Credit Default Swaps: A Plan Leading For Next Global Crisis The roots of subprime crises can be traced

back to as early as 2001, when the terrorist attacks happened and US economy had started reeling under immense pressure and that was also the period when dotcom bubble had burst. During that time in order to spur growth, the Fed flooded the US banks with loads of liquidity. People were encouraged to borrow and savings plummeted. Loans were given to all and sundry including NINJA(No Income No job assets). That era was also an era of low interest rates. Bankers aggressively started lending loans at cheap rates and people who could not even afford a proper house, with the help of banks now owned a house. By this time we all know why subprime crises happened, who were the parties involved and what impact it has had on world economy. In fact the world economy is still reeling from its impact. Derivatives and Sub- Prime Crisis A derivative is a simple contract between two institutions that ensures payments on a particular schedule based on agreed upon criteria. In theory, CDS provide securities¶ owners a
means to cheaply insure against their default. By paying a small premium (or series of premiums) [usually far smaller than the security's yield] the risk of default is swapped to the CDS seller.

In theory, as with all derivatives (in a former life I used to trade these things), sellers can instantaneously hedge (for instance, by selling the security issuer¶s stock, bond, or currency) the assumed risks, deriving (sellers hope) profit from the received premiums less any hedging costs. Giving loans do not amount to crises that we are witnessing today. Banks do make provisions against loans and their required to keep some amount of capital aside i.e. minimum 8% according Basel norms. Many people look at these loan defaults and see only the potential to profit from someone's failure, and certainly the potential for speculation exists. Eg. Bank of America lends to a X Company but does not want to take the full credit risk. So, Bank enters into a CDS deal, say with Credit Suisse; under this, Credit Suisse promises to pay Bank of America if the corporate defaults. The money that Credit Suisse earns for this is the CDS premium, which is similar to an insurance premium.

Here Bank X is the protection buyer and Credit Suisse is protection seller. Credit Suisse got into insuring CDO¶s and paid heavy price for it, because the tranches consisted of subprime loans and it had to cover the foreclosures it had promised to cover. A Credit Default Swap can be written a by a well capitalised banks even if it has no deposits, and as making deals is far more glamorous than making loans such banks may altogether opt out of building the gross assets of the economy. As part of normal business, each institution faces occasional ³shocks´ -- threats to financial health stemming from loans made to failed businesses and the like. A firm¶s ability to withstand such shocks reflects its financial resilience. But an institution¶s sturdiness also depends on the resilience of its trading partners, because if one of them gets into trouble, its distress will spread to others to whom it owes money. One would be hard put to find even one redeeming feature in introduction of CDS. Usually the institution buying a CDS pays on a quarterly basis, though some contracts are more frequent. The payout for these contracts comes when the company, country or individual defaults on whatever debt it owes. Sometimes, as in a person declaring bankruptcy, this can be clear-cut, but it can noted that for sovereign debt and corporate bonds, there is usually an extended process to establish the exact size and nature of the damages and thus how much must be paid on CDS contracts. Derivatives - µfinancial weapons of mass destruction¶ The market for credit derivatives is now so large; in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. Derivatives may have been famously labelled µfinancial weapons of mass destruction¶ by legendary US investor Warren Buffett, and regarded by some as a root cause of the global financial crisis, but investors¶ continued enthusiasm for them contradicts simple, negative headlines. Clearly issues have arisen around the speculative use of derivative products and the subsequent liabilities some companies have faced as transactions have gone µbad¶, as well as the ability of some to capitalise on the misfortunes of publicly listed companies through short-selling.

CDSs are a product within the credit derivative asset class, constituting a type of OTC derivative. They are bilateral contracts in which a protection buyer agrees to pay a periodic fee (called a ³premium´) and/or an upfront payment in exchange for a payment by the protection seller in the case of a credit event (such as a bankruptcy) affecting a reference entity or a portfolio of reference entities such as a CDS index. The market price of the premium is therefore an indication of the perceived risk related to the reference entity. Companies that sell credit-default swaps argue that they do reduce risks, and many of their arguments are convincing. For example, international banks making loans to banks or corporations in a particular country may buy swaps on sovereign debt to protect themselves from systemic economic turmoil in that country. The possibility of protection encourages lending. Due to this, the default rates on subprime loans started to rise and when it turned out to be way higher than expected, these very institutions became jittery and they started running haywire to get rid of these subprime related securities. In the market, when everybody wants to exit, prices of securities will definitely plummet. Many observers have focused on problems caused by counterparty risk in arguing that derivatives and especially credit default swaps made the credit crisis worse. The argument has two parts. First, derivatives lead to a huge web of exposures across financial institutions. If an institution fails in this web of exposures, it can lead other institutions to fail as they make losses on their exposures. As a result, this web of exposures could lead to a collapse of the financial system and to considerable uncertainty about the solvency of financial institutions in the event of the failure of a major financial institution. Second, credit default swaps heighten this concern because their value jumps, and often by large amounts, when a default occurs. I examine these arguments in turn. When Lehman failed, it had close to one million derivatives contracts on its books with hundreds of financial firms. Some of these firms expected to receive payments from Lehman on their derivatives. Suddenly, Lehman was no longer in a position to make these payments because it had filed for bankruptcy. One might therefore be concerned that these firms became financially weaker, leading to contagion of Lehman¶s problems through losses on derivatives contracts because of the failure of a counterparty. However, the typical derivatives transaction uses protections against the risks of a counterparty not meeting its obligations. The biggest protection is generally the

