Credit Default Swaps, the Collapse of AIG and Addressing the Crisis of Confidence

Five years ago, billionaire investor and American icon Warren Buffett suggested that financial derivative products were "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Five years ago, few people were paying attention, and even fewer understood what he meant. Even today, as the term credit default swap (CDS) is migrating from the financial cable networks to CNN, MSNBC and the mainstream media, the critical role of these arcane derivative products in the undoing of the financial markets is not well understood.

The term derivative product is a general term for a contractual agreement between two parties whereby the counterparties exchange -- or swap -- payments based some underlying benchmarks, applied against a contract notional amount.

The most widely used derivatives are interest rate swaps, which account for more than 75% of the global $530 trillion derivatives market, compared to the 10% that comprise credit default swaps. In its most basic structure, an interest rate swap provides that Party A will pay Party B an amount equal to a fixed interest rate times the contract notional amount, and receive an amount equal to a variable interest rate times that same amount. Many businesses that borrow money from commercial banks at the variable prime rate use interest rate swaps to fix their annual cost of borrowing and avoid interest rate risk.

In contrast, credit default swaps are financial products that allows for the transfer of the default risk related to owning a corporate bond from one party to another. For example, imagine that before the current market meltdown, CalPERS -- the large California public pension fund -- owned $100 million of IBM bonds, but wanted to insure against the risk of a bond default. CalPERS could accomplish this by negotiating a $100 million, five-year credit default swap with AIG -- which up until a month ago was a global, triple-A rated financial institution.

Under the terms of the swap, CalPERS would make an annual swap payment to AIG equal to -- for example -- 1% of the $100 million swap notional amount. In return, AIG would pay CalPERS the amount of any losses that CalPERS realized in the event of a default by IBM. For example, if IBM went bankrupt during the contract period, and bondholders were only repaid twenty cents on the dollar, AIG would pay CalPERS $80 million. And to secure AIG's obligations, the swap contract would require that if AIG were downgraded from triple-A level to below double-A, AIG would post collateral equal to 20% of the notional amount of the swap contract, or $20 million.

Then came the AIG collapse.

While the general view of the AIG collapse is that it was a function of collapse of the mortgage-backed securities market, in truth it was a direct consequence of AIG's CDS exposure. Four weeks ago, AIG was a triple-A rated insurance company. Today, it is being dismantled. If AIG had large investment losses in mortgage-backed securities, but no CDS exposure, AIG would still be in business today.

In simple terms, AIG's collapse came as a result of the following sequence of events:

1. In the wake of the decline in real estate prices, the market value of mortgage-backed securities declined.
2. Under accounting rules that were established after the downfall of Enron -- implemented to require rapid disclosure of investment losses -- AIG marked down the value of its mortgage-backed securities portfolio.
3. These investment losses resulted in a reduction of AIG's capital reserves -- the core measure of its financial strength.
4. As a result of the decline in AIG's capital reserves, Standard & Poor's and Moody's Investors Service downgraded AIG from triple-A to the single-A level.
5. These rating downgrades to the single-A level triggered collateralization requirements under AIG's CDS contracts.
6. The amount of the collateral that AIG had to produce under its estimated $450 billion of CDS contracts approximated $100 billion.

And AIG did not have $100 billion in available funds.

This was the explosive event that destroyed AIG. It was not the market losses on its investments in mortgage-backed securities. It was not payouts on CDS contracts where default events had actually occurred. It was a collateral call.

The AIG story illustrates two important aspects of the current crisis of confidence within the financial markets. First, AIG's collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements. As Buffett and others have suggested, the risk in the AIG derivatives portfolio was explosive -- and ignored until it was too late.

Second, the AIG story illustrates how a collateral call under a CDS contract can have the effect of positioning the CDS counterparty -- the institution on the other side that claims rights to the collateral -- senior to the AIG policy holders and bondholders.

As US and European central bankers are working to define a collective strategy to rebuild confidence in the financial system and to reinvigorate inter-bank lending, the destabilizing impact of the CDS market remains one of the central problems to be addressed.

The problem seems straightforward. After the AIG collapse, how does one institution trust its exposure to another? If CitiBank seeks a loan from JPMorgan, how does JPMorgan know whether some event might be looming that will result in a collateral call under some of the myriad derivatives contracts to which CitiBank is a party, a collateral call that in a matter of hours could bring Citibank to its knees.

The US has now signed on to the British plan to make direct investments in banks, but simply injecting liquidity and capital will not address this concern. But US officials appear to be resisting the second British proposal -- which provides for direct central bank guarantees of inter-bank loans. Like guaranteeing deposits, guaranteeing inter-bank loans would transfer the risk of the unknown from the banks to the central banks.

Paulson and Bernanke may view this last British proposal as one step too far in the socialization of the financial system. But until the CDS market is brought into an effective regulatory framework and the legal rights of creditors are clearly established, do we really have any choice but to take this next step?

It seems that long ago -- weeks maybe -- we stared the moral hazard issue in the eye. And we blinked.

Whatever the theoretical importance of letting people and institutions fail, it seems that we have already decided that as a matter of public policy and political priorities, we just can't take the pain.

Comments

[neostarbuck]

Excellent article and comparison of AIG and other financial firms to the Enron collapse.

