Main content
Finance and capital markets
Course: Finance and capital markets > Unit 10
Lesson 3: Credit crisis- The housing price conundrum
- Housing price conundrum (part 2)
- Housing price conundrum (part 3)
- Housing conundrum (part 4)
- Mortgage-backed securities I
- Mortgage-backed securities II
- Mortgage-backed securities III
- Collateralized debt obligation (CDO)
- Credit default swaps
- Credit default swaps 2
- Wealth destruction 1
- Wealth destruction 2
© 2023 Khan AcademyTerms of usePrivacy PolicyCookie Notice
Credit default swaps
Introduction to credit default swaps. Created by Sal Khan.
Want to join the conversation?
- Do you really think it would have been that much better if the rating agencies had been from government? why? look at the SEC and CFTC. they are aware of fraud all the time and are even less inclined to do anything about it than a private entity. Just because it's government doesn't mean its immune to corruption
-Chris(23 votes)- The recent financial reform bill made several notable changes to how the rating agencies do business. Three of the most important changes are as follows:
1: Rating agencies can now be held liable(and sued) for knowingly or recklessly giving a bad rating.
2: Rating agencies must now disclose their methodologies, use of 3rd parties, and their track record(ratings compared to defaults)
3: SEC regulation - the SEC has the power to decommission a ratings agency and is supposed to do a once a year examination.
These changes have already started and are expected to be fully implemented in about 2 years.
With these changes I expect that the rating agencies will have to be more objective - not only for fear of being sued, but also for fear of the SEC shutting them down or investors finding flaws in their methodology.(19 votes)
- Why does Moody's give the AIG a AA rating if they have no money to set aside in the first place?(3 votes)
- Moody's isn't entirely objective in their rating process. AIG had to pay Moody's for their initial AAA rating, and I'd assume that the more that is paid, the higher the rating. Looking back at the video and seeing how leveraged AIG is with this business model; also seeing how popular CDS's were becoming prior to the crash of '08, Moody's as well as S&P saw the potential both for profit and the colossal success of AIG.
As a side note, AIG has had a AAA rating for quite some time (at least since 1987). In 2005, long time CEO since 1968 relinquished his position which rocked the company sending credit rating agencies to downgrading AIG to a AA rating; triggering many of AIG's Credit Default Swaps and Obligations. Since 2005, and especially in September 2008, AIG began to fall apart as scandal, Swaps, and Obligations were called at an increasing rate. This marked the beginning of AIG's downfall.(7 votes)
- I notice that you use the word "insure" when describing the service that AIG provides. It is my understanding that the whole reason for calling this process "credit default swaps" is because the insurance industry is better regulated and would not have allowed what you have described here, if it was simply called insurance. Is this true? And if so, why can't regulators see that insurance by any other name is still insurance?(4 votes)
- regulators can't see this because they don't want to, wall street (along with Alan Greenspan) made plenty sure that the CDSs, derivatives, etc. remained unregulated so they could get away with this. If you objectively step back and ignore how angry this whole system makes you, you'd have to acknowledge that these guys are pretty smart for being able to get away with this and leaving the taxpayers on the hook.(4 votes)
- I understand that if an insurance company with a high rating backs a loan to a company with a low rating, the loan will get a high rating. But whenever the insurance company is dependable for its survival on a bunch of companies with a low rating, wouldn't it be normal that it too would get a lower rating? Or is that a wisdom that just came after this crisis (or even corruption at the rating companies)?(4 votes)
- 1) Are rating agencies bribed by Insurance Companies to give them AA or AAA or they'd look good to investors ? If not, on what grounds do the agencies rate those companies ?
2) Did the agencies know what was going wrong with AIG before the financial crisis ? I mean, obviously, some analysts working for Moody's must have had suspicion about AIG's imbalance between Equity and Value of Assets Insured, right ?
3) If, all of a sudden, Moody's decided to rate down AIG, would that lead to investors being so panic that they would all come to AIG to claim their money back ? I simply think, such a scenario would result immediately in AIG's bankruptcy and still the same financial crisis.(3 votes) - What are the highest to lowest Ratings?
AAA
AA
A...
