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									                                                                              Garrett Vogenbeck
                                                                          Oregon State University
                                                       BA 543 – Financial Markets and Institutions
                                                                                   April 20, 2009

     Credit Default Swaps: The Good, The Bad, and The Ugly
Credit Default Swap Basics

         A Credit Default Swap (CDS) is credit derivative used to provide protection against a

reference entity (or issuer of debt) in the case of default1. A CDS is the most popular type of

credit derivative2. As the term swap implies, when the reference entity defaults (either by failure

to pay, restructuring, bankruptcy, or any other credit event), the protection seller must reimburse

the protection buyer through means of either physical settlement (delivering the obligation, or

reference asset, to the protection buyer in exchange for cash) or through a predetermined

termination value.3 The protection seller receives a swap premium on a regular basis in return for

a contractual agreement to settle in the case of a credit event. The CDS spread is the premium

paid by the protection buyer to the seller 4. This means that a higher spread implies a riskier

underlying reference asset.

         A single name CDS describes one containing a single reference entity, whereas a basket

CDS contains multiple reference entities. In the case of the latter, payout is contingent on the

agreed number of reference obligations that must default. A standardized index of credit risk

protection has been compiled by Dow Jones, known as the North American Investment Grade

Index allows a more liquid form of protection in what is known as a credit default swap index. In

this case, when a credit event occurs for a reference entity in this basket, the swap premium

decreases and physical settlement for the value of the defaulted bond is paid out. The contract

does not cease, but rather the payments decrease. 5

     (Fabozzi, Modigliani, & Jones, p. 634)
     (Fabozzi, Modigliani, & Jones, p. 631)
     (Fabozzi, Modigliani, & Jones, pp. 632-634)
     (Beck, 2009)
     (Fabozzi, Modigliani, & Jones, pp. 635-638 )

                                                                                              Page 1
                                                                              Garrett Vogenbeck
                                                                          Oregon State University
                                                       BA 543 – Financial Markets and Institutions
                                                                                   April 20, 2009

         The CDS was invented by J.P. Morgan over a weekend at the tony Boca Raton Resort &

Club in 1994 during what is known in the financial world as an “Off-site Weekend” 6. One might

think of a CDS as an insurance policy against bad debt. The popularity of CDSs exploded in the

last decade, and this has had a profound effect on the causes of the current economic crisis. CDSs

have a multitude of uses, but have received extensive criticism.

The Good

         CDSs have an accounting effect on a company’s books. JP Morgan needed a solution to

the massive amount of debt on its books in the mid 1990’s, and by selling protection via CDSs,

the company was able to transfer the risk to others. In doing so, they were able to reorganize the

numbers in their books.

         In essence, placing an insurance policy on debt and offloading risk seems like a

reasonably good idea. That being said, it is important to understand the accounting treatment of

CDSs. CDSs are marked-to-market daily. This means that those writing credit protection have to

deal with the risk involved, which means their financial position is margined daily. This

treatment, in theory, should allow managers of funds to use CDSs to safely reduce the credit

exposure risk involved to manipulate the fund to better fit the investors’ risk profile.

         It is also important to realize that a CDS is technically not an insurance policy. Insurance

policies (such as health insurance or auto insurance) are generally required by the government to

be sold by regulated entities, and those purchasing insurance must own the underlying asset. This

gives the investor a lot of leeway when it comes to the application of the CDS. For example,

CDSs may be used by investors for speculative purposes. Depending on whether an investor

believes a company may soon default on its debt or remain stable, a CDS can be either bought or

     (Philips, 2008)

                                                                                              Page 2
                                                                              Garrett Vogenbeck
                                                                          Oregon State University
                                                       BA 543 – Financial Markets and Institutions
                                                                                   April 20, 2009

sold with the aim of making a profit. Investors can even utilize an arbitrage strategy known as

capital structure arbitrage in which a profit is made based on the CDS spread of an asset7. For

example, imagine a corporation that is having problems and whose stock price is dropping, but

the CDS spread is remaining unchanged. A hedge fund could be created in which $10 million

dollars is used to purchase CDSs at the current price. When the spread does increase, the fund

can turn around and sell those CDSs at a higher price for a net gain.

