means that you can purchase or sell
CDS based on the credit market improving in order to make more money to prevent potential
damages without the occurrence of a default incident. You can't trade insurance policies based on
environmental changes. CDS are also over-the-counter (OTC) contracts. CDS for the underlying
shares may also be purchased. A CDS on Dell bonds, for example, can be purchased without
buying Dell bonds. As a result, the CDS market has expanded over time (Murphy, 2009). The
estimated notional volume remaining in CDS, for example, increased from $34.4 trillion in 2006
to $62.2 trillion in 2007. Nevertheless, due to the expiration of expired contracts, the figure was
reduced to $26.3 trillion at June 30, 2010 after the financial crisis, as reported in the introduction
section.
In another way, a CDS is a financial derivative or contract that allows an investor to “swap” or
offset his credit risk with that of another investor. It is considered as one of the most widely used
type of credit derivative and a powerful force in the world markets. According to Barclays Plc.,
the value of CDS is increasing gradually, despite a negative reputation in the financial crisis of
2008-2009.
 III. How CDS works?

A credit default swap is a financial derivative/contract that allows an investor to “swap” their
credit risk with another party (also referred to as hedging). For example, if a lender is concerned
that a particular borrower will default on a loan, they may decide to use a credit default swap to
offset the risk. To do this, the lender will buy a credit default swap from another investor. If the
borrower defaults, the investor will reimburse the lender, thereby protecting them from risk.
Credit default swaps seems very similar to insurance policies, although they’re usually used to
protect against the default of high-risk sovereign debt, corporate debt, emerging market bonds,
municipal bonds, junk bonds, collateralized debt obligations, and mortgage-backed securities.
It’s also important to note that the buyer of the credit default swap will need to make quarterly
payments to the seller for providing the swap, not unlike an insurance premium.

IV. Benefits

When it comes to joining the CDS market, there are a number of advantages that portfolio
managers should take advantage of. First and foremost, a manager can effectively create
diversified portfolios because CDS can be exchanged under a variety of terms, including those
with debt in foreign currencies. Second, investors can see that liquidation through CDS contracts
is easier to come by. In order to sign a CDS, protection buyers do not need to own the underlying
properties. Furthermore, buyers have the option of choosing the contract's maturity. About the
fact that the normal period is five years, they will also purchase shorter maturities for greater
returns. Finally, CDS contracts should be used as a fund balance for the majority of investors.
They can easily go short or long. As a result, it opens up the possibility of risk reduction.
Furthermore, the most fundamental interpretation of CDS' benefit is dependent on its description.
Credit risks are transferred from one entity to another. Investors may use these contracts to
protect themselves against the uncertainties of stock price fluctuations. Consequently, from the
standpoint of a manufacturer, it ensures that he will increase demand while lowering commodity
costs. (2010, Banque de France, p. 10)

V. Shortcomings

CDS has a number of major disadvantages. Firsly, until 2010, they were unchecked. There was
no federal department to ensure that the swap seller had enough money to pay the buyer if the
bond defaulted. As a result, they will set off a cascade of events that could bring the whole credit
market down. In reality, the majority of financial institutions that sold swaps lacked sufficient
funding. They just had a limited portion of the funds necessary to cover the premiums. Until the
debtors defaulted, the scheme succeeded. Unfortunately, the swaps offered bond buyers a false
sense of protection. They purchased more risky debt, believing that the CDS would shield them
from losses.
 VI. What has CDS contributed to the financial crisis of 2008-
2009

The credit crisis of 2009-2009, when lending among banks and other financial institutions
effectively seized up, was in large measure a crisis of transparency. The most serious issue was a
general lack of trust in the financial status of trade counterparties. If one company cannot be
certain that another will stay viable, it is understandable that it will be unable to lend to it. The
demand for loans dried up as concerns over consumers' and trading partners' credit exposure
reached heights not seen since the Great Depression.

More than $45 trillion had been deposited in swaps by mid-2007. That was more than the total
amount of money deposited in US bonds, mortgages, and Treasuries. The stock market in the
United States was valued at $22 trillion. Mortgages totaled $7.1 trillion, and the U.S. Treasury
bonds is valued at $4.4 trillion.

Lehman Brothers are smack dab in the middle of the financial meltdown. The company had a
debt of $600 billion. Credit default swaps "hid" $400 billion of that. American International
Group (AIG), Pacific Investment Management Company, and the Citadel hedge fund were
among the firms that offered the swaps. These businesses did not anticipate any of their debts
being due at the same time. AIG didn't have enough cash on hand to finance swap contracts
when Lehman went bankrupt. It had to be bailed out by the Federal Reserve. Worse still, banks
used derivatives to hedge complex financial instruments. They exchanged derivatives on
uncontrolled exchanges with traders that had little links to the underlying properties. They were
unaware of the dangers they were taking. Swap sellers like MBIA, Ambac, and Swiss Re were
hard hit as they defaulted. The CDS industry collapsed overnight. No one wanted to buy them
because they knew the insurance wouldn't cover major or widespread defaults. They built up
reserves and made less loans as a result. Small companies and leases were unable to obtain
funding as a result of this. There were two major causes that contributed to unemployment
reaching new highs.

The Dodd-Frank Act, enacted in the wake of the financial crash, called for stricter regulations
and amendments. The establishment of a single clearinghouse for credit derivatives such as CDS
contracts is one of its proposals. A scheme like this will promote position clarity, allow for the
netting of offsetting positions, and enable regular recognition of gains and losses on positions
through a margin or collateral account. If liabilities start to pile up, roles must be unwound until
they reach unsustainable amounts. Allowing traders to reliably measure counterparty risk and
mitigating the risk by margin accounts and the clearinghouse's additional backup will go a long
way toward reducing systemic risk.
 VII. Bibliography

Bodie, K. M. J., 2010. Essentials of Investments. United States of America, Patent No.
2012020874.
Kuepper, J., 2021. Investopedia. [Online]
Available at: https://www.investopedia.com/terms/c/creditdefaultswap.asp#:~:text=A%20credit
%20default%20swap%20(CDS)%20is%20a%20financial%20derivative%20or,with%20that
%20of%20another%20investor.&text=To%20swap%20the%20risk%20of,the%20case%20the
%20borrower%20defaults.
[Accessed 3 May 2021].
Pinsent, W., 2020. Investopedia. [Online]
Available at: https://www.investopedia.com/articles/optioninvestor/08/cds.asp
[Accessed 3 May 2021].

Stulz RM. 2010. Credit default swaps and the credit crisis. J. Econ. Perspect. 24:73–92

Buffett W. Berkshire Hathaway Inc. 2002 annual report. Berkshire Hathaway, Omaha, NE.
http://www. berkshirehathaway.com/2002ar/2002ar.pdf

Greenspan A. 2004. Economic flexibility. Remarks at Her Majesty’s Treasury Enterprise

Conference, Jan. 26, London.
http://www.federalreserve.gov/boarddocs/speeches/2004/20040126/default.htm

Murphy, R.P. (2009) Did deregulated derivatives cause the financial crisis. [Online]. Available
at: http://www.thefreemanonline.org/featured/did-deregulated-derivatives-cause-the-financial-
crisis/ (Accessed: 15 Nov 2011).

Banque de France (2010) ‘Derivatives: Financial Innovation and Stability’, FinancialStability

Review, pp. 1 – 200. [Online]. Available at:
https://blackboard.uwe.ac.uk/webapps/blackboard/execute/content/file?
cmd=view&content_id=_2698718_1&course_id=_200264_1 (Accessed: 15 Nov 2011).