Risk Management of Financial Institutions

(part 1)

Philippe Grégoire

Luc Henrard

Credit

Default

Swaps “Are you advocating a ban on the holding of

open position of CDS related to sovereign

counterparties?”

Mathieu Philippe, Loïc Sarton and Cédric Percy

1

Recovery CDS Premium

“Are you advocating a ban on the holding of open position of CDS

related to sovereign counterparties?”

1. Introduction :

Credit default swaps (CDS) are subject of considerable analysis. On the one hand, they seem like high

liquid derivative products that help hedging our bonds or other debts. In addition to this, CDS help

financial institutions to make loans they would not otherwise be able to make.1

On the other hand, a lot of observers and analysis have pointed out the role of CDS in the financial

crisis. While searching the definition of CDS in Google, a search under “worst wall street invention”

come up with the credit default swap as the first entry.2

Throughout this paper, we will try to answer a fundamental question from our point of view: “Are

you advocating a ban on the holding of open position of CDS related to sovereign counterparties?”.

Firstly, we will describe the processes of CDS and then, we are going to tackle the role of CDS in the

current financial crisis. In the third part, we will come up with PRO’s and CON’s of the CDS. Finally, we

will conclude this paper by answering the previous question from our point of view.

2. Mechanism of Credit Default Swap

A CDS is a bilateral contract between two parties: the seller and the buyer. The Buyer pays a fee

called premium to the seller. Therefore, if the underlying counterparty or asset goes into default, the

buyer would receive a payoff. This payoff depends of the recovery rate; for example, a bond can be

reimbursed for 50% so the seller of the CDS has to pay the buyer the 50% left. Such mechanism

allows financial institutions to reduce their capital requirements thanks to the risk weighting asset in

the Basel II regulation (by mitigating the risk). Nevertheless, the premium depends on the quality of

the reference entities.

What is an “open position”

Any investment that has been entered and still exists. In the case that we hold CDS without the underlying asset (loan, bond), we have a naked position.

1 STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives - Volume 24,

Number 1. p.1 2 STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives - Volume 24,

Number 1. p.1

Buyer of protection

(Short credit risk)

Seller of protection

(Long credit risk)

2

3. PRO's and CON's

First of all, CDS are off-balance sheet activities. Therefore, it is difficult for the market participants to

have an idea of the real size of this market. Moreover, the Basel II regulations led to new arbitrage

opportunities that caused excessive off-balance sheet leverage.

Secondly, banks did not fully understand the risk of such new complex products (especially when

linked to CDOs). This lack of understanding and transparency has led to a poor risk management of

these new products. For instance, the sellers of CDS on complex products (CDOs) for which they have

no idea of the real quality of the underlying product. They just had an over reliance on the external

ratings from agencies like S&P which did not produce an amazing job regarding complex structured

products (ABS-CDOs).

CDS allowed some smaller companies and non-financial institution to issue bonds because these

bonds were covered by protection (CDS). Furthermore, it has a positive impact on the liquidity in the

bond market. On the other hand, companies that included CDS indices had to face higher bond yield

spreads than the other one.

CDS is not really a new product; like other derivative products, it appeared 20 years ago. For a long

time, no one really paid attention to the importance of this market and to the fact that it somehow

hides financial risks. Moreover, these products can increase volatility and market overreactions.

Therefore, these characteristics had certainly a role in the acceleration of the crisis.

The CDS market is an Over the Counter market, in other words, the products are not standardized.

The two parties agree on the specificities of the contract. This market was thus unregulated but as

many economists have pointed out, this market has become too big to not be organized. The

macroeconomic aspect was hidden and it violently came up in September 2008. Before the crisis,

even the Chairman of the Fed, Alan Greenspan expressed a clear opinion that market forces were

able to regulate the derivatives markets.

Many argue that CDS contracts are not only protection products for hedging your investments but it

has actually become a real speculation instrument.

“Particular problems can arise with naked short selling and CDS. Many jurisdictions are moving to ban

or seriously limit naked instruments. When Greece had problems, investors rushed to buy CDS,

including investors who did not own Greek bonds, but who would get paid in the event of a default.

Greater demand for CDS means higher price for this form of insurance, making the bonds seem

riskier, so forcing a higher interest rate on the government and hurting the economy”i3

Some argue that the CDS like other derivative products only put light on weaknesses of several

companies or countries. It only reflects the real value of this bond thanks to a more liquid bond

market (a real financial barometer of these bonds/companies/countries).

3 European Parliament (08-02-2011)

http://www.europarl.europa.eu/news/en/headlines/content/20110204STO13204/html/Short-selling-banking-on-others%27-misfortune-or-just-hedging-bets

3

At the beginning, CDS were promoted as an instrument which would disperse the risk. However, in

reality, it has done the opposite. A major part of the risk was concentrated in organisms who accept

to buy risk such as AIG Insurance. Finally, it was the money of the American taxpayers which was

used in the 85 billion “bail-out” of AIG.

As previously said, the assessment of CDS-CDOs and other structured products were/are mainly

based on external rating agencies, which have made terrible mistakes in the perception of the risk.