         CDSs may present outstanding opportunities for investors, but their effects on the market

have had mixed results at best. It may be easy to jump to the conclusion that because CDSs

played a major role in our current economic collapse, they must be somehow intrinsically

flawed. Blythe Masters is head of global commodities at J.P. Morgan and helped to create the

CDS. She has said “Ironically, the CDS product has been performing exactly as it was intended

to.”8 Her message is that it is those abusing CDSs who have caused so much pain in the market,

an argument equivalent to that of “guns don’t kill people, people kill people.” Perhaps the degree

to which companies and investors tried to manipulate risk using CDSs, combined with a lack of

government oversight and regulation prevented the CDS to be used in a positive way across the


The Bad

         Imagine betting on a horse race or a basketball game. You benefit from a certain outcome

and lose from the opposite. It's a gamble, and worst of all, once you place your bet, the outcome

is out of your control (unless of course, like Pete Rose, you actually may affect the outcome

directly). CDSs are essentially a gamble. That being said, think of this scenario. Car insurance is

a collective effort. Instead of insurance companies selling insurance, it's a collective effort. Your

     (Spectator Business, 2008)

                                                                                               Page 3
                                                                              Garrett Vogenbeck
                                                                          Oregon State University
                                                       BA 543 – Financial Markets and Institutions
                                                                                   April 20, 2009

friend, who has never even gotten a parking ticket, says he'll pay you a premium and suddenly

you become the insurance seller. Then imagine his car is involved in a pileup, and everyone

including yourself that is involved in this collective insurance effort is on the hook for costly

settlements. AIG and Lehman Brothers are perhaps examples of an “insurance company” of debt.

Ali Velshi, in his book Gimme My Money Back, described the situation with another metaphor. A

group of climbers are going up a mountain. Tied together, when one falls, it brings down the

entire line. But, Velshi says, imagine if that line of climbers is attached to other lines, which are

attached to other lines. Perhaps in Velshi's metaphor, whereas the mortgage meltdown may have

been the slip that made the climbers fall, the CDS may be the rope connecting the climbers.

CDSs allow everyone to become involved in insurance, but is this a good idea, even with

stronger government regulation?

        Enron became a victim of improper use of mark-to-market accounting. Perhaps AIG is

also a victim of this, as much of the revenue they recorded never materialized. So should CDSs

be marked-to-market? If not, how could a company that issues substantial protection recognize

its future revenue on its financial statements?

        AIG's problems were accentuated because many people bought CDSs for speculation 9.

Think of it this way: instead of buying insurance on your car for peace of mind, you buy it with

the hopes that it will get destroyed so that you can receive the settlement. Then take it one step

further, and imagine that instead of owning this insurance on your own car, it was on your

neighbor's car, who you knew to be driving recklessly lately. This problem was accentuated even

further by the fact that billions of dollars were invested into hedge funds specifically designed to

take advantage of the collapse of financial institutions such as Lehman Brothers.

     (Blumberg, 2008)

                                                                                               Page 4
                                                                             Garrett Vogenbeck
                                                                         Oregon State University
                                                      BA 543 – Financial Markets and Institutions
                                                                                  April 20, 2009

         Another potentially deadly manipulation of CDSs may be in what is known as “netting”.

Assume a hedge fund designed for speculatively taking advantage of CDSs bets right. When the

spread of the CDS increases, it can then sell CDS protection for that same company at a higher

rate, netting a steady income with completely hedged risk 10. Perpetuated further, this creates a

dangerous chain, the “ropes” in Velshi's metaphor. The hedge fund may appear to be in good

shape, but with everyone linked together, the breakdown and financial losses will be


         Warren Buffet, in the 2002 Berkshire Hathaway Annual Report, warned against the

unchecked expansion of financial derivatives such as CDSs, even going so far as to say that

“derivatives are financial weapons of mass destruction, carrying dangers that, while now latent,

are potentially lethal.” 11 Ironically, despite Buffet's oracle like wisdom, Berkshire Hathaway sold

more than $2.5 billion in CDSs in 2008, and the company eventually posted a $2.2 billion loss

stemming from Berkshire Hathaway's credit derivative business 12.