If I were President, I would:
* Eliminate personal income tax back to the level it was before 1913 - ZERO
* Eliminate the Central Banks that have caused every economic crises and war since 1913. Let America start printing its own money again.
* Eliminate Congress and replace with a Wikipedian Government for the people by the people.
* Socialize Energy and Resources because no banker owns the Sun, the source of 99.999% of the Energy in this Solar System
* Socialize medicene, actually socialize wellness.
* Consolidate all world militaries into ONE Army to end all wars
* Restore personal choice of ONE's own body. Choice about abortion, sexual preference and whether you want the government to put RFID chips in your body or not.
* Plant food everywhere. Breaking news... Food can grow in abundance without farmers, like weeds...
* Invest $1 Trillion into Solar Energy, enough to replace 100% of America's energy requirements.
* Legalize drugs to end senseless, no chance of ever winning, war on drugs.
* Either put most bankers, Fortune 100 CEOs, politicians and Generals in jail, or release the convicts that are spending years in prison for a fraction of the crime.
* Freeze assets of all churches worldwide and give it back to the people instead of secretly profiting on wars, starvation and genocide.
* Send Cruise Missle Greeting cards to dictators, arms dealers and heads of

[MatoSka]

The issue of fluctuating asset valuation on property is an inherent quality of the housing market. Conventional mortgages incorporate this issue in their 30 year term length and equity requirements. The presumption of rising home properties is an illusion that has been perpetuated and was institutionalized in derivatives.

Perpetuating low interest rates by the Fed created a scenario in which movement of currency became more important than the value of assets attached to the paper being transferred. It was inevitable that a decline in housing prices would have a more profound impact then it would have under other conditions.

[pandaemonia]

Every now and then you get an article like this on this blog and it's refreshing - someone writing about a topic that (a) they know about and (b) without angry/partisan opinion and unfortunately it's ignored by the majority of commenters because it does not generate the FAUXtrage and finger pointing and name calling so beloved by most members of this site because it makes sense and represents true journalism - reporting of the facts. Many thanks.

[darthdarcy]

What blows my mind if I understood this correctly is that under these new post regulation or rules they no only needed to be exempt from the SEC regulation but also the Gaming Commission...?

WTF..?

How can you make something like that the bedrock foundation of your entire economic system..?

Even the Mafia protects it's principle assets..!

[LiberalsAlwaysSuck]

Best article ever on this website. However, the loony liberals who read this website, won't have a clue to anything you said. They are stuck on " I hate Bush". And cannot move past it. Obama, McCain, Pelosi, Frank, Reid, Bush, et al..Do not have the brain capacity to fix this problem. What would you suggest as a fix to the CDS problem? Any politician willing to get into that technical issue will win alot of votes if they can explain it in laymen terms.

[JBS]

I hate to say this, but your explanation is just as opaque as the transactions you're trying to explain.

[Theramus]

An interesting question here is - What specifically is AIG using as collateral for its federal loans ? So far, we've heard vague references to AIG subsidiaries. But what happens if AIG defaults on its loans - the devil may be in the details? Could we see something as horrifying as the Federal government taking monies from AIG retirees or retirement plan contributors ? What say these people are gun owners ? I have not seen a satisfactory answer to this question yet.

[tompoe]

How can anyone talk about socialization of the financial system? For crying out loud, on September 19, 2008, Paulson demanded entitlement to the tune of $1 trillion dollars as Bush's going away present to his cronies. This is about corporate welfare. America does not tolerate corporate welfare. That date is also the date the RNC admitted they are the Party of Corporate Welfare. America does not tolerate corporate welfare.

[David Paul - Huffpost Blogger]

We have seen the socialization of risk in the financial system, not yet--and to your point quite unlikely--the socialization of profits in the financial system. How the purchase of non-voting preferred stock will change bank behavior in regard to interbank lending in the current environment is hard to see. Even when the Brits talk about nationalization of the banking system, it is unclear how what will transpire is more than simply the transfer of risk to the central banks. That having been said, we have already seen an effective assumption of risk by the public in our clear unwillingness in public policy and political reality, to suffer any further the pain of large institutional failure.

[Ahkeem]

Good points, but kinda generic and beside the point. Privitization of profit--socialization of risk--nationalization of banks-- regualtory framework,blah, blah, blah and etc, etc, etc. Bottom line is that little folks really can't do much about all this - the deals are done or are going to be done.

On the other hand, this dude asking about WHOSE MONEY is AIG using to pay up if they DO go bust. Sunshine in this murky little corner could make some powerful people very uncomfortable.

[schatsie]

I adored this explanation, it is becoming clearer and clearer to me... So since we the TAXPAYERS are ASSUMING the Risks for these, doesn't that mean that the interest rates that were based on risks should no longer be based on risks????

Wouldn't it make sense to restrict the amount of the interest on the bad loans to something reasonable, like 3% over the COLA.(since there would be minimal or no risk).. I am hearing that people are paying outrageous interest rates on loans..

I think this is where the issue lies, that people were able to service the mortgage at a reasonable rent equivalent... Now however the interest rates are going up and consequently the bubble has broken, so an equivalent rental would be about the same....What we buy with a mortgage of 100% is the right to live there, sorry but the bank has the Asset Value risk.... BUT if we use the RENTAL Concept, then the bank with the same payment from the renter would be still receiving the same amount for the renters occupation of the house.... and would not really have experienced any asset devaluation, if the asset valuation was based on the Present Value of the cash stream itself....