Does it go to F?(2 votes) - At about, Sal is saying "as long as Moodys doesn't get suspicious". Isn't it their job to investigate? How does Moodys make it's money? Aren't they supposed to be trustworthy? 10:35(2 votes)
- You asked the pertinent question. Moody gets paid to rate a security by the company/bank that is issuing the security. Hence, there is a conflict of interest.(2 votes)
- I may have missed it however - who PAYS the private entities such as Moody's to rate?(2 votes)
- The company that needs a rating - in this case, AIG.(2 votes)
- At, Sal talks about how AIG does not have to set aside funds in case Company A defaults. Are home or life insurance companies required to set aside funds for every policy that they provide? 8:17(2 votes)
- Hi Beth, yes most insurance companies are required to set aside what are known as 'reserves' against claims. However, the reserve requirement is not equal to 100% of the potential claims. Ultimately, the reserve requirements are established by state regulatory agencies and they use a mathematical formula to determine what the reserve requirements for the insurance company ought to be.(2 votes)
- Why AIG can insure trillions without corresponding significant assets? Isn't there any policies? After all these mess,now at the end of 2010, does anything really changes concerning this issue?(2 votes)
- I think Khan is totally off on this one. Insurance agencies are heavily regulated. Each state regulates the insurance companies in their state through the NAIC(National Association of Insurance Commissioners)
The NAIC has very specific and formal guidelines that ensure that insurance companies have enough assets to cover their liabilities. There is a complicated formula called Risk Based Capital(RBC) that spits out a number is representative of how much assets compared to liabilities an insurance company has(simply speaking).
If the RBC drops below a certain number the state can take over the insurance company.
So there ARE checks to ensure an insutance company does not have 1 trillion in liability and 1 billion in assets. The biggest problem is estimating the worth of those assets or the extent of those liabilities - how much liability is a 1M loan to a BB company? How much of an asset is a 1% revenue stream worth if it is from a BB+ company?
PS AIG's insurance companies were doing fine in 2009 - it was the risky activities in its AIG Financial Products arm that were the problem.
Insurance companies/insurance = regulated
Financial products/credit swaps = unregulated(1 vote)
Video transcript
Let's say that I'm a pension
fund, and I have money to lend to other people. And I want to lend it to other
people, because that way I can get interest on it instead of
it just kind of sitting and doing nothing. And if I lend it to someone
other than the government, I'll get better interest. So
let's say that there's-- so let me draw me, I'm
the pension fund. Maybe I'll drawn
me in magenta. So that's me, pension fund. And let's say that there's
some corporation, let's say it's GM. They make cars. I think you've heard of them. Some corporation, GM. Let's just call it
Corporation A. They need to borrow money, maybe
to buy a factory or to do something else, we're not
going to get involved in what they need the money for. And I'd like to lend
them the money. But there's an issue here. I am a pension fund. I manage the retirement fund
for the teachers of California, or for the
auto workers of Michigan, or whatever. And part of my charter says
that I can only invest in very, very, very safe
instruments. So I'm not allowed to go gamble
people's money, because this is people's retirement. So I can't do very fancy
things with it. I can only invest in things
that are rated AAA, or let's say AA. I'm just kind of making
this up on the fly. So AAA would be like
the highest rated securities, right? These are things that have a
very low chance of default. But Corporation A is only rated,
I don't know, let's say it's rated BB. And actually, this is a good
time to think about well who is doing all these ratings. And you might think, oh, it
surely is a government entity, because only the government
would be objective enough give all of these corporations
frankly objective ratings. But unfortunately, it's not. They're private entities,
that are actually paid to rate things. And I think I touched on it in
the video on collateralized debt obligations. But their incentives are
a little bit strange. Let's say I have Moody's. Moody's is one of the ratings
agencies, and they rate Corporation A as BB. So they've said, these guys,
they're pretty good, but they're not the U.S. government
or something. There's a chance that they can
go under, for whatever reasons, or they're sensitive
to the economy as a whole. And I say, man, I would love
to lend these guys money. I would love to lend
these guys the $1 billion that they need. And these guys are willing to
pay me 8% interest. But I can't do it, me as
a pension fund, I cannot lend them money. Because I'm only allowed
to lend money to A or above types of bonds. Or I can only buy A or above
type of instruments. So what do I do? This guy needs money. I have money to give him, but
his corporate credit rating, that was given by Moody's, just
isn't high enough for me to lend him the money. And this is where credit
default swaps come in. In an ideal world, I would give
Corporation A, I would give them $1 billion. And then maybe they would
annually give me, let me make up a number, 10% per year. And then this might have a term
for 10 years, and then after 10 years, they'll pay me
the $1 billon back and then I'll be happy. But as I said multiple times,
I can't do it, because they are BB rated. And my charter says I can only
invest in A rated bonds. So I go to another entity. And let's call this
entity AIG. And these entities are
essentially insurance companies on debt. And I'm calling this