The Ugly

         Without regulation or prudence, the volume of CDSs exploded from $1 Trillion in 2001

to $26 Trillion in 2006 (Figure 1).13

      (Blumberg, 2008)
      (BBC News, 2003)
      (Epstein, 2009)
      (The History Channel, 2009)

                                                                                             Page 5
                                                                               Garrett Vogenbeck
                                                                           Oregon State University
                                                        BA 543 – Financial Markets and Institutions
                                                                                    April 20, 2009

                     Figure 1 – Expansion of the CDS from 2001 to 200614

         As CDSs surged in volume in 2005, the fundamentals of the CDS appeared to still be

intact. In fact, although AIG’s use of CDSs exposed the company to billions of dollars in risk, the

company’s computer simulations showed only a minute chance that they would have to make

even a single payout15. Why would they, considering that historically, only 0.2% of investment

grade companies will default in any one year 16. The question arises, “If owning a CDS required

accounting for the risk involved, then what caused companies like AIG to find themselves

walking right up to the edge of despair?” Enter credit rating agencies. Credit rating agencies such

as Standard and Poor’s and Moody’s Investors Services, which are private nongovernment

entities (but may be considered “government blessed”) may be partly to blame for the current

economic crisis. Because AIG was given a AAA rating, they were not required to put up

collateral against their credit protection risk as other financial firms were required to do so 17. In

      (Reserve Bank of Australia)
      (Dennis & O'harrow Jr., 2009)
      (Avert, 2008)

                                                                                                Page 6
                                                                             Garrett Vogenbeck
                                                                         Oregon State University
                                                      BA 543 – Financial Markets and Institutions
                                                                                  April 20, 2009

fact, the beginning of the end for AIG was perhaps the resignation of then CEO Maurice “Hank”

Greenberg in March 2005, just days after it was revealed that he was involved in improper

accounting practices18. The following day AIG had its credit ratings downgraded. Immediately,

provisions now required AIG post $1.6 billion as collateral19. As the economy worsened, and

unemployment went up, more people defaulted on their mortgages, causing AIG to payout for

the subprime mortgage backed securities it insured. AIG, after marking billions of profits in its

books using mark-to-market accounting for CDSs while not backing up these credit derivatives

with capital was on the hook for billions of dollars in collateral when its credit rating was again

downgraded on September 15, 200820. The end had come, and the wildfire had to be put off by

the Federal Government bailing out AIG with $85 billion.

         New York Attorney General Mario Cuomo has widened an already broad investigation of

AIG. Politicians, including Cuomo, are demanding information about counterparties to the AIG

CDSs (which include Goldman Sachs, Société Générale of France, and Deutsche Bank of

Germany) 21, while democrats are calling for an investigation into the Bush administration’s role

in AIG’s collapse22. Meanwhile, the public outcry has caused politicians such as Barney Frank to

demand AIG executives who received legally attained bonuses to be named, regardless of their

direct role in AIG’s economic collapse, a situation being likened to that of the Josephy

McCarthy’s witch-hunt of potential communists 23. AIG executives are being stalked and

harassed, being grouped in with financial crooks like Bernie Madoff and former Enron

      (Valdmanis, 2005)
      (Dennis & O'harrow Jr., 2009)
      (Stansberry, 2008)
      (Sorkin, 2009)
      (Grim, 2009)
      (Shepherd, 2009)

                                                                                              Page 7
                                                                               Garrett Vogenbeck
                                                                           Oregon State University
                                                        BA 543 – Financial Markets and Institutions
                                                                                    April 20, 2009

executives. Hank Greenberg insisted that the government’s bailout of AIG is a “failure” 24. The

irony gets deeper when you consider that in 2008, federal candidates received $644,218 in

campaign contributions, including $104,332 to new President Obama and $103,900 to

Connecticut Senator Chris Dodd25.

