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Use cases for credit default swaps
How credit default swaps can be used as hedges, insurance or side-bets. Created by Sal Khan.
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- What has happen since the financial crisis with AIG was their credit rating changed?(11 votes)
- Yes - AIG's credit rating was downgraded.(12 votes)
- Why are hedge funds allowed to bet on other people's money and securities that way? It seems strange that AIG pays two insurances for the same security.(7 votes)
- Like anything, the truth is usually complicated.
Hedge Funds (or anyone else) had lots of legitimate reasons for purchasing CDS'. They might have taken a significant position in the equity markets with Mortgage lenders and were looking to hedge their risk by purchasing CDS' on a couple of the bigger Mortgage companies. While they might not have any direct debt, their equity position would certainly have taken a hit if the company defaulted on some debt. The Hedge Fund might be invested in Mortgage Servicing companies who would take a big hit if the mortgage market collapsed.
There are dozens of other reasons, some of them as complicated as the MBS+CDO mess itself.(7 votes)
- It sounds like Sal is saying "Senior traunch" and "traunch". What word am I mishearing? And what does it mean?(4 votes)
- According to Dictonary.com, it's a French word spelled "tranche" and prounounced "traunch". It means literally "slices". In finance, it's defined as: "one part or division of a larger unit, as of an asset pool or investment".(3 votes)
- Are credit default swaps now regulated?(5 votes)
- In the USA, at least, according to Bloomberg, the CDS market has fallen from trillions due to regulation imposed by the government. Thus simple answer is no. I am not a finance expert so here is the link to where you can find out more: http://www.bloomberg.com/professional/blog/why-would-anyone-want-to-restart-the-credit-default-swaps-market/(3 votes)
- when the bailout happened, who was paid? the investors, the pension funds, or the hedge funds?(1 vote)
- If AIG didn't have enough reserves to pay all the investors who signed CDS (and eventually "won"), how did the investors get paid?(1 vote)
- When AIG was bailed out, the bailout funds were used to pay investors.(3 votes)
- Can credit default swaps be used to hedge against interest rate risk for a bond investor? For example if you bought CDS in a bunch of companies that you think will topple if interest rates go up.(1 vote)
- If you think the companies will topple if interest rates go up, then that is default risk, not interest rate risk. Interest rate risk is when interest rates go up, but your long-term bond remains at the lower rate. Credit default swaps will protect you if the companies topple. However, they won't protect you from interest rate risk.(2 votes)
- where does one put a credit default swap in a balance sheet? Seeing that its not really a liability until a company defaults.(1 vote)
- The amount would not be placed on the balance sheet of the credit insurer. It is neither an asset nor a liability. It is a potential liability, but it does not affect the equity of the company. In fact, the same is true for every insurance company in the world. The insurance companies don't have liabilities, except for their own debt.(2 votes)
- Am i right to say that Hedge fund companies had a mega bonus "christmas" on the GFC and earned tons of money. But because a majority of the CDO's were failing at the time of GFC the insurance company might run out of money thus who will pay the hedge funds that won their bet in the later periods.? i.e after some hedge bunds successfully cashed out their bets?(1 vote)
- Basically, AIG itself got a ratings downgrade after the collapse of Lehman Brothers, because it was undercapitalized. As a result, people stopped buying insurance from AIG, because now it was riskier. Eventually AIG went bankrupt anyway, but the government stepped in and bailed it out.(2 votes)
- 1:52What is meant by piper there?(1 vote)
- This is what I found online to explain the phrase, "pay the piper": "It originates from the story of the Pied Piper of Hamelin. The town of Hamelin agrees to pay the Piper to get rid of all the rats. When they fail to pay him, he steals their kids". Per Wiktionary, the phrase has come to mean "to pay a monetary debt or experience unfavorable consequences, especially when the payment or consequences are inevitable in spite of attempts to avoid them".(1 vote)
Video transcript
Let's think about
the different use cases for credit default swaps. So let's say that I have
some company over here, and it's given a
BB credit rating. And this rating, of course,
comes from a credit rating agency, sometimes called a
ratings agency or a rating agency. I've seen it every
different way. So this would be like Moody's or
Standard and Poor's or whatever else. And they look at this company,
and they look at its business, they look at its balance
sheet, and they say, OK, it's not super safe, but
it's not super risky either. We give it a BB rating. And let's say that there's
an investor over here who wants to lend money
to this company. So he might lend them
some money and get some interest in return. But this investor doesn't
like this level of safety. He wants to make sure
that he's made whole even if this company
goes out of business. So he can go to a writer
of a credit default swap, and the most famous of
those credit default swap writers is or was AIG. And he'll say,
hey, AIG, I'm going to pay you a little
bit every year. You could view that as
an insurance premium. And in exchange,
you are essentially going to ensure me in the case
of a default by this company. And what we already said,
it's a little bit shady because it was not
regulated like insurance. So AIG did not have
to set anything aside. And what was
powerful here for AIG is that the rating
agencies continued to give AIG a very high rating. So let's say it had a AA rating. So despite the fact
that it kept taking on all these liabilities,
the credit rating agency says, hey, we'll
still give you a AA. So they were able to use
this AA rating to keep writing these contracts,
to keep writing insurance and not setting anything aside,
and essentially just getting, almost you could
view it, free money with having to pay
the piper eventually. Now this is one scenario. Another scenario is
maybe an investment bank creates some type of
special purpose entity or some collateralized debt
obligation right over here. And they have their
different tranches. And maybe for the senior
tranche over here, just so that they can sell them
to pension funds who can only buy AA rated debt,
pension funds. The investment bank goes
to AIG and says, hey, can this entity right over
here buy credit default swaps? Can we enter into credit
default swap agreements on you, so that in case any
of this stuff were to default, you will also insure that? And once we do that,
then a rating agency. So this is a security. This is a senior tranche of a
collateralized debt obligation now, the senior tranche, and
now that that senior tranche is essentially insured by
AIG, a credit rating agency, once again, will assign
this a AA rating. Even though this
thing might be made up of a bunch of sub-prime
mortgages and all of the rest, although it is a senior tranche
so it'll be made whole first, but now pension funds can
buy this type of thing. The last use case is maybe you
have a hedge fund out here who doesn't want to lend
anybody any money, but is convinced that a whole
bunch of these companies, maybe this company over here or maybe
this company over here, that has some other rating. So this is another company. This hedge fund is convinced
that these companies are going to default on their
debt, that there's going to be a credit
crisis of some kind. Well, then this hedge fund can
enter into credit default swap agreements to essentially
get insurance, but not having
anything to insure. It's like getting car insurance
on someone else's driving or someone else's
car, and you kind of are starting to hope that they
have to have a car accident. Because now if this guy
has a credit default swap on this company
right over here, despite the fact that they
didn't lend out to them, the hedge funds is going to
pay a little bit every year and get the insurance. And they are essentially going
to hope that this company goes out of business,
because if it does, then they're going to get
the insurance payment. They're going to get the same
payment that this investor would have, but they would have
never had to lend the money. So you could use
it as a side bet, you could use it as a way of
making lower-rated securities all of a sudden acceptable
to pension funds, or you could use it as a
straight-up way of insuring debt that you're
lending to someone else.