San José State University
Department of Economics

applet-magic.com
Thayer Watkins
Silicon Valley
& Tornado Alley
USA

Credit Default Swaps (CDS) and their Role
in the Financial Crisis of 2007-2008

The Original Source of the Financial Crisis

The full story of the nature and origin of the financial crisis specifically in the subprime mortgage market is told elsewhere, but here is a sketch of the background. The U.S. government created, at different times, two organizations to provide a secondary market for home mortgages. A secondary market is where primary lenders such as banks can sell the mortgage they have created. The government-created agencies for providing a secondary market in home mortgages are known as Fannie Mae and Freddie Mac. Aroung 1960 they became private companies. Fannie Mae was probably the largest business in the world in terms of asset holdings.

In the 1990's Fannie Mae announced that it would not deal with lenders who red-lined; i.e., refused to lend to buyers who were wanting to purchase homes in poor and perhaps dangerous neighborhoods. The lenders agreed to those terms, but Fannie Mae told them that they would have to prove that they were not red-lining by issuing quotas of mortgages to ethnic minority buyers. When the lenders could not meet those quotas and still maintain their standards for lending Fannie Mae and Freddie Mac encouraged the lenders to lower those standards and they would insure or buy these subprime mortgages.

The subprime mortgages were not good investments. They were made worse by charging the subprime borrowers a higher interest rate which just increased the risk of default. For the lenders it did not matter how poor of an investment the subprime mortgages were as long as they could sell them immediately in the secondary mortgage market. The lenders got a fee for writing the mortgage and the size of the fee was substantially larger for the subprime mortgages.

Meanwhile Fannie Mae and Freddie Mac began to bundle mortgages, prime and subprime, and sell securities based upon the mortgage payments deriving from the pool of mortgages. They even created securities with a gradation of risks ranging from those with first claim to the mortgage payments to those with last claim, called toxic waste. Fannie Mae, Freddie Mac and others creating mortgage-backed securities appeared to be making a profit on this process of securitization. But the subprime mortgages were actually a loss for Fannie Mae and Freddie Mac. They paid too much for the subprime mortgages and not enough for the default insurance they were providing. It only took ten years for the social policy imposed in the late 1990's to bankrupt the largest business in the world.

As the market for subprime mortgages and the market for securities based upon those mortgages grew there was increased an increased market for default insurance. This took the form of credit default swaps (CDS's). The CDS's were a form of derivative security.

The market for derivative securities has become very large in recent years. Worldwide these securities provided in the 1990's "insurance" on an estimated $16 trillion of financial securities. This is an enormous amount, far larger than the gross domestic product (GDP) of the United States at the time. However it pales in comparison to the level reached in the 2000's. According to the International Swaps and Derivatives Association (ISDA) the notional value of the CDS's in 2007 worldwide in 2007 was $62.2 trillion. The total GDP of all the countries in the world in 2008 was about $60 trillion. The total value of household real estate in the U.S. at the time was only about $19.9 trillion. This indicates that much of the activity was not in providing insurance against risk but was sheer speculation.

The economic function of derivative securities is to transfer risk from those who do not want to bear it to those who are willing to bear it for a fee. In this respect the derivatives market is much the same as the insurance industry. For example, a put option is insurance against the price of a stock falling. And, like the insurance industry, both the insuree and insurer are better off as a result of the transaction. However, one usually does not refer to this insurance function as insuring; it is called hedging.

Most of the transactions in these derivative securities is for speculation rather than for hedging. Nevertheless the speculators serve a purpose. They provide the liquidity for the market to fulfill its social function of transferring risk. The derivative market, like the insurance industry, does involve gambling. The sizes of the bets in the financial markets however are vastly greater than in the gambling industry. Salomon Brothers had in the recent past derivative contracts for more than $600 billion in securities. The leader in derivative securities has been Chemical Bank which has contracts for $2.5 trillion in securities. As big as this amounts are they represent only a small portion of the entire market. The International Swaps and Derivatives Association estimated that in 2007 the notional value of all swaps worldwide was $587 trillion.

