A Swap is a type of derivative tools that use by the company to hedge the financial risk or earn profit from speculation and arbitrage. Company will enter a contract with other parties to exchange a series of cash flow on periodic settlement dates over a certain period of time by using swap (Cuthbertson and Nitzsche, 2001). In this paper, we have chosen AIG to discuss about the credit default swap during the subprime crisis. Section I: we will discuss the company background and the purposes of the credit default swap (CDS). Section II: we will identify the AIG strategies to deal with CDS. Section III: we will show the outcomes of the CDS. Section IV: how the U.S. government to overcome the crisis. Section V: we will conclude what are the impacts to AIG.
Company Background
American International Group, Inc. (AIG) is the U.S. based insurance company that provides life insurance, general insurance, retirement planning services, and financial services. AIG Financial Products Corporation (AIGFP) is the subsidiary of the AIG that run the financial services segment for capital markets operations, consumer finance, and insurance premium financing (AIG, 2007). During the financial crisis of 2008, AIGFP forced to be winding up because the massive losses at trading in credit derivatives. Therefore, AIG credit rating has been downgraded by the credit agencies and the company is near at the stage of bankruptcy due to liquidity crisis. At last, U.S. Federal Reserve Bank has to bailout at least $128 billion to AIG for protect the financial system to be collapse.
Credit Default Swap
What is credit default swap (CDS)? According to Hughes and Donde (2009), CDS is a contract between two parties where the protection buyers pays a premium to the protection seller to exchange the credit risk of a specific issuer. CDS is trade over-the-counter and able to be customised. In the event of default such as bankruptcy, default on loan, difficulty to pay, restructuring, or any other credit event, the protection seller will receive the assets like equities or bonds and in exchange they will pay the buyer the amount that agree for the value of the assets by cash or auction. Wang (2004) claim that CDS is getting popular because of the trading profit, better liquidity than corporate bonds or loans and accurate delinquency rates which change directly with real delinquency rates of underlying assets via estimate the premium pay for the CDS by market analysts.
Regulatory Capital Relief CDS & Multi-Sector CDS
There are 2 type of CDS is running by the AIG as regulatory capital relief CDS and multi-sector CDS. Before regulatory capital relief CDS exist, there are several financial firms apply hedging by transfer out high risk-weighted assets through securitizations and changing credit assets composition in the balance sheet (Ying, 2005). Due to the disadvantage of not entitle the legal interest on the asset that shifted out, regulatory capital relief CDS solved this problem by reducing the credit risk hidden in the balance sheet by providing off-balance sheet support, with no assets being shifted out, maintain the legal interest on the assets, and no adjustment of balance sheet structure. As a result, CDS trading became an effective financial tools to managing risks while create a stable return over a long-term period for AIG. The multi-sector CDS is a pool of sub mortgage-backed securities which form by residential mortgage-backed security (RMBS), commercial mortgage-backed security (CMBS) and some other collateral debt obligations. In the U.S., Fannie Mae and Freddie Mac are act as a securitization trusts to issue mortgage-backed security and guarantees against the default risk to the investors with certain return. These securities had attracted the investment from banks, hedge funds and pension funds.
Valuation of Credit Default Swap
It is important to measure the CDS prices by the spreads. Therefore, the CDS spreads will increase when creditworthiness declines and CDS spreads will decline when credit-worthiness increases. The investor who speculates on a company's creditworthiness to be dropping will buy CDS protection to prevent default. Otherwise, when the company's creditworthiness is improving investor will sell protection. The action of "long" on the CDS and credit mean that the investors who owned the assets are selling the CDS. In the other way, the investors who bought protection are "short" on the underlying assets and CDS (Blanci, Brennan and Marsh, 2005).
In early 2005, the rate of the house ownership is increasing because the U.S. government is promoting the campaign of "ownership society". Therefore, the housing prices in the U.S. are on the peak and many investors like investment banks and hedge funds are speculate that the rate will increase in the future. AIG had speculated that the mortgage markets will be rise and sold a credit default swap to the investors for the profit from the stream of income that receive for the protection. In the other hand, Société Générale, Goldman Sachs, Deutsche Bank, Barclays and the others investors are using credit default swap as a hedge and protection from the risk of default.
Furthermore, the CDS transformed debt markets to the new era. Investors are requiring higher return by not taking any additional risk that taking into account by lending to less creditworthy borrowers. The CDS help the investors to hedge the default risk and the expected rate of return. From AIG the seller of the contract's point-of-view, the CDS is considered as a steady income. They were predicting the economy was rising, rate of corporate bankruptcies were less, the housing market was booming, and high consumers spending power. It shows that CDS was seen as a low risk method to generate income. During the periods of 2005 to 2007, the U.S. economy was doing well and there are a lot of the investment funds entered the CDS market. The secondary market also expanded due to the demands from investors for the CDS because they bought and sold CDS frequently to bet on the underlying firms' creditworthiness. At last, CDS markets had become more liquid and worth $62 trillion.
