Credit default swaps and the credit crisis Flashcards Preview

Financial Economics > Credit default swaps and the credit crisis > Flashcards

Flashcards in Credit default swaps and the credit crisis Deck (14)
Loading flashcards...
1

Two sides of CDS

On one side, they make it easier for credit risks to be borne by those who are in the best position to bear them, enabling financial institutions to make loans they wouldn’t otherwise be able to make, and revealing useful information about credit risk in their prices. On the other side, CDS are prominent villains -> “worst Wall Street invention” George Sorus, a hedge fund manager, wants most or all trading in CDS to be banned.

2

CDS

– an insurance contract against the default of a particular company

3

Advantages for CDS

• Market efficiency: risk transfer → cost of capital ↓ , liquidity ↑
• Information: CDS price purely based on credit risk
• Implicitly allows short-selling
=>Better allocation of risks; easier for you to pay fixed amounts than to calculate all the risks yourself
• Transparency (improving price discovery)

4

Drawbacks of CDS

• Remove incentives for monitoring
• Perverse incentives to cause bankruptcy (good for you if someone defaults)

5

• True reasons behind the crisis

– No one (investors & financial institutions) expected real estate prices to fall dramatically
– too high leverage & too much investment in real estate

6

Some argue, CDS made the credit crisis worse:

• Derivatives lead to a huge web of exposures across financial institutions. If one fails, it may drag others to fall with it.
• CDS value jumps (usually by large amount) in case of default  collateral might not be enough to protect buyers of insurance in case of counterparty default  additional failures of financial institutions.

7

Reforms for CDS market

* Limit or ban the “naked” position, because it enables investors to short-sell debt.
* Move trading from OTC to exchange
* Move trading from OTC to exchange

8

Why Limit of the naked CDS is not the best idea

• Financial economists believe short-selling helps efficiency;
• Prohibiting naked position would destroy CDS market;
• Then there would be only hedgers (no speculators) => hedgers won’t find counterparties for trade because no liquidity => prices cannot be efficient if investors who see profit opportunities, cannot exploit them.

9

Reasons for moving trading from OTC to exchange

• Reduce counterparty risk;
• Create greater transparency and order in the market.

10

 Difference between CDS and insurance

o You don’t need to have a bond/underlying to buy a CDS (naked positions)
o CDS are traded over the counter, while insurance contracts are not traded.
o May insure default risk of many firms (single-name vs multi-name contracts)

11

 Potential costs of CDS

• Separation of risk bearing and funding decreases incentives for monitoring.
• Perverse incentives to drive a firm into a bankruptcy.

12

Clearing process

all the steps that take place from the trade to completion of the settlement.

13

OTC vs. Exchange-traded

OTC:
• custom made
• disorganized clearing houses
• unknown exposure
• provide market for less liquid CDSs
Exchange-traded:
• standardized (size & maturity time)
• counterparty – clearing house
• transparency
• not flexible

14

Reasons why CDS did not cause the crisis

Lehman Brothers & Bear Sterns failed not because of CDS
No one (investors & financial institutions) expected real estate prices to fall dramatically
Too high leverage & too much investment in real estate