Credit default swaps
Use Cases for Credit Default Swaps How credit default swaps can be used as hedges, insurance or side-bets
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- Let's think about the different use cases for credit default swaps,
- so let's say that I have some company over here
- and it's been, it's given a BB credit rating
- and this rating of course comes from a credit rating agency
- credit rating agency, sometimes called a ratings agency
- or a rating agency, I've seen it every different way
- so this would be like Moody's or Standards & Poor's,
- or whatever else. And they say, they look at this company
- and they look at it's business, look at it's balance sheet
- and they say, "Okay, it's not super safe, but it's not super risky either,
- we give it a BB rating."
- and let's say that there's an investor over here
- who wants to lend money to this company
- so he might lend them some money and get some interest in return
- but this investor doesn't like this level of safety
- he wants to make sure that he's made whole
- even if this company goes out of business,
- so he can go to a writer of a credit default swap.
- And the most famous of those credit default swap writers is, or was, AIG
- And he'll say, "Hey AIG, I'm gonna pay you a little bit every year,"
- -- you can do that as an insurance premium,
- and in exchange, you are essentially going to insure
- you are going to insure me in the case of a default by this company
- Insurance. And what we already said, it's a little bit shady
- because AIG, it was not regulated like insurance,
- so AIG did not have to set anything aside,
- and what was powerful here for AIG is that the rating agencies
- continued to give AIG a very high rating.
- So let's say it had a AA rating, so despite the fact
- that it kept taking on all these liabilities
- the credit rating agencies says, "Hey, we'll still give you a AA,"
- so they're able to use this AA rating to keep writing these contracts
- to keep writing insurance, not setting anything aside
- and essentially just getting, almost you could view it,
- free money with eventually having to pay the piper, eventually.
- Now, this is one scenario, another scenario is
- maybe an investment bank creates some type of special purpose entity
- or some collateralized debt obligation right over here
- and, they have their different tranches,
- and maybe for the senior tranche over here
- just so that they can sell them to pension funds
- who can only buy AA rated debt,
- pension funds, the investment bank goes to AIG and says,
- "Hey, can this entity right over here buy credit default swaps?
- "...can we enter into credit default swap agreeements on you? So that incase any
- "... of this stuff were to default you will also insure that."
- And once we do that, then, a rating agency,
- so this is a security, this is a senior tranche of a collateralized debt obligation now
- the senior tranche. And now that that senior tranche
- is essentially insured by AIG, a credit rating agency
- once again will assign this a AA rating
- even though this thing might be made up of a bunch of subprime mortgages
- and all of the rest, although it is the senior tranche
- so it will be made whole first, but now pension funds
- can buy this type of thing.
- The last use case, is maybe you have a hedge fund out here
- Hedge fund out here, who doesn't want to lend anybody
- any money, but is convinced that about
- a whole bunch of these companies, maybe this company over here
- or maybe this company over here, that has some other rating
- so this is another company. This hedge fund is convinced
- that these companies are going to default on their debt,
- that there's going to be a credit crisis of some kind,
- well then this hedge fund can enter into a credit default swap agreements
- Could enter into credit default swap agreements
- to essential get insurance, but not having anything to insure
- it's like getting car insurance on someone else's driving
- or someone else's car, and you kind of are starting to hope
- that they have a car accident.
- And because now this guy has a credit default swap
- on company, on this company right over here,
- despite the fact that they didn't lend to them,
- the hedge fund is going to pay a little bit every year and get the insurance,
- and they're essentially going to hope that this company
- goes out of business, because if it does,
- then they're going to get the insurance payment
- they're going to get the same payment that this investor would have
- but they would have never had to lend the money
- so you could use it as side bet, you could use it as a way of making
- lower rated securities all of a sudden acceptable to pension funds,
- or you could use it as a straight up way of insuring debt
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