A credit default swap (CDS) is a financial derivative that allows one investor to “swap” or balance their credit risk with that of another. If a lender is concerned that a borrower will fail on a loan, for example, the lender can use a CDS to balance or swap such risk.
How are credit default swaps profitable?
Do you recall credit default swaps? Some hedge funds (and banks) exploited derivatives to create not-so-small riches betting against the housing market. The derivatives that exacerbated subprime losses and made it impossible to predict where they would appear. The derivatives that brought AIG to its knees.
In theory, these “financial weapons of mass devastation,” as Warren Buffett dubbed them, are quite easy. Credit default swaps (CDS) are simply loan insurance. You’re wagering against a debt when you buy a CDS. It also doesn’t have to be a debt you took out. You can even bet against a loan issued by someone else. It’d be like buying vehicle insurance for someone you believe is a horrible driver. As a result, if the loan defaults, you stand to profit. And if there isn’t a default, you’re stuck paying premium after premium for auto insurance on your good driver who never has an accident.
What could possibly go wrong? Plenty. For one thing, CDS are exchanged one-on-one rather than on exchanges, making it difficult to determine who owes what. Because they didn’t know who had been left carrying the subprime bag during the financial crisis, banks stopped lending to each other (or if it was them). Furthermore, you could offer more CDS insurance than you could possibly afford to pay out if things went wrong. (This was the $180 billion blunder made by AIG.) However, there are some rather simple remedies available, and some of them have been accepted by the industry. CDS trades are now publicized and processed through clearinghouses that demand collateral. As a result, CDS are more visible, and selling them if you can’t afford to pay them is more difficult.
Even with these financial shock absorbers, there are plenty of ingenious and possibly legal but ethically questionable methods to rig CDS. The two most cunning are listed below.
1. Purchase CDS on a bond and then entice the borrower to default temporarily. It’s the equivalent of buying insurance on your neighbor’s car and bribing him to cause an accident. You get the insurance, and then you give him some money to upgrade his vehicle.
Doesn’t it seem a little far-fetched? It’s not the case. It’s essentially what the Blackstone Group did with Codere SA, a Spanish casino company. First, Blackstone purchased bond insurance on Codere’s bonds, ensuring that it would profit handsomely if Codere defaulted on an interest payment. But how do you get a corporation to stop paying interest? “We’ll force you to pay back this entire revolving loan unless you politely miss the next interest payment on your bonds,” Blackstone said, holding one of Codere’s revolving loans as a hostage. It was an ingenious ransom. What’s more, guess what? The smart ransom was successful. The interest was not paid on time. From their CDS, Blackstone made $15.6 million. Codere, on the other hand, performed admirably. Blackstone agreed to restructure its obligations and receive a $48 million loan as a reward for its good behavior.
2. On a bond, sell as many CDS as you can to protect it from defaulting. This is like to selling as much insurance as possible on a car that was clearly coming apart and then paying to fix it before it could be involved in an accident.
Consider some shoddy bonds. Some truly dreadful connections. You already know how bad they are. I’m quite aware that they’re abysmal. And Wall Street is well aware of their poor performance. Everyone wants to buy these, but no one wants to sell CDS on them since they’re so bad.
That would normally be the end of the story. To insure this pile of poisonous garbage, Wall Street would hunt for a greater fool, but such a fool does not exist. But what if it actually did? What if someone on Wall Street was insane enough to insure all of these guaranteed-to-default bonds? That insurance, on the other hand, would be prohibitively expensive, and everyone would gladly pay for it. Indeed, it would be so expensive, and there would be so many people eager to purchase it, that the fool who sold it all would have plenty of cash on hand enough to buy up all the bonds it had covered. And to get them for a higher price than the market!
You see, if you pay an above-market price for certain types of bonds, you can pay them off before they mature. Let’s pretend our shoddy bonds are these callable bonds. In that case, our blunder in insuring these shoddy bonds has ensured that they will never default. After all, it wasn’t so silly after all. It’s a risk-free profit, and Amherst Holdings, based in Texas, did it in 2009. It sold $130 million in insurance on $29 million in subprime bonds to JP Morgan, Bank of America, and the Royal Bank of Scotland, among others. The company then paid above-market prices for the $29 million in bonds to avoid default.