The sizes of the involvement of banks and stock brokerage firms in derivative securities raised fears that there could be a catastrophic loss that would bring about a collapse of the financial system. There had been cases which demonstrate the real dangers of such speculation. A German corporation, Metallgesellschaft, had an American subsidiary, MG Corp., which had been playing the derivative market. MG reported losses in 1993 of $500 million and its total losses could go to $800 million.

On the other hand, some participants in the derivatives markets in the past reported huge profits. Chemical Bank reported profits of $236 million for the first nine months of 1993 and J.P. Morgan reported gains of $512 million.

Swaps

The derivatives market involves more than just put and call options. There are also contracts involving swapping fixed interest rate payment streams for adjustable or floating interest rate payment streams. A company may have borrowed money under an adjustable interest rate security such as a mortgage and is now fearful that the interest rate is going to rise. It wants to protect itself against rises in the interest rates without going through the refinancing of the mortagage. The company or individual liable for an adjustable rate looks for someone who will pay the adjustable interest payments in return for receipt of fixed rate payments. This is called a swap. The origin of swaps can be identified as a deal made between IBM and the World Bank. For more on swaps and their history see Swaps.

Other Derivative Securities

There are many other contracts that businesses may find of interest. A cap is a contract that protects against rises in the interest rate beyond some limit. Likewise some businesses may want protection against a price drop beyond some level. This type of contract is called a floor. A swaption (option on a swap) gives the holder the right to enter into or the right to cancel out of a swap. Similarly there are captions and floortions (options on caps and options on floors).

Forward Contracts and Futures

Swaps, caps, and floors are recent innovations in the derivatives markets. The derivatives market traditionally included forward contracts in addition to options (puts, calls, warrants). A forward contract involved a commitment to trade a specified item at a specified price at a future date. For example, if an American company will have need of 1 million British pounds six months from now they may avoid exposure to exchange rate risk by entering into a forward contract for the pounds now. The forward contract takes whatever form the two parties agree to. There is also a market for standardized forward contracts, which is called the futures market. The standardization makes possible a wider market with greater liquidity and efficiency. Often the futures markets eliminate the ties between specific parties, the party and the counter-party, and the risk that the other might not fulfill the contract. In the futures market everyone deals with the clearinghouse who guarantees fulfillment.

Options

In the options market there has developed some terminology that is somewhat intimidating to the uninitiated. A call option is the right to buy a share of a stock, the underlying security, at a specified price, called the exercise price or the strike price. A put option is the right to sell a share of a stock at a specified price, the exercise price or the strike price.

There is a limited time for the exercise of the call option. An American option can be exercised at any time up to and including the expiration date. A European option can only be exercised on the expiration date. The value of a call option at any time depends upon:

When any of these change the value of the option will change.

The options terminology that is most obscure is the use of Greek letters to refer to the response of the option value to changes in the variables which affect it.


When businesses became involved speculation in the derivatives market it was not much different than if they were out-and=out gambling. Suppose businesses began to bet heavily on the Kentucky Derby. Imagine GM placing a $500 million bet on the Derby and Microsoft risking $100 million and so on. Then on Derby day there might be some major companies that would go broke as a result of their gambling losses. Others might be rolling in money. There could be a financial crisis on Derby day if Wells Fargo and the Bank of America and so forth bet the wrong way. Blaming the financial crisis of 2008 on CDS's would be like blaming a Derby Day crisis in the hypothetical situation described above on the Kentucky Derby. The problem was not the instruments but instead the businesses being heavily involved in gambling.

Instead of a hypothetical case consider what happened when American businesses in the 1980's found that they were subject to a risk due to their dealing in foreign transactions. Typically in foreign transactions there are gaps between when a sales contract is entered into and when the money appears in their accounts in dollars. Some companies set up divisions to handle the the transaction risk and made many millions of dollars in speculation in the foreign currency markets. Others were cautious and immediately sold the future foreign currency payments for dollars now. Those that speculated found to their sorrow that a huge profit in one year did not mean that they could count on profits in subsequent years. Many incurred solvency threatening losses in their foreign currency speculation. The full story is told at Transaction Risk.


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