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Finance and capital markets
Credit default swaps (CDS) intro
Introduction to credit default swaps and why they can be dangerous. Created by Sal Khan.
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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)- 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)
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)- 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)
- 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)- 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)
But how does AIG earn the double A rating then?(2 votes)
Good question. Someone made quite a mistake. Or chose to look the other way.(3 votes)
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)- That is correct, except idk what egregious means(1 vote)
- 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) 
Why is AIG accepting a 1% return on a BB rated borrower?(2 votes)- Assuming they would be willing to pay the cost, can a 3rd party buy a CDS on the same MBS?(2 votes)
- 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)
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)
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)
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.