The Future of Credit Default Swaps

          Credit Default Swaps have gotten a bad name lately. Will future legislation restrict their

usage in an attempt to create more transparency? There's no doubt that CDSs played a huge role

in recent financial failures, and so one must assume that changes are impending. In an article for

the New York Times, SEC Chairman Christopher Cox noted that CDSs “play an important role

in the smooth functioning of capital markets by allowing a broad range of institutional investors

to manage the credit risks to which they are exposed”, but added that “markets function best

when they are highly transparent, when everyone can see exactly which transactions are

occurring and what the instruments being traded are worth”. He urges Congress to pass

legislation aimed at making CDSs more transparent, suggesting public reporting of CDS trades,

explicit authority be given to the SEC to issue rules against manipulative acts, and mandating the

use of central counterparties26. Unfortunately, it doesn't appear that the problems are going to go

away anytime soon. In April 2009, The International Swaps & Derivatives Association (ISDA)

released new standardized protocols for CDSs, which were subsequently signed by over 2000

participants. AIG, However, refused, claiming its CDS contracts are too complex to sign on to a

“catch-all rule”27. Will regulation allow CDSs to become the positive market force they were

designed to be, or will future problems with them cause them to be stomped out at all costs?
       (Farber, 2009)
      (Center for Responsive Politics, 2009)
      (Cox, 2008)
      (Carney, 2009)

                                                                                               Page 8
                                                                     Garrett Vogenbeck
                                                                 Oregon State University
                                              BA 543 – Financial Markets and Institutions
                                                                          April 20, 2009

   1. Works Cited
Avert, Ryan. Market Movers. 19 October 2008. 13 April 2009

BBC News. Buffett warns on investment 'time bomb'. 4 March 2003. 2009 April 17

Beck, Roland. "The CDS market: A primer. Including computational remarks on
“Default Probabilities online”." Deutsche Bank Research. 2009 April 18

Blumberg, Alex. Unregulated Credit Default Swaps Led to Weakness. 31 October 2008.
15 April 2009 <
Carney, John. AIG Refuses To Accept Swap Reform. 13 April 2009. 20 April 2009

Center for Responsive Politics. American International Group: All Recipients. 2 March
2009. 16 April 2009 <

Cox, Christopher. Swapping Secrecy for Transparency. 19 October 2008. 20 April 2009
Crash: The Next Great Depression? Dir. The History Channel. 2009.

Dennis, Brady and Robert O'harrow Jr. Credit rating downgrade, real estate collapse
crippled AIG. 2 January 2009. 16 April 2009

Epstein, Edward Jay. Warren Buffett's Hidden Stake in Financial Weapons of Mass
Destruction . 2 February 2009. 19 April 2009

Fabozzi, Frank, Franco Modigliani and Frank Jones. Foundations of Financial Markets
and Institutions. Boston, MA: Pearson Education, Inc., 2010.

                                                                                  Page 9
                                                                     Garrett Vogenbeck
                                                                 Oregon State University
                                              BA 543 – Financial Markets and Institutions
                                                                          April 20, 2009

Falkenstein, Eric. Default Rates. 12 April 2009 <

Farber, Daniel. Greenberg Calls AIG Bailout a "Failure". 2 April 2009. 16 April 2009

Grim, Ryan. Dems Investigating Bush Administration Role In AIG Collapse. 1 April
2009. 16 April 2009 <

Nelken, Izzy. "Capital Structure Arbitrage." Super Computing Consulting, Inc. 20 April
2009 <>.

Philips, Matthew. "How 'credit default swaps'—an insurance against bad loans—
turned from a smart bet into a killer." NEWSWEEK 6 October 2008.

Reserve Bank of Australia. Credit Default Swaps Outstanding. 20 April 2009

Shepherd, Nikki. Shep Smith Blasts Congress Over AIG Hypocrisy. 18 March 2009. 14
April 2009 <

Sorkin, Andrew Ross. Cuomo Widens His A.I.G. Investigation. 26 March 2009. 16 April
2009 <

Spectator Business. 28 October 2008. 16 April 2009

Stansberry, Porter. How AIG's Collapse Began a Run on the Banks. 4 October 2008. 16
April 2009 <>.

Valdmanis, Thor. AIG's chief executive Greenberg resigns. 15 March 2005. 2009 April
16 <

Velshi, Ali. Gimme My Money Back: Your Guide to Beating the Financial Crisis. New
York, NY: Sterling & Ross Publishers, 2009.

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