one AIG because AIG actually did do this. But it could be anything. A lot of banks did this,
a lot of insurance companies did this. There are some companies that
just specialize in writing collateralized-- sorry, in
writing credit default swaps. What does AIG do for me? Well first of all, it's
important to note that Moody's has given AIG, I don't know,
let's give it a AA rating. I don't know what their
actual rating was. They said, you know what, they
are almost risk-free. They're almost like the
U.S. government. Moody's has looked at their
books, or supposedly, or hopefully has looked at their
books, and says, oh you know, if you loan them money,
they're good for it. So they have a very,
very high rating. Although, once again, you have
to worry about the incentive. Because who paid Moody's to
give them that rating? And whenever you're getting
paid to give a rating, you have to wonder about what your
incentives are, in terms of how you rate things. But anyway that's a discussion
for another video. But what AIG says is, you
know what pension fund? I know you want to lend
Corporation A money, and Corporation A wants to borrow
money from you, but you have this problem because
they're BB rated. So what we're going to
do is we're going to insure this bond. We're going to insure this loan
that you're giving to Corporate B. What we want in return for that
is an insurance premium. We want you to pay us
a little bit of this interest every year. If you pay us a little bit of
this interest every year, we will insure this payment. So you get 10% a year, and
you give us 1% a year. So you give us 1% a year. And this is also 1%-- just
to learn a little bit of financial jargon-- this is also
someone would say 100 basis points. One basis point is
1/100th of 1%. So 1% of the same thing
as 100 basis points. 2% is the same thing as
200 basis points. So you pay me 100 basis points
of the 10% per year, and in exchange, I will give you
insurance on A's debt. And in fact, it might have not
even been structured this way. It might have been structured
so that Corporation A right here, before even issuing the
bonds, they include this insurance with the bond. So instead of giving 10%, they
cut out 1% to insure it. And then these essentially
become AA bonds. And why is that? Well, they're BB, but you're
being insured by someone who is AA. So all of the sudden, these
bonds, because they're being insured by this entity that
is AA, which Moody's has determined is AA, these bonds
are now good enough for my pension fund to hold. Because I said, you know what
even if corporation A goes under, I have this AA
guy insuring it. And so I'm fine. So this is the equivalent
of holding AA bonds. And what's my effective
interest rate? I'm getting 9% per
year, right? I'm getting 10% per year from
Corporation B, and then I have to pay 1% to AIG. And if Corporation B goes under
tomorrow, AIG is going to give me my $1 billion back. And you might say, Sal,
this sounds like a pretty good situation. And this is where it starts
to get a little bit shady. Because AIG, they're not just
insuring my debt or my loan that I gave to corporation A. And think about it, AIG didn't
have to do anything. AIG didn't have to put
up any collateral. AIG didn't say, you know what,
out of all of our assets, here is $1 billion that we're going
to set aside, just in case Corporation A doesn't pay. Right? You would think that if you
wanted to be guaranteed that this money was going to come to
you, this AIG corporation would have to set
aside the money. But they didn't have
to do that. They just have to say, hey,
Moody's has said we're AA, we're good for debt. We're good for insurance. So you just pay us 1% a year
and trust us, or trust Moody's, that we really are
good for the money. They never had to set
aside the money. You're just going on a leap
of faith that, if and when Corporation A defaults,
AIG is going to be good for the money. Now this is where it
gets interesting. Let me erase Moody's from the
screen-- actually, maybe I'll go down here. AIG didn't just insure
my debt. Let's say that there is
Corporation C's debt. Let's say that they're B-- I
don't know, all these ratings have different terminology. They're B+ rated. Right? And let's say there's $10
billion of debt that they borrow from some other party. And in return, they give 11%. And this is Pension Fund B. And this pension fund had
the same problem. They can only buy A-rated
or above bonds. AIG also insures their
debt that they gave to Corporation C. Maybe they'll pay them--
Corporation C is maybe a little bit riskier, so out of
the 11% I have to pay maybe 150 basis points. Or 1 and 1/2%, that's the
same thing as 1%. And in exchange, they
insure C's debt. Now something very interesting
can happen here. AIG all of the sudden
has an excellent business model, right? Because they were able to get
this AA rating from Moody's, they can just keep insuring
other people's debt, and they don't have to put any
money aside, right? They don't have to give their
assets to anyone else. And they just get these
income streams, right? From my pension fund
they're getting 1% per year of $1 billion. From this pension fund, they're
getting 1 and 1/2%, 150 basis points, per year. And they can do this, frankly,
as much as they want. They could do this
a thousand times. And as long as Moody's doesn't
get suspicious. As long as Moody's doesn't
start saying, hey, wait a second, AIG, you only have $100
billion in assets, but you have insured $1 trillion
of other people's debt. Something shady going on, I'm
going to lower your rating. As long as that doesn't happen,
this AIG corporation can just keep insuring
more and more debt. And frankly, as long as none
of that debt goes bad, they just get this excellent income
stream, and their CEO will get excellent bonuses. I think you start to see where
you're having a single point of failure and a house of cards,
and I'll continue that in the next video.