Evolution of the CDS and impact of the sovereign debts

This graph gives an illustration of the cost of insuring sovereign debt against default. At the end of

2008, the subprime crisis caused an increase of the CDS prices of countries with a bad quality debt.

As a result, there has also been an increase in the return on investment those countries had to give in

order to get funding and thus, it has accelerated the sovereign debt crisis. As we can see in the

beginning of 2010, there was a double dip due to the fears of the fragility of some European

Sovereigns as well as a lack of confidence in the stability of the Euro zone.

The Role of CDS in the crisis

From an insurance tool to a speculative tool…

In 2007, just before the financial crisis, the notional value of the CDS market was about 62 trillion

USD whereas the total value of the assets insured was about 5 trillion USD4. We can easily

understand that about 80% of CDS investments were purely speculative and became, at first sight, an

“efficient” tool for banks to make billions.

4 DEMIRGUC-KUNT A., EVANOFF D., KAUFMAN G. (2011). The International Financial Crisis: Have the rules of

Finance Changed ?, World Scientific, p.374

4

AIG Insurance sold alone around 500 billion USD. However, on September 2008, the FED had to make

an enormous loan of 85 billion USD to AIG in order to avoid its bankruptcy and big troubles at its first

counterparty, Goldman Sachs.

For the financial crisis of 2008, four roles played by CDS have been highlighted5;

a) CDS created ambiguity about who eventually bears credit risk

b) CDS enhanced the systemic risk by making the principal CDS sellers (AIG,…) mutually

vulnerable

c) CDS fostered CDS sellers to assume risks

d) CDS accelerated and played a role in economic cycles by its pro-cyclicality

Moreover, as we have previously seen, banks have largely used CDS in order to mitigate their

regulatory capital requirement. This has led to an important increase in the leverage of banks (huge

balance sheet) and thus, in the exposure they had.

Indeed, Yale economist Geanakoplis has observed that “the financial crisis and recession (…) has

been more violent because of the creation of the derivative credit default swap market for

mortgages in 2005, just at the top of the leverage cycle”6

We are going to introduce now the role of CDS during the sovereign debt crisis.

Since the beginning of 2010, the debt crisis in Europe has dramatically increased with fears and panic

of a real collapse of several European countries (Portugal Ireland Greece Spain (PIGS)). This crisis has

led to significant spreads of government bond yields and sovereign CDS. “The speculation with naked

CDS (…) is criticized for the turbulence in the European bond market.”7 As a result, in May 2010,

Germany banned naked CDS based on euro-denominated sovereign bonds. Nevertheless, CDS

continued to skyrocket after the prohibition of naked positions within the Eurozone. This pointed out

the panic of market participants toward the viability of these countries. However, there has been a

bright side; Indeed, the ban of these naked sales has brought more stability (or at least less volatility)

within the CDS market8.

Conclusion Our answer to the question is yes. We think that we should ban all speculative instruments relative

to sovereign debts because countries are not like companies. The consequence of the bankruptcy of

a country is much bigger than for a company. According to a lot of surveys and analysis, speculative

instruments increase the probability of default of a country or a company aimed.

Nevertheless, it gives a good view of the financial health of a country. Furthermore, it puts political

on pressure to take real measures to cope with their debt issues.

5 McGrawHill Company (2008). http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CDS.pdf (

consulted on 05-11) 6 Geanakoplis J. (2009) Solving the Present Crisis and Managing the Leverage Cycle, Yale University, p.49

7 XIAOLING PU, JIANING ZHANG (2012), Sovereign CDS Spreads, Volatility, and Liquidity : Evidence from 2010

German Short Sale Ban, The Financial Review 47 (2012) 171-197, p173-174 8 Ibidem

5

We also believe that we should standardize CDS because this could lead to several benefits: It would

improve transparency and reporting of positions, boost confidence and avoid panic; it would allow

the supervision of the clearing house and it could also limit the huge size of this market.

6

Bibliography

DEMIRGUC-KUNT A., EVANOFF D., KAUFMAN G. (2011). The International Financial Crisis: Have the rules of Finance Changed ?, World Scientific, p.374

EUROPEAN PARLIAMENT (08-02-2011) http://www.europarl.europa.eu/news/en/headlines/content/20110204STO13204/html/Short-selling-banking-on-others%27-misfortune-or-just-hedging-bets (consulted on 05/10)

Geanakoplis J. (2009) Solving the Present Crisis and Managing the Leverage Cycle, Yale University

ILHYOCK SHIMY/HAIBIN ZHUHTTP (2010) :twistedeconotwist.wordpress.com/2010/12/02/the-pros-cons-of-credit-default-swaps/ (consulted on 05-10)

McGrawHill Company (2008). http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CDS.pdf ( consulted on 05-11)

Professeur Forex, http://www.professeurforex.com/analyse-fondamentale-professeur-forex/dossier-analyse-fondamentale-forex/les-cds-credit-default-swaps/

STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis, Journal of Economic Perspectives - Volume 24, Number 1.

XIAOLING PU, JIANING ZHANG (2012), Sovereign CDS Spreads, Volatility, and Liquidity : Evidence from 2010 German Short Sale Ban, The Financial Review 47 (2012) 171-197