Credit Derivatives

1. Credit Derivatives A Look at Credit Default Swaps, Collateralized Debt Obligations, And our Current Crisis Brought to you by: Dan Cain, Jenny Flasher & Olivia Pietrunti

2. Basic Outline • History • Definitions of the Key Components • Credit Derivative • Credit Default Swap • Collateralized Debt Obligations • The Default Correlation • Winner’s in the Crisis • Toxic Assets • Rebuilding Today’s Economy

3. History • 1991- First credit default swap created by Banker’s Trust • 1997- Asian financial crisis • 1997- J.P. Morgan creates the Broad Indexed Secured Trust Offering, BISTRO • 2000- David X. Li publishes his copula formula for default correlation • 2001- CDS market hits $900 billion worth of credit • 2003- Warren Buffett: “financial weapons of mass destruction” • 2007- CDS market hits $62 trillion worth of credit • March 2008- Bear Stearns collapses • October 2008- AIG is nationalized by the government before it goes bankrupt

4. Credit Derivative • The Basic Definition: • A derivative who’s payoff depends on the credit worthiness of one or more companies or countries

5. Collateralized Debt Obligations • A Basic Definition • A way of packaging credit risk. Several classes of securities (known as tranches) are created from a portfolio of bonds. There are rules for determining how the cost of defaults are allocated to classes. • Apparently got rid of the risks of correlated CDS’s.

6. Collateralized Debt Obligations Tranche 1 1st 5% loss Yield =35% Bond 1 Bond 2 Bond 3 . . . Bond n Annual Yield 8.5% Tranche 2 2nd10% loss Yield =15% Trust Usually Sold into the Market Tranche 3 3rd10% loss Yield =7.5% Tranche 4 Residual loss Yield =6%

7. Credit Default Swap • A Basic Definition: • An instrument that gives the holder the right to sell a bond for it’s face value in the event of a default by the issuer (writer). • The main way of losing money on a bond investment is in the event that the bond is defaulted. • Essentially, a CDS is insurance on your bond.

8. Credit Default Swap Payment if default Default Protection Buyer Default Protection Seller Payments

9. Relationship Between CDO’s & CDS’s • Bistro- JP Morgan’s method of combining CDO’s and CDS’s to eliminate the bank’s exposure and generate capital to reinvest in its own stock • Bistro: “the most sublime piece of financial engineering that was ever developed”; “Frankenstein’s monster”

10. Relationship Between CDO’s & CDS’s • When the tech bubble burst in 2000, many of these Bistro-like deals collapsed • By 2003, synthetic CDO’s made up of subprime mortgages and some embedded credit derivatives were the new trend

11. Relationship Between CDO’s & CDS’s • A CDS is essentially an insurance sold on the CDO’s. In the event that there is a default on the CDO’s the CDS’s would be called in for the payment. • Like any other type of insurance, for example car insurance. • The pricing of the CDS’s are dependent on the correlations between the elements of the CDO’s.

12. Default Correlation • Default Correlation • Measures the tendency of two companies to default at the same time. • Hedging against each other to decrease the volatility. • The rate of default is directly related to the price of the bond’s interest rate.

13. Problems With Correlation Correlation was essentially treated as a constant, whereas it is far from that and should be calculated frequently.

14. Problems With Correlation • “.. the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.”

15. How it was Misused • This equation was made for bonds but applied to other aspects of the market. However this equation should have been altered for the different markets. • For example, this was used in the mortgage industry, when the housing bubble burst the 1% chance of default happened. • This gave the CDO’s a higher bond rating than it should have been. • For example the bond rating would be AAA with only a 1% percent chance of default however that 1% was ignored.

16. Was this Preventable? • YES! • Some CEO’s and Bankers were able to recognize this problem. However they chose to ignore the warning signs, such as a change in the correlation, and did not make an objective decision. • Rather they chose short term bonuses over long term stability of the companies. • Therefore there was an overinflated bond rating, which was unrepresentative of reality. • Note: there was a close relationship between the Ratings Agencies and the CEO’s.

17. John Paulson- Paulson & Co. hedge fund As of the end of 2008, oversaw $36 billion in hedge fund assets His funds’ gains averaged 15-25% for 2008 making ~$1.05 billion profits Main strategy- betting the housing bubble would burst; bet on takeovers, restructurings and other corporate events Jim Simons- Renaissance Technologies hedge fund As of the end of 2008, oversaw $37 billion in hedge fund assets 2008 performance: Medallion Fund (+58%), other funds (-15%) Main strategy- employs mathematical and statistical methods to execute investments and trades Paulson and Simon

18. Toxic Assets • “The troubled assets clogging banks’ balance sheet…” • Assets-Liability=Equity • Need to be eliminated in order to boost confidence • Higher Confidence Increase in lending  Stimulate the Economy • However, Banks have a fear that they will not gain a high enough bid price for these assets • Morgan Stanley and Goldman Sachs had some write downs, it is speculated that they might have an easier time selling these assets.

19. Where are we going from here? • Geithner heading a plan to restart the economy • Government is going to step in and assume some of the risk of a default • Series of private investments that will soak up 50 Billion to 1 Trillion dollars worth of troubled loans and securities. • Taxpayers will reap gains if this is profitable • Pump capital into Banks

20. Timothy Geithner

21. Design Features • Use Government Capital from the Treasury and Financing from FDIC and the Fed. to mobilize capital. • The Public Private Investment Program will insure that the private sectors AND taxpayers share the risk, but the taxpayer also shares in the profits. • The private sector purchasers will establish the value of the loans and securities so to protect the government from overpaying

22. Opinions on Derivative Regulations • The derivatives market are the root of the current crisis because there was not legal regulation or legal obligation to record and track the assets tied to these derivatives • Currently new procedures regarding derivatives are being established. • 1. All the documents, assets and transactions need to be recorded and publically accessible. This is to avoid the use of “creative financials” which caused this recession. • 2. The law has to make sure that the “externalities” of the transactions do not harm third parties.