What was the purpose of mortgage swaps?
You keep a careful check on interest rates if you have a variable-rate loan. Interest rates fluctuate, affecting your borrowing costs and making it impossible to predict what you’ll pay month to month. Changes in variable rate indexes might make forecasting debt service levels challenging. An interest rate swap could be a good fit if you want a set cost of debt service but don’t want to switch to a regular fixed rate loan.
Interest rate swaps are a good way to protect against the danger of changeable interest rates. An interest rate swap has various strategic advantages for both existing and future loans. It’s important to understand how an interest rate swap works in order to make the most of it. What you need to know is as follows:
How an interest rate swap works.
In the end, an interest rate swap converts a variable rate loan’s interest into a fixed cost based on an interest rate benchmark like the Secured Overnight Financing Rate (SOFR). It accomplishes this through the borrower and lender exchanging interest payments. (There is no principal exchanged between the parties.)
The borrower still pays the variable rate interest payment on the loan each month with an interest rate swap. This is established for many loans using the suitable benchmark (usually SOFR plus a spread adjustment) as well as a credit spread. The borrower then pays the lender an additional payment based on the swap rate. The swap rate is fixed from month to month and is determined when the swap is set up with the lender. Finally, the lender rebates the variable rate amount (calculated as the percentage of the rate attributable to the applicable benchmark), resulting in a fixed rate for the borrower.
What was Michael Burry’s approach to CDS?
Investors began to pour money into the US housing market after the launch of subprime mortgage-backed securities, and house prices began to increase. Housing prices rose as a result of the newly eased lending regulations and low interest rates, making MBS and CDOs appear to be even better investments. They reasoned that even if the borrower defaulted on their loan, the bank would still be left with a very valued home to resell. They were, however, completely mistaken.
As property prices rose, a bubble was forming, and it was set to explode. People began to default because they were unable to pay for their exorbitantly priced homes or keep up with their expanding mortgages. By August of 2008, 9% of all mortgages in the United States had gone into default. Houses were re-listed on the market, but no one seemed interested in buying them. Housing prices plummeted as supply increased while demand decreased. The real estate boom has burst. Even those who were still able to pay their mortgages eventually learned they were paying far more than their homes were worth. This resulted in even more defaults and a further drop in prices.
Big financial firms ceased buying subprime mortgages when housing prices plummeted, and the price of MBS and CDOs began to decrease. Investors who had poured a large sum of money into MBS and CDOs were losing a significant amount of money. Even those in the CDOs’ Senior Tranches, which were thought to be the safest, were not immune to the crash.
What Was Lost
Beginning in the fall of 2007, the stock market in the United States began to decline, dropping about $8 trillion in a year’s time. Unemployment increased from 5% in December 2007 to 9.5 percent in June 2009, reaching a high of 10% in October 2009. As home values plunged and retirement accounts vanished, Americans lost $9.8 trillion in wealth. Between the fourth quarter of 2007 and the second quarter of 2009, real GDP declined by 4.3 percent. Around ten million Americans were evicted from their homes, and 8.8 million were laid off. Home values declined 30% on average from their peak in mid-2006 to mid-2009, while the S&P 500 index fell 57% from its top in October 2007 to its bottom in March 2009.
The Big Shorts
Some investors recognized the risk that was accumulating in the housing market in the years leading up to the crisis and saw a bubble forming. In Michael Lewis’s book of the same name, these people became known as “The Big Shorts.” They recognized the dangers of subprime lending and securities such as CDOs and MBSs. They were also aware that the housing market will eventually crash. Michael Burry, the fund manager at Scion Capital, was one of these individuals. Burry started focused on the subprime sector in 2005, after realizing that the housing market would eventually crash around 2007.
Michael Burry’s CDS Trade
Through his research, he discovered that as adjustable-rate mortgages became more prevalent, the value of mortgage bonds would begin to erode. He decided to short the property market after seeing this. Michael Burry was able to accomplish this by purchasing credit default swaps (CDS), a financial swap arrangement in which the CDS seller commits to reimburse the buyer if the debt defaults. It’s essentially purchasing asset default insurance. Based on the market’s estimate of the risk of default, this “insurance” can be inexpensive or expensive.
