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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's say that I run some type of a pension fund, and I have $1 billion that I need to invest someplace. And I dig around a little bit, and there's this Company A over here, and it needs to borrow a billion dollars, and it's willing to give 10% interest in exchange for borrowing that billion dollars. So if I give these characters over here my billion dollars, if I lend it to them, if I lend them the billion dollars, on an annual basis, they're going to give me 10% interest. There's a problem here though. The rating agencies, the ones that in theory should be independent, they've only given Company A a BB rating. And this is a pension fund. I have to only invest in the safest of safest of securities. I have to invest only in things that are AA. And so here might enter a character like AIG, and obviously things have changed since their heyday. But AIG, based on at least Moody's perspective, has a AA rating. So AIG could say, hey, look pension fund, why don't you lend them the money, and what we're going to do is enter into a credit default swap. And what that essentially is, is a form of insurance. Of that 10% every year, why don't you give us 1% of that? And in financial lingo, that's sometimes referred to as 100 basis points. And in exchange for that, in exchange for that 100 basis points a year, you could view this as the insurance premium, we are going to ensure that if for whatever reason Company A defaults on that debt, you can give us the debt, you can give us that debt security, and we will just give you back your billion dollars. Now from the pension's point of view, this sounds pretty good. They're now getting a net 9% of interest, 10% minus the 1%. And they're essentially getting to lend to a BB company, but it's in effect like lending to a AA, because as long as AIG is good for the money, then the pension fund is going to get their money back one way or the other. Now where this gets a little bit shady is AIG right here didn't have to do anything. What's interesting about credit default swaps-- credit default swaps sometimes referred to as CDSs-- is that even though they are insurance, for all purposes they are insurance, they are not regulated like insurance. So typically an insurance company when they insure something, they have to set aside some money, in case that thing actually happens. And they have to work out the probabilities and all of that. Credit default swaps were not regulated in that way. So AIG could do this without having to set aside any type of money. And they could do this over and over and over and over again, kind of snowballing all of their potential liabilities. And so you could imagine, it's really good money while no one is defaulting, but all of a sudden when people start defaulting, then all of a sudden AIG is going to be in trouble. And all the people who thought they had, in effect, AA debt because AIG was insuring it, might not.