And you thought Frankenstein was scary: The rise of credit derivatives

by Shane Murray
The monster Frankenstein was scary; there are no two ways about it. Regardless, the creature was created with all good intents, but confused and conflicted he desired nothing more than to see the life of his creator ended. Comparably, it seems credit derivatives are not too dissimilar. Created by the financial sector as a credit risk mitigant some 15 years ago, misunderstanding around their fair value coupled with their exponential growth has left the finance sector in a state of near ruin! Now you might ask, how did something as simple as a collection of swaps prompt the Global Financial Crisis (GFC)? Well it seems these humble swaps are more intricate than their name suggests. While the cash flows between counterparties can be assimilated to those of a tradition swap, the real payday comes after a credit event when the ‘swap’ more so resembles an insurance product. But don’t tell the regulator! In a market where the lenders are reaping the rewards of highly-leveraged seemingly de-risked positions, and the protection-sellers are happily watching the premiums accumulate, why concede to restrictive governance? Particularly, when considering the genius of the creator. But it seems the smarts are not all there, as the coming together of deficient credit modelling; moral hazards; and the unravelling of the sub-prime market, generated the very bolt of lightning needed to awaken the sleeping monster, which brought the thriving financial sector to its knees.

Credit Default Swaps (CDS) account for approximately 80% of credit derivatives. Simply put, they provide protection against an entity defaulting on debt payments where the coverage premium, or credit spread, is determined by the credit worthiness of the respective firm. The two contemporary methods for understanding a firm’s credit worth, both of which have come under heavy scrutiny since the GFC, come via the application of sophisticated mathematical models and analysis made by specialist ratings agencies.

The first method relies heavily on historical data for calibration and verification of the models. While the mathematics behind these models still holds true, the ensuing problem came from an underestimation of the likelihood and impact of a highly-correlated credit market. Pre-GFC the probability of default (PD) on debt obligations by highly rated issuers was next to nothing. Furthermore, the correlation between entities was also markedly low, but as the popularity of CDS grew and the market spun itself into an intricate web of coverage, so too increased the correlations and in turn the individual PDs. But unfortunately, before the first domino falls, none of these interdependencies are observable, model back tests pass and the monster charges on. Austin Murphy, in his paper titled An Analysis of the Financial Crisis of 2008: Causes and Solutions questions the ability to effectively make a credit analysis without some human judgement. He notes further that purely mathematical analysis will only ever consider a subset of all the relevant variables and inter-relationships, which somewhat promotes the use of independent rating agencies.

The three largest and most well known ratings agencies would certainly agree with the above statement, but they too have questions to answer. In late 2007, Princeton economist Alan Blinder wrote in an article for the NY Times regarding the mortgage crisis that:

Investors placed too much faith in the rating agencies which, to put it mildly, failed to get it right.

Many people have speculated that the ratings agencies could see the writing on the wall, so to speak, but were reluctant to act with their own profits on the line. See, in a somewhat unintuitive payment structure, ratings agencies are paid by companies that wish to be rated, not by those whom are interested in the credit rating of a particular company. Obviously an unfavourable rating or a rating downgrade doesn’t sit well with the paying entity and so a hefty conflict of interest arises.

So in the lead up to the GFC, the market found itself in a situation where the credit worthiness of debt issuers was exceedingly understated. This was a major contributor to the breakdown of the financial sector, as relatively cheap credit coverage fuelled the exponential growth of the credit market. This is where things got really frightening!

The flooding of the market with cheap CDS created a nirvana for banks whose risk exposures are stringently regulated. Essentially, these banks now had a means for cheaply ‘offloading’ risk from their portfolios which allowed them to accumulate more risk elsewhere. This was great news for banks that are wholly focused on maximising risk adjusted returns. But remember, the risk associated with debt doesn’t just disappear, it only moves from the buyer to the seller of the CDS. But with all outstanding monies guaranteed, what incentive did these banks have to monitor counterparty cash flows and enforce strict debt servicing ratios? Parton and Skeel ask just this in their paper The Promise and Perils of Credit Derivatives. The authors noted that relaxed monitoring creates a moral hazard on behalf of the borrowers whom are now subject to less financial discipline from their lenders. Such lacklustre discipline is the very hand that opened the door to sub-prime mortgages.

The emergence of sub-prime mortgages into a highly leveraged, over stimulated financial market provided plenty of force to send the first domino tumbling. That domino is more commonly referred to as the now troubled AIG. Through the years leading up to the GFC AIG sold CDS to everyone and anyone who wanted them. Over this period AIG was highly profitable but in hindsight the CDS they sold were never correctly priced and as a result AIG never held enough money to adequately cover their standing agreements. So once the sub-prime mortgages began defaulting and CDS holders began claiming, AIG quickly went broke. Thankfully, as the financial sector tumbled into ruin governments around the world intervened and with massive bailout packages have seemingly managed to revive the sector. Now here is a scary thought, what if they had not? What if governments had decided that the assurance from the financial sector, only a few years prior, that credit derivates were manageable without regulation was the final insult they were willing to take? For mine, only a handful of banks the world over would remain!

While CDS were created with all good intentions and provide fantastic means for reducing a lenders credit risk exposure, if not properly priced and regulated this facility is easily abused. This has been observed. Unfortunately, it is only human nature to push the limits and forge into the unknown and with this in mind one could be fooled into believing the finance sector may have learnt its lesson; but fooled twice these people shall be. For CDS still exist, are still traded and are still highly unregulated. So while the monster caught up with its creator once, it seems likely it will get a second chance to finish the job. And that my friends, is the chilling reality to this modern-day horror story!

Shane Murray is a Master of Applied Finance student at Queensland University of Technology.

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