Credit derivatives were mainly used to diversify credit risk and hedging transactions by financial institutions but now they are also used as a major investment instrument. Credit derivatives are basically traded between two parties and both these parties enter into contract to hedge their risk. More or less all credit derivatives are similar to credit default swap, which transfers the default risk of one or more corporations or entities from one party to the other. In 2004 credit indices were introduced and it has been the major factor contributing to the growth and liquidity of the market. The major challenge faced by credit derivative was confusion between reference entities and in the definition of credit events.
According to Frank Iacono (1996) "A Credit Derivative is based on the credit performance of some credit sensitive asset or assets. Credit performance is typically measured
by yield or price spreads relative to benchmarks
by credit ratings or
by default status."
Various types of Credit Derivatives are
Credit Default Swap
Collateralized Debt Obligations
Credit Linked Notes
Total Return Swap
Credit Default Swaps
Credit Default Swaps commonly known as CDS is the most commonly used Credit Derivative. It is one of the uncomplicated types of derivative. A credit default swap is an agreement to shift the default risk of a reference party between parties of the contract. During the life of the CDS the seller of the protection receives a periodic premium from the buyer. On the other hand, the seller is required to pay back to the buyer in case any credit event (such as default, bankruptcy etc.) occurs, the amount being the estimated face value of the security which was agreed upon.
CDS are of two types funded and un-funded. In case of a funded CDS, the seller makes a prerequisite in a form of loan or special purpose vehicle (SPV), to hedge the buyer against if a credit default or credit event occurs. In case of un-funded CDS there will be no prerequisite and the buyer will have to bear the default risk.
CDS differ on the basis of number of reference parties participating. Single name or Vanilla CDS has only one reference party. Basket CDS has more than two or more reference parties. But the actual component of CDS growth has been CDS index, where almost 125 corporate entities can be reference party to a single fund.
The following diagram shows how cash flow takes place in case of a transaction in Credit Default Swap.
XXX Basis points per year
Protection Buyer
Protection Seller
(Investor)
Default Payment
Reference Party
The Protection Seller receives a periodic premium from the Protection Buyer in exchange for a contingent payment if there is a Credit Event of the Reference Entity. The contingent payment is determined based on pre-specified settlement terms.
Source: Credit Derivatives & Synthetic Structure 2nd Edition, John Wiley & Sons, 2001 by Janet Tavakali.
Role of Credit Derivative in Economic Crisis
The boom in Credit Derivatives market has took regulated entities such as banks away from credit risk. According to Basel I norm banks can reduce their CAR i.e. capital adequacy ratio for loans by 80% once the loan is hedged with derivatives. This norm helps bank to enjoy more freedom and they have enough liquidity in order to use it more profitably. The market for these products was close to 45 Trillion US Dollars by mid-2007 (Credit shocks: Three questions, John Silvia, ABA Banking Journal, July 2008). But the main concern here is that these derivatives which were created made a way for highly leveraged institutions in the structure and thereby causing capital inadequacy in the whole structure.
Derivatives also created avenues for entities to focus risk in the quest for higher return on their investment. If the institutions have enough funds to take in the losses while market downtrends then it is ok but if the institution or the entity is highly leveraged than this situation is a disaster. As derivatives are contingent liabilities they do not have to be accounted into the balance sheet and therefore it is very easy to use derivatives and hide the credit risk from the market. One example for this can be AIG, the American insurance company. It had high exposure to CDS. AIG could have taken similar position and risk in the cash market but CDS made it very easy for them to take huge risk and not account it on the books because CDS is treated as contingent liability.
In a credit derivative generally the underlying assets are loans and the principle buyers are banks. Banks are a net buyer of protection in the credit derivatives market. The main criteria for banks while using CDS was to make huge profits therefore may be due diligence was not conducted before lending the money. In fact banks tried to eliminate the credit risk from their books and hence used more and more CDS. In such scenario we cannot say no to insider trading also. In order to generate profit and reduce the risk banks may have intentionally bought protection on loans about which they know are bad but the seller as no idea about the loan.
Were Credit Derivatives solely responsible for the financial crisis? The direct effect of CDS market showed us the result in both credit and stock market. The US federal government had to interfere in case of Bear Stearns just as it did in the case of AIG. It was because of the US Federal Government's interference that trillions of dollars of Credit Default swaps were not wiped out. If the US Fed government had aloud Bear Stearns to enter bankruptcy then all the banks and financial institutions which had insurance with the firm would not be insured and they would have been exposed to risk and also they were not be hedged anymore. The banks and institutions would have to written off billions and billions of dollars, as they were at risk and also they would not have been insured anymore. The risk of letting Bear Stearns enter bankruptcy was so huge that the Fed government had to interfere otherwise the trading partners of the firm would have taken years and years just to sort out the risk and the losses. The main problem was that how these derivatives were targeted by the financial institutions like banks, business houses, funds houses etc. The problem was how these derivatives were treated. If used properly they are useful and ethical as they were mainly used to hedge risk and not as an investment instrument. It distributes risk to all concerned parties and also it benefits all the parties concerned. But if not used properly can be a disaster for an economy. This happened mainly in the Real Estate sector in the US. Real Estate had a boom and prices increased enormously. Increasing housing prices coincided with lower lending rates of the banks and financial institutions. Banks started giving loans even without any due diligence or KYC. Banks spread these real estate loans in to the system through CDOs and other derivatives. This was fine till the time interest rate was under control but when the interest rate increased, cost increased and therefore credit event such as default payment and bankruptcy happened, and they created a panic in the market and made the market more opaque and complex. The banks were forced to write off these defaulted loans and therefore they found themselves in a tricky position and exposed to risk.
Conclusion
It is still debatable whether the Credit Derivatives were the reason behind financial crisis, but on the basis of various research articles it is indeed one of the major components which catalyzed the financial meltdown. Financial crisis could not have been so disastrous if we would have proper rules and regulation and also if the financial institutions had not taken such huge risk. Credit Derivatives has their advantages such as ability to hedge. Credit derivatives are effective in improving the distribution of risks within the financial structure. These effectively allocate the risks and manage it more efficiently and effectively but at the same time there is risk such as poor transparency and overpricing of the derivatives etc. They are a useful but only if used properly. If these derivatives works in favor it pays off and companies generate abnormal profits but if it doesn't work then the common man has to pay for it. If there would have been proper guidelines about using Credit Derivatives and also rules regarding trading and the limit for trading then maybe we would not have faced such a huge financial meltdown. Therefore in order to protect investors and common man's interest and also to not repeat the same mistakes there should be proper simple and strict rules and regulations for Credit Derivatives. These rules and regulations will help protect investor's interest.
