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Credit default swaps (CDS) intro

Introduction to credit default swaps and why they can be dangerous. Created by Sal Khan.

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  • blobby green style avatar for user koshdog
    I do not know how credit rating works but to me it would seem the insurers credit rating would and should be deteriorating due to their exposure to a BB rated borrower, is this right? If this were the case this would surely limit the number of CDS the insurer could engage in as their credit rating would be compromised if exposure to more than one deal, which would thus result in them not being able to insure anymore, at least to pension funds who require an AA rated insurer.
    (8 votes)
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    • blobby green style avatar for user eusebio.garre
      Very good question, and you think exactly along the right lines. The point here is, AIG and other insurers found clever ways to hedge CDS risk very, very cheaply with other capital market players (delta hedging), which made them very keen to keep the amount of CDS growing because the net risk as they were calculating it appeared to be close to zero. Rating agencies did give a lot of credit to the delta hedging. This allowed AIG and their peers to keep their AAA ratings for a very long time while the amount of CDS contracts on their balance sheets kept growing exponentially.
      (8 votes)
  • leaf green style avatar for user Cong Tran
    If AIS is good at investing, Why would AIG issue CDS to insure risky loans while it could just borrow directly from the lender and invest else somewhere that could generate higher profits?
    (4 votes)
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    • blobby green style avatar for user eusebio.garre
      There is a number of reasons why insurers may prefer CDS to cash investments:
      1) To start with: AIG was not good at investing. Not at all. Otherwise, they wouldn't have done what they did. They underestimated and underhedged major risks and did not reverse course after things started going badly.
      2) CDS are not funded, so they don't blow up the balance sheet (which would worsen metrics like Return on Assets, e.g.).
      3) CDS were not regulated, so the insurers were not legally required to set aside any capital by entering into CDS contracts, while buying a cash bond from the same company would have required them to set aside some capital.
      4) AIG and other insurers found clever ways to hedge CDS risk very, very cheaply with other capital market players (delta hedging), which made them very keen to keep the amount of CDS growing because the net risk as they were calculating it appeared to be close to zero.
      5) Rating agencies, which other than regulators did look at CDS exposures and also required some capital to be put aside for those exposures also underestimated CDS risks, especially because they did give a lot of credit to the delta hedging. This allowed AIG and their peers to keep their AAA ratings for a very long time while the amount of CDS contracts on their balance sheets kept growing exponentially.
      (7 votes)
  • blobby green style avatar for user christianborys
    I have a question but it won't be phrased properly. Okay so.

    If someone says that the CDS is at 400bps...then that means that the "insurance agency" is selling the CDS at 4% to the pension plan based on the risk associated with Company A defaulting right. So the higher the bps on a CDS...the higher the risk associated with the company that the pension plan is borrowing to. So a high bps reflects the overall health of the company A and has nothing to do with the Pension plans health.

    (4 votes)
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    • blobby green style avatar for user Vishrudh.Sarathy
      Correct. They quote CDS in terms of "spread" That 400bps you refer to is the "spread" you pay on the total amount (notional) you would like to insure.
      The higher the spread, the higher the perceived credit risk of the company you are lending money to.
      Your understanding is correct.
      (5 votes)
  • leaf blue style avatar for user Sprintup
    But how does AIG earn the double A rating then?
    (2 votes)
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  • primosaur ultimate style avatar for user Oliver Worley
    So if I understand correctly, Credit Default Swaps are basically one giant Ponzi Scheme? If so then why the hell are they still legal if any time they have to pay up they don't have the liquidity?!!
    (3 votes)
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  • blobby green style avatar for user koshdog
    Great video, what is the correct terminology for each party in this transaction (ie the insured / lender, insurer, and borrower)?

    Also how would this risk be recorded on the insures financial statements?
    (2 votes)
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  • duskpin sapling style avatar for user Hayden
    Why is AIG accepting a 1% return on a BB rated borrower?
    (2 votes)
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  • blobby green style avatar for user BradNayles
    Assuming they would be willing to pay the cost, can a 3rd party buy a CDS on the same MBS?
    (2 votes)
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  • leaf green style avatar for user Duncan Gibb
    Shouldn't it be mentioned that banks like AIG allowed other investors to speculate on the insurance they provided? So if you have 3 more parties paying 100 bps to insure the $1B, if it happens to default suddenly AIG owes $4b instead of just 1. This is what the film 'Inside Job' lead me to understand; AIG let people insure something that they didn't even own.
    (2 votes)
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    • female robot grace style avatar for user Hima Madhusoodan
      Hedge funds which figured out that the CDS was underpriced for the actual risk bought several hundred millions' worth. The problem was not that others are allowed to invest in these derivatives. The problem was of derivative pricing. Had AIG correctly priced these instruments, CDS would have been a lot more expensive for the other parties to invest in. If some one sells gold for the price of copper, who is at fault when the seller incurs huge losses? The buyer or the seller?
      (1 vote)
  • mr pink red style avatar for user Bobby Smith
    Is the agreement to pay up the full billion at once in case of default or incrementally, the same way A was doing?
    (2 votes)
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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.