use of collateral, and usually the amount of collateral insuring a counterparty¶s performance on a contract changes with the value of the contract. Market of Credit Default Swaps The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. When the CDS have been made for purely speculative purposes, in addition to spreading risk, credit derivatives can also amplify those risks. If the CDS were being used to hedge, the notional value of such contracts would be expected to be less than the size of the outstanding debt as the majority of such debt will be owned by investors who are happy to absorb the credit risk in return for the additional spread or risk premium. A bond hedged with CDS will, at least theoretically, generate returns close to LIBOR but with additional volatility. Long term investors would consider such returns to be of limited value. However speculators may profit from these differences and therefore improve market efficiency by driving the price of bonds and CDS closer together. However CDS premiums can act as a good barometer of company's health. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default. For example the credit spread of Bear Stearns widened significantly in the period immediately prior to being bailed out by the Fed and JP Morgan, providing equity investors with advance warning of impending problems at the company Add to this the loss in these securities and the total loss was huge in magnitude causing big institutions like Lehman and Bear Stearns to collapse. Also the credit rating agencies paid their part in this downfall.

If the credit default swap market well, why is it considered to have been so dangerous? Credit default swaps were clearly part of the story of how banks and other financial institutions ended up holding mortgage securities on which they made large unexpected losses. Because of the way capital requirements are determined, financial institutions generally were able to hold less regulatory capital if they packaged loans in securities and held them on their balance sheets than if they just kept the loans on their balance-sheet.

Further, some financial institutions apparently believed that it was advantageous for them on their books if they insured them with credit default swaps. Regulators across countries allowed financial institutions to set aside less capital because these institutions had bought protection through credit default swaps.

Hence, there was a large demand for insurance of super senior tranches that was significantly met by credit default swaps. However, the losses on credit default swaps referencing subprime mortgage securitizations came about because of defaults on subprime mortgages and because of disappearing liquidity for financial institutions. Though some market participants had entirely optimistic about the prospects of subprime securitization cannot be entirely blamed for the excessive optimism, it was actually confidence that market will remain good for a very long giving them advantageous position to exit the markets. The one basic fact that each of these financials bigwigs forgot, was, that nothing is permanent in this world. They expected the good times will last forever and they failed to see the risks associated with their investments. But there are limits. What reduces risk for individual institutions in small quantities spells trouble for the larger banking system when pushed too far. This is especially worrying when you consider that the number of CDS contracts outstanding on European sovereign debt has doubled in only the past three years, even after the AIG catastrophe. We don¶t know if similar dangers lurk in the network of CDS contracts that links European banks with one another, as well as with banks in the U.S. and elsewhere As derivatives use continues to explode around the globe, it is prudent for investors to closely monitor derivatives and the companies dealing in them. The markets, if they have taught us anything in this chaotic past year, have certainly reinforced the historical truism that they are as unpredictable as ever over the short-term. Major discontinuities in price and unforeseen

volatility events can erupt at any moment, potentially putting unfathomable structural stress on highly-leveraged derivatives portfolios. According to the Bank for International Settlements [BIS], the global Over the Counter [OTC] derivatives market has grown almost 65% from $414.8 trillion in December, 2006 to $683.7 trillion in June of 2008. On the BIS¶s own website, there are no updated figures for the notional derivatives market since June 2008, so we can likely assume, with some margin of safety, that this market has now grown to more than $700 trillion. Comparatively speaking, the total market cap of all major global stock markets is approximately $30 trillion. As reported in the media, huge losses were sustained by business and industry on account of complex structured and synthetic, but so much less transparent, derivatives. In other words, business and industry must go in for plain vanilla derivatives which upfront, transparently, and explicitly, disclose cost of hedging strategy rather than arcane, complex, synthetic and structured derivatives which camouflage risk. As regards prudent use of derivatives, the touch-stone that business and industry can use with profit is that any derivatives strategy which promises reduction, or elimination, of hedging cost, or promises enhancing income, is intrinsically speculative and the one that involves incurring hedging cost and promises no income enhancing is intrinsically a hedging strategy.
Financial Market Volatility and the Risk Management Imperative (Address delivered by Mr. V.K. Sharma, Executive Director, Reserve Bank of India, at the Bangalore Chamber of Industry and Commerce, Bangalore, India, on January 5, 2012) The Sub Prime Meltdown Is Tip Of The Iceberg The Financial Tsunami has not reached its Climax Credit Default Swaps: Next Phase of an Unravelling Crisis By F. William Engdahl 6-7-8 Credit Risk Transfer Statistics -Report submitted by a Working Group established by the Committee on the Global Financial System, This Working Group was chaired by Jean-Marc Israël of the European Central Bank Credit Default Swaps and the Credit Crisis-René M. Stulz is the Reese Chair of Banking and Monetary Economics, The Ohio State University, Columbus, Ohio. Credit default swaps and counterparty risk - European Central Bank, August 2009

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