To do so, he persuaded huge investment banks like Goldman Sachs to sell him credit default swaps on subprime loans that he considered to be at risk. In March 2020, Bill Ackman employed credit default swaps to short the market. Many investment banks and insurance companies, such as Goldman Sachs and AIG, offered swaps because they believed the housing bubble would never crash. As a result, the prices of MBS and CDOs would continue to rise, making it effectively free money if they sold them.
Michael Burry’s argument was that he should acquire these swaps without holding any MBS or CDOs, so that when the price of these securities fell, he would gain money through the CDS payout instead of losing money by owning the securities. His investment eventually paid off, and his company, Scion Capital, saw gains of roughly 490 percent. Michael Burry noted in a 2010 interview that anyone who thoroughly researched the financial markets from 2003 to 2005 might have seen the mounting risk in the subprime markets. Michael Burry was one of many people who conducted their own research and investigated the subprime market rather than assuming that prices would never decline.
Lehman Brothers Falls
One of America’s largest and oldest banking companies filed for bankruptcy in September 2008. On Monday, September 15, 2008, Lehman Brothers, a New York-based investment bank, filed for Chapter 11 bankruptcy protection. The rationale for this was that they had sustained significant losses as a result of holding big positions in subprime and other lower-rated mortgage tranches.
Lehman Brothers reported a $2.8 billion loss in the second quarter of 2008. Lehman stock lost 73 percent of its value in the first half of 2008. Lehman Brothers announced in August 2008 that it planned to lay off 6% of its employees, or 1,500 individuals, just before of its third-quarter reporting deadline in September.
On September 9, 2008, investor confidence was weakened as Lehman Brothers’ shares lost over half of its value, sending the S&P 500 down 3.4 percent. Many investors were alarmed by the collapse of Leman Brothers, and investor confidence fell. Investors became aware of the country’s financial weakness, which prompted stock prices to plummet, causing global fear and financial instability. With over $600 billion in assets, the collapse of Lehman Brothers remains the largest bankruptcy filing in U.S. history. When the government realized the panic in America, it had no choice but to act.
Is it still possible to employ credit default swaps?
A credit default swap (CDS) is a financial swap arrangement in which the buyer is compensated by the seller in the event of a debt default (by the debtor) or other credit event. That is, the CDS seller protects the buyer against the default of a reference asset. The CDS buyer pays the seller a series of payments (the CDS “fee” or “spread”) in exchange for the possibility of receiving a payoff if the asset defaults.
In the case of default, the CDS buyer receives compensation (typically the loan’s face value), while the CDS seller obtains the defaulted loan or its market value in cash. A CDS, on the other hand, can be purchased by anyone, including those who do not own the loan instrument and have no direct insurable stake in the loan (these are called “naked” CDSs). There is a mechanism in place to hold a credit event auction if there are more CDS contracts outstanding than bonds. The payment received is frequently far less than the loan’s face value.
Credit default swaps have been around since the early 1990s, and their popularity grew in the early 2000s.
The outstanding CDS amount was $62.2 trillion at the end of 2007, declining to $26.3 trillion by mid-2010 and reportedly $25.5 trillion in early 2012. CDSs aren’t traded on a stock exchange, and there’s no requirement to record transactions to the authorities. During the financial crisis of 20072010, regulators were concerned that the lack of transparency in this big market could constitute a systemic danger. The Depository Trust & Clearing Corporation (see Market Data Sources) announced in March 2010 that it will provide regulators more access to its credit default swaps database. As of June 2018, there was “$8 trillion notional value outstanding.”
Financial professionals, regulators, and the media can utilize CDS data to compare how the market assesses credit risk of any entity for which a CDS is available to that supplied by Credit Rating Agencies.
Courts in the United States may soon follow suit.
Although there are various variations, most CDSs are documented using standard forms created by the International Swaps and Derivatives Association (ISDA).
Basket default swaps (BDSs), index CDSs, financed CDSs (also known as credit-linked notes), and loan-only credit default swaps are also options in addition to single-name swaps (LCDS). Aside from corporations and governments, a special purpose vehicle issuing asset-backed securities can be used as a reference entity.
Some argue that CDS derivatives are potentially dangerous since they combine bankruptcy priority with a lack of transparency. A CDS that is unsecured (meaning it has no collateral) is more likely to default.