As a result, speculators are benefit from the new change of CDS because they could go long on a bond exclusive of any upfront cost of buying a bond. The only commitments for the investors are to pay in the event of default. It is very difficult to short a bond because that shorting was often not possible. So, CDS become trendy by made shorting credit achievable because the speculator only trade at the value of the CDS and does not presently own the bond. AIG is earning the transaction costs and the premium from the selling of CDS to those investors that do not have own the securities. Furthermore, AIG was exceptional among large credit default swaps seller because they consistent to sold protection rather doing the hedging. Credit rating becomes the important issues to be considered by the investors because there are investors with different risk/reward profiles. The higher the credit rating, the lower the interest rate the CDS will be offer (Sjostrom, 2009). The credit rating for AIG is 'AAA' rated company, AIG's derivatives counterparties had not required the company to post collateral on most of its derivatives trades. This is become more attractive because investors are seeking demand for safety of highly rated (AAA or AA) debt securities rather than lower rated securities with higher returns.
Counterparty Risk
Jorion and Zhang (2009) stated that main risk for CDS is counterparty risk. Counterparty risk arises when the default of one firm causes financial pain for its creditors. They examining the large capital firm and small capital firm with the chance they will get default during the financial crisis. As a result, they show evidence that the counterparty effect is significantly stronger when the debtor is a major customer of the creditor, and when the debtor liquidates rather than when it reorganizes because the creditor incurs a loss not only from its current exposure but also from future business. Moreover, creditor firms with large exposures to the CDS and have experience a credit loss are more likely to default than other firms that in same industry, size, and rating. The disadvantage of counterparty risks are the CDS is not regulated because contracts can be traded and traded again without guarantee that the buyer has the funds to cover the losses in event of default. In other words, the main different between CDS and insurance are there is no requirement that money be set aside to ensure payment of financial obligations unlike the insurance Young, McCord and Crawford, 2010).
Subprime Crisis 2008
On 2008, the housing price had reached the top and start declined after that. Housing bubble is the main trigger for the subprime crisis. Hence, AIG was facing financial crisis because the credit rating had been downgraded by Standard & Poor and Moody. The derivative market practices allow firms with highest credit ratings to enter swaps without depositing collateral with their trading counterparty. Therefore, when AIG's credit rating was downgraded, they required topping up additional collateral with their clients, so it affected AIG liquidity position. The investors were started sold the CDS to AIG because they feel the CDS is more risky to hold. Therefore, the value of CDS start to decline and AIG do not invest collateral in treasury bills for the short-term liquidity rather to put all the collateral in subprime mortgage backed securities (MBS). They found out that they can't get the liquidity in short-term by selling the securities and the value of the shares price had declined 95%. At last, they need to seek help from the government to prevent insolvency.
U.S. Government Bailout
Federal Reserve Bank of U.S. decided to bailout total $128 billion to AIG to save them from the bankruptcy. The following is the breakdown for the bailout:
$40 billion to enable AIG maintain operating from a bridge loan while selling the non-business assets.
$28 billion to buy the collateralized debt obligations from AIGFP.
$40 billion to purchase AIG's shares with the Trouble Asset Relief Program.
$20 billion to obtain subprime mortgage backed securities in AIG's securities lending program
After the funding by the government, AIG was able to continue their business from the losses that incurred by CDS. Many people critic that the fall of AIG was due to the risks of exposing to the MBS and CDS market without any hedging. The downgrade of AIG's credit rating and tremendously declined in the mortgage markets was the trigger of the crisis (Kos, 2010).
Regulatory for Derivatives Market after Financial Crisis 2008
After the financial crisis 2008, U.S. government tightened the rules and regulations for the derivatives market. The main two areas were focus on regulation and supervision of dealers in OTC derivative markets, and clearing of standardised CDS through central counterparties and exchanges. The International Swaps and Derivatives Association (ISDA) had form a derivatives clearing house to settle or clear all derivatives including CDS transactions. Moreover, ISDA had require limits on positions in OTC derivatives if it found out that trading in the OTC market has a potential to interrupt the liquidity or price discovery function on a financial body or cause a severe market disorder in the essential cash or futures market and to suspend CDS trading to maintain the public interest and to protect the investors. So, if any investors will have to keep records of CDS trading for at least five years to deal with CDS through a clearing house. In term to control the market manipulation, the government would have rule-making power in respect of fraudulent, deceptive or manipulative acts or practices in connection with CDS, promoting the transparency and competence of those markets, preventing market manipulation, fraud, and other market abuses and preventing OTC derivatives from being marketed inappropriately to unsophisticated parties (Shiren, Damianova and Crosignani, 2009).
Thus, the U.S. government had improved the market liquidity and transparency of the CDS market by restructured and standardised the rules and regulations. In the future, if AIG want to sell the CDS to getting the premium, they have to go through the clearing house. It helps to minimise the counterparty risk and they can't manipulate the balance sheet by providing inaccurate information for the investors.
Conclusion
In the nutshell, the failure of the derivatives investments of AIG is due to the collateral obligations embedded in the CDS. The main trigger of subprime crisis has a chain effect that force AIG in illiquidity positions. They were not capable to raise funds in the private markets or quickly sell off some of its trillion dollars in assets. Therefore, U.S. government had to bailout to save AIG from insolvency. In other way, we should conclude AIG should not speculate that the house pricing will be increasing infinitely and underestimate the systematic risks. They should do the hedging for the CDS collaterals by buying some short-term bonds or t-bills or buying some of the CDS from other finance institutes to hedge the liquidity risks. Hence, the government also admitted that U.S. financial markets were too weak to take up an AIG bankruptcy. So, the bailout of total $128 billion to rescue AIG is a necessity. After that, ISDA had regulated the derivative markets especially CDS by imply the clearing house. As a result, regulation of CDSs should be measured and flexible enough to adapt to our constantly evolving financial markets.