23. Opinions on Derivative Regulations • 3. Every transaction must be tied to the original assets. This allows us to quickly detect whether the transaction has been created to “help production or to bet on the performance of distant ‘underlying assets’.” • 4. The government must not forget that production is of greater value than finance. “ Finance supports wealth creation, but in itself creates no value.” • 5. Governments can encourage assets to be morphed and repacked into a number of tranches if it improves the value of the asset. • 6. The use of convoluted language or formulas much be eradicated, “clarity and precision are indispensible for the creation of credit and capital through paper.”

24. Ultimately this will improve asset values, therefore increase the lending capacity, thereby decrease uncertainty about major losses and lead to a flow of credit into the economy (not into the hands of executives).

25. Works Cited • Borchardt, Debra. "Credit Default Swap Market Change Is Slow." TheStreet 17 Mar. 2009. 22 Mar. 2009 <http://www.thestreet.com/story/10473384/credit-default-swap-market-change-is-slow.html>. • Borchardt, Debra. "Credit Default Swaps Move From Shadows." TheStreet.com 12 Mar. 2009. 22 Mar. 2009 <http://www.thestreet.com/story/10471457/credit-default-swaps-move-from-shadows.html>. • "Credit default swaps 'orderly' amid carnage-report." Reuters 9 Mar. 2009. 22 Mar. 2009 <http://www.reuters.com/article/marketsNews/idUSN0947417020090309?rpc=77>. • "Credit Derivatives: A look at the American Regulatory Structure." Thesis. FordhamUniversity School of Law. 11 Nov. 2007. 17 Feb. 2009 <http://law.fordham.edu/publications/articles/600flspub9503.pdf>. • De Soto, Herando. "Toxic Assets Were Hidden Assets." The Wall Street Journal 25 Mar. 2009, Vol. CCLIII No. 69 ed., sec. A: 13. • Eisinger, Jesse. "The $58 Trillion Elephant in the Room." Credit Derivatives' Role in Crash. 15 Oct. 2008. Conde Nast Portfolio. 10 Mar. 2009 <http://www.portfolio.com/views/columns/wall-street/2008/10/15/Credit-Derivatives-Role-in-Crash>. • Geithner, Timothy. "My Plan for Bad Bank Assets." The Wall Street Journal 23 Mar. 2009, Vol. CCLIII No. 67 ed., sec. A: 15. • Hamilton, Dane. "Paulson Hedge Fund Wins Big In Subprime Fallout." 10 July 2007. Reuters. 10 Mar. 2009 <http://uk.reuters.com/article/bondsNews/idUKN1036654820070710>. • Karabell, Zachary. "The Case For Derivatives." Newsweek.com. 24 Jan. 2009. Newsweek Business. 6 Feb. 2009 <http://www.newsweek.com/id/181266>.

26. Works Cited • Lenzner, Robert. "Who's Afraid Of Credit Default Swaps?" Forbes 19 Mar. 2009. 22 Mar. 2009 <Forbes.com>. • Morrissey, Janet. "Credit Default Swaps: The Next Crisis?" 17 Mar. 2008. Time Magazine. 10 Mar. 2009 <http://www.time.com/time/business/article/0,8599,1723152,00.html>. • Salmon, Felix. "Recipe for Disaster: The Formula That Killed Wall Street." 23 Feb. 2009. Wired Magazine. 24 Feb. 2009 <http://www.wired.com/techbiz/it/magazine/17-03/wp_quant>. • Solomon, Deborah. "Geithner Banks on Private Cash." The Wall Street Journal 23 Mar. 2009, Vol. CCLIII No. 67 ed., sec. A: 1+. • Task, Aaron. "The Stock Market is Signalling Things Are Better Than You Think." Finance.yahoo.com. 24 Feb. 2009. 26 Feb. 2009 <http://finance.yahoo.com/tech-ticker/article/192663/The-Stock-Market-Is-Signaling-Things-Are-Better-Than-You-Think?tickers=^dji,^gspc,^VIX,XLF,SPY,DIA,QQQQ>. • The Crisis of Credit Visualized. Prod. Jonathan Jarvis. YouTube. 18 Feb. 2009. 28 Feb. 2009 <http://www.youtube.com/watch?v=Q0zEXdDO5JU>. • "Toxic Assets." Youtube.com. 10 Apr. 2009 <http://www.youtube.com/watch?v=06PwMyJY1vA>. • Untangling Credit Default Swaps. Perf. Paddy Hirsch. YouTube. 8 Oct. 2008. 10 Mar. 2009 <http://www.youtube.com/watch?v=DdEI6PkGZK8>. • Visual Explanation of Collateralized Debt Obligations. Perf. Paddy Hirsch. Infosthetics. 10 Mar. 2009 <http://infosthetics.com/archives/2008/10/visual_explanation_of_collateralized_debt_obligations.html>. • Whitehouse, Mark. "How a Formula Ignited a Market That Burned Some Big Investors." 12 Sept. 2005. The Wall Street Journal. 24 Feb. 2009 <http://math.bu.edu/people/murad/MarkWhitehouseSlicesofRisk.txt>.