Credit default swaps
Credit Default Swaps Introduction to credit default swaps
Credit Default Swaps
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- Let's say that I'm a pension fund, and I have money to lend
- to other people.
- And I want to lend it to other people, because that way I can
- get interest on it instead of it just kind of sitting and
- doing nothing.
- And if I lend it to someone other than the government,
- I'll get better interest. So let's say that there's-- so
- let me draw me, I'm the pension fund.
- Maybe I'll drawn me in magenta.
- So that's me, pension fund.
- And let's say that there's some corporation,
- let's say it's GM.
- They make cars.
- I think you've heard of them.
- Some corporation, GM.
- Let's just call it Corporation A.
- They need to borrow money, maybe to buy a factory or to
- do something else, we're not going to get involved in what
- they need the money for.
- And I'd like to lend them the money.
- But there's an issue here.
- I am a pension fund.
- I manage the retirement fund for the teachers of
- California, or for the auto workers of
- Michigan, or whatever.
- And part of my charter says that I can only invest in
- very, very, very safe instruments.
- So I'm not allowed to go gamble people's money, because
- this is people's retirement.
- So I can't do very fancy things with it.
- I can only invest in things that are rated AAA,
- or let's say AA.
- I'm just kind of making this up on the fly.
- So AAA would be like the highest
- rated securities, right?
- These are things that have a very low chance of default.
- But Corporation A is only rated, I don't know, let's say
- it's rated BB.
- And actually, this is a good time to think about well who
- is doing all these ratings.
- And you might think, oh, it surely is a government entity,
- because only the government would be objective enough give
- all of these corporations frankly objective ratings.
- But unfortunately, it's not.
- They're private entities, that are actually
- paid to rate things.
- And I think I touched on it in the video on collateralized
- debt obligations.
- But their incentives are a little bit strange.
- Let's say I have Moody's.
- Moody's is one of the ratings agencies, and they rate
- Corporation A as BB.
- So they've said, these guys, they're pretty good, but
- they're not the U.S. government or something.
- There's a chance that they can go under, for whatever
- reasons, or they're sensitive to the economy as a whole.
- And I say, man, I would love to lend these guys money.
- I would love to lend these guys the $1
- billion that they need.
- And these guys are willing to pay me 8% interest. But I
- can't do it, me as a pension fund, I
- cannot lend them money.
- Because I'm only allowed to lend money to A or
- above types of bonds.
- Or I can only buy A or above type of instruments.
- So what do I do?
- This guy needs money.
- I have money to give him, but his corporate credit rating,
- that was given by Moody's, just isn't high enough for me
- to lend him the money.
- And this is where credit default swaps come in.
- In an ideal world, I would give Corporation A, I would
- give them $1 billion.
- And then maybe they would annually give me, let me make
- up a number, 10% per year.
- And then this might have a term for 10 years, and then
- after 10 years, they'll pay me the $1 billon back and then
- I'll be happy.
- But as I said multiple times, I can't do it, because they
- are BB rated.
- And my charter says I can only invest in A rated bonds.
- So I go to another entity.
- And let's call this entity AIG.
- And these entities are essentially insurance
- companies on debt.
- And I'm calling this one AIG because AIG
- actually did do this.
- But it could be anything.
- A lot of banks did this, a lot of insurance
- companies did this.
- There are some companies that just specialize in writing
- collateralized-- sorry, in writing credit default swaps.
- What does AIG do for me?
- Well first of all, it's important to note that Moody's
- has given AIG, I don't know, let's give it a AA rating.
- I don't know what their actual rating was.
- They said, you know what, they are almost risk-free.
- They're almost like the U.S. government.
- Moody's has looked at their books, or supposedly, or
- hopefully has looked at their books, and says, oh you know,
- if you loan them money, they're good for it.
- So they have a very, very high rating.
- Although, once again, you have to worry about the incentive.
- Because who paid Moody's to give them that rating?
- And whenever you're getting paid to give a rating, you
- have to wonder about what your incentives are, in terms of
- how you rate things.
- But anyway that's a discussion for another video.
- But what AIG says is, you know what pension fund?
- I know you want to lend Corporation A money, and
- Corporation A wants to borrow money from you, but you have
- this problem because they're BB rated.
- So what we're going to do is we're going
- to insure this bond.
- We're going to insure this loan that you're giving to
- Corporate B.