How does CDS function?
Banks and credit unions provide a certificate of deposit as a simple and popular way to save money. When a depositor buys a certificate of deposit, they commit to put a specified amount of money in the bank for a specific period of time, such as a year. In exchange, the bank agrees to pay them a fixed interest rate and guarantees that their principal will be repaid at the end of the term. For example, investing $1,000 in a one-year 5% certificate would result in $50 in interest plus the $1,000 you initially invested over the course of a year.
Is CDS without risk?
CD accounts owned by average-income consumers are relatively low-risk and do not lose value because they are covered by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. A CD account usually requires a minimum deposit of $1,000.
How do banks profit from swaps?
The difference between the higher fixed rate received from the customer and the lower fixed rate paid to the market on its hedging is the bank’s profit. To establish what rate it can pay on a swap to hedge itself, the bank looks at the wholesale swap market. On the swap with the consumer, you’ll get a 20% discount.
What are the dangers of swapping interest rates?
Interest-rate swaps, like other non-government fixed-income investments, have two main risks: interest rate risk and credit risk, sometimes known as counterparty risk in the swaps market. Swaps involve interest-rate risk since real interest rate fluctuations may not always match forecasts.
What characteristics distinguish swaps?
The following are three key characteristics of swaps:
- A third party introduced two counterparties with identical of/setting exposures.
- Arbitrage-driven swap: The trade was driven by an arbitrage that earned all three parties a profit.
What was Jared Vennett’s salary?
The director of Anchorman and Step Brothers adapts Michael Lewis’ great book into an unusual mainstream smash. Prepare for a slew of business jargon and a film that can’t determine whether it’s on a moral crusade or a quest for laughs, starring Ryan Gosling, Steve Carell, Brad Pitt, and Christian Bale…
The Big Short examines the events of the 2008 financial crisis from the perspective of Wall Street, which profited handsomely. Michael Burry, played by Christian Bale, is an odd and scruffy introvert who first detects many subprime house loans that are practically shite and are in danger of failing, causing the US housing market to collapse. Burry then spends almost $1 billion of his investors’ money in credit default swaps, all the while being mocked and chastised for his blunder.
Others soon find out what Burry is up to, including Ryan Gosling’s character, Jared Vennett, a banker (who also narrates the movie). Vennett is the most traditional cliché version of a banker; he’s only interested in making as much money as he can, regardless of how he does it. As a result, the rumor of a house collapse is music to his ears. Burry’s plan to short the housing market is subsequently presented to hedge-fund specialist Mark Baum, played by Steve Carell.
The American economy collapsed, 5 trillion dollars were lost, eight million people lost their jobs, and six million people lost their homes, and Jared Vennett made $47 million in commissions, Mark Baum’s team made $1 billion, and Michael Burry made $100 million for himself and $700 million for his investors.
The portrayal of Micheal Lewis’ book ‘The Big Short: Inside the Doomsday Machine’ by Adam McKay is a grower, not a shower. It takes an hour and a half for it to get fascinating, with the first half consisting of seeing how many huge words full of business jargon we can cram in before someone turns off. It’s also intriguing how the film switches genres halfway through; initially, it’s a black comedy in the vein of ‘Wolf of Wall Street,’ then it’s a righteous expose of Wall Street’s true corruption. However, we assume that this is similar to how those who were affected by the 2008 financial crisis felt.
Overall, we think the film has done a good job of using a number of well-known faces to present a serious and difficult story while also attempting to dress it up in a fun and sexual way… though not quite successfully.
After two years of skepticism and threats from each of his investors, Michael Burry sends emails to each of them telling them how much money he’s made. Then he closes the firm – a movie-style fist pump into the air.
Mark Baum’s (in real life Steve Eisman) ongoing sanctimonious angst that makes him so angry with the system and the world, but the entire while is making the decision to bet against the banks he works for and screwing the poorest people in America is an overall worst factor. Not to add that he does it in a shittone. The worst part is when he’s having to make a difficult decision: should he sell and profit billions from the crooked system he despises? Of course he does, of course he does, of course he does, of course he does
Jared Vennett: Something fishy is going on here. This is very personal. I’m not sure if I’m financially inside of you or not.