- What we want in return for that is an insurance premium.
- We want you to pay us a little bit of this
- interest every year.
- If you pay us a little bit of this interest every year, we
- will insure this payment.
- So you get 10% a year, and you give us 1% a year.
- So you give us 1% a year.
- And this is also 1%-- just to learn a little bit of
- financial jargon-- this is also someone would say 100
- basis points.
- One basis point is 1/100th of 1%.
- So 1% of the same thing as 100 basis points.
- 2% is the same thing as 200 basis points.
- So you pay me 100 basis points of the 10% per year, and in
- exchange, I will give you insurance on A's debt.
- And in fact, it might have not even been structured this way.
- It might have been structured so that Corporation A right
- here, before even issuing the bonds, they include this
- insurance with the bond.
- So instead of giving 10%, they cut out 1% to insure it.
- And then these essentially become AA bonds.
- And why is that?
- Well, they're BB, but you're being insured by
- someone who is AA.
- So all of the sudden, these bonds, because they're being
- insured by this entity that is AA, which Moody's has
- determined is AA, these bonds are now good enough for my
- pension fund to hold.
- Because I said, you know what even if corporation A goes
- under, I have this AA guy insuring it.
- And so I'm fine.
- So this is the equivalent of holding AA bonds.
- And what's my effective interest rate?
- I'm getting 9% per year, right?
- I'm getting 10% per year from Corporation B, and then I have
- to pay 1% to AIG.
- And if Corporation B goes under tomorrow, AIG is going
- to give me my $1 billion back.
- And you might say, Sal, this sounds like
- a pretty good situation.
- And this is where it starts to get a little bit shady.
- Because AIG, they're not just insuring my debt or my loan
- that I gave to corporation A.
- And think about it, AIG didn't have to do anything.
- AIG didn't have to put up any collateral.
- AIG didn't say, you know what, out of all of our assets, here
- is $1 billion that we're going to set aside, just in case
- Corporation A doesn't pay.
- You would think that if you wanted to be guaranteed that
- this money was going to come to you, this AIG corporation
- would have to set aside the money.
- But they didn't have to do that.
- They just have to say, hey, Moody's has said we're AA,
- we're good for debt.
- We're good for insurance.
- So you just pay us 1% a year and trust us, or trust
- Moody's, that we really are good for the money.
- They never had to set aside the money.
- You're just going on a leap of faith that, if and when
- Corporation A defaults, AIG is going to be
- good for the money.
- Now this is where it gets interesting.
- Let me erase Moody's from the screen-- actually, maybe I'll
- go down here.
- AIG didn't just insure my debt.
- Let's say that there is Corporation C's debt.
- Let's say that they're B-- I don't know, all these ratings
- have different terminology.
- They're B+ rated.
- And let's say there's $10 billion of debt that they
- borrow from some other party.
- And in return, they give 11%.
- And this is Pension Fund B.
- And this pension fund had the same problem.
- They can only buy A-rated or above bonds.
- AIG also insures their debt that they gave
- to Corporation C.
- Maybe they'll pay them-- Corporation C is maybe a
- little bit riskier, so out of the 11% I have to pay maybe
- 150 basis points.
- Or 1 and 1/2%, that's the same thing as 1%.
- And in exchange, they insure C's debt.
- Now something very interesting can happen here.
- AIG all of the sudden has an excellent
- business model, right?
- Because they were able to get this AA rating from Moody's,
- they can just keep insuring other people's debt, and they
- don't have to put any money aside, right?
- They don't have to give their assets to anyone else.
- And they just get these income streams, right?
- From my pension fund they're getting 1%
- per year of $1 billion.
- From this pension fund, they're getting 1 and 1/2%,
- 150 basis points, per year.
- And they can do this, frankly, as much as they want.
- They could do this a thousand times.
- And as long as Moody's doesn't get suspicious.
- As long as Moody's doesn't start saying, hey, wait a
- second, AIG, you only have $100 billion in assets, but
- you have insured $1 trillion of other people's debt.
- Something shady going on, I'm going to lower your rating.
- As long as that doesn't happen, this AIG corporation
- can just keep insuring more and more debt.
- And frankly, as long as none of that debt goes bad, they
- just get this excellent income stream, and their CEO will get
- excellent bonuses.
- I think you start to see where you're having a single point
- of failure and a house of cards, and I'll continue that
- in the next video.
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