In the first article, we learned how the credit default swap (CDS) was created to enable businesses to insure themselves against the risk of default. But someone needs to take the other side of the deal as a protection seller, and that usually requires a speculator.

The CDS became the speculator’s favourite instrument. In the insurance business, insurers who insure against fire and theft can set premiums on the basis of decades of experience. Financial markets are less predictable. The CDS soon evolved into complex structures that managed to make even the worst loans appealing to investors. The problem of moral hazard, well known in the insurance industry, tainted the CDS business too. Sooner or later, speculators went bust.

The exponential growth of the CDS
According to The Depository Trust & Clearing Corp (DTCC), in just over a decade the CDS market swelled to US$62 trillion before collapsing to US$25 trillion in April 2009, which is still almost twice the size of America’s GDP. It is believed that one reason the market took off so fast is that CDS allows speculation. You do not have to own a bond to buy a CDS on it.

Anyone and everyone can place a bet on whether a bond will default. Another reason is that the hedge funds joined in. Big financial institutions who sold protection to businesses hedged themselves by buying protection from hedge funds. Many of these were just start-ups, and hardly solvent. At the same time, the sluggish interest rates further encouraged fund houses to focus on the attractive yields in the credit market.

The single-name CDS, with one reference asset, soon spun off into many forms. The reference asset could now be a portfolio of credit names. The most interesting of these was the collateral debt obligation (CDO). In a CDO, the underlying reference assets could be anything: bonds, mortgage loans, credit card loans, car loans, and so on. In a mortgage CDO, as creditors pay their instalments, the money goes into a pool for distribution to the many investors (protection sellers). The investors are divided into tranches by seniority in making default payouts. The lowest tranche (equity tranche) will take the first hit in any delinquency in mortgage instalments. Investors in this tranche have the highest chance of making a default payout — therefore command a very high premium. The top tranche (super senior tranche) is of high credit quality as it will take the last hit in the pool. Rating agencies like Moody’s and S&P could assign the highest AAA rating to this tranche, which justifiably paid low premiums. 

Investors wrongly believed property prices would never stop rising and built a whole edifice of derivatives on the back of the housing market.  In the US, rating agencies were unusually confident about securitised borrowings. They used the actuarial approach to value packaged loans, which seemed to throw out a very low default probability that supported the high ratings.

The explosion
Hindsight, as they say, is 20:20 vision, and little did any of the players know then of the dire consequences of these actions.

Suddenly banks found that they could turn the worst mortgages into investment grade paper and sell them to investors like pensions and insurance companies. These big investors were attracted to the CDO as the returns were much more attractive than treasury bills. This brought about the moral hazard problem which led to irresponsible lending. Sub-prime mortgages were launched, and loans could be granted to creditors with a bad or no credit history. After all, the entire credit risk could be transferred to someone else at the end of the day. The CDOs then spurred a massive explosion.

The Crash
As the housing market bubble began to deflate in Q32005, mortgage interest rates begin to rise. This triggered defaults, obviously felt most by the sub-prime borrowers. Many of these defaults had to be borne not by the commercial banks, but investors like insurance companies and hedge funds. Among others, the massive losses caused the insurer AIG, hedge fund Bear Stearns, and investment bank Lehman Brothers to crash.

Investment banks, not being in the business of directional deals but mainly warehousing, hedged their default risk of the CDOs with AIG. AIG started to become the protection seller to several CDOs including sub-prime ones. AIG, an AAA rated company then, did not have to post any collateral up front. This spurred them to keep on guaranteeing billions of loans without having to worry about having the assets to back them up. AIG did not own the underlying loans either (naked CDS deals). So it could be selling protection on the same credit name over and over again. When the sub-prime borrowers did default, AIG’s liability was naturally amplified. Worse still, when questionable accounting practices were exposed, AIG’s rating was downgraded. It now needed to post billions in collateral, which it did not have.

Bear Stearns had fancy credit hedge funds that were heavily invested in seemingly low-risk CDOs, high grade AAA or AA. The funds were heavily leveraged by borrowing money in the low-cost short term repos to buy higher yielding long term CDO tranches. The difference between the borrowing interest rate and the yield on the CDOs would generate the funds’ profits. As the sub-prime credit market blew over, the dried-up liquidity in the repo market caused interest rates to shoot up, leading to the unsustainable business and downfall of the hedge funds.

In Lehman Brothers case, the investment bank was holding on to the very dangerous equity tranches of the sub-prime loans. It is unclear why they did this, whether it was a conscious decision or it was simply unable to offload the tranches. When the market blew over, Lehman’s loss was enough to cost it everything it had.

The valuation problem
A CDO is a complex structure, but its valuation is a bigger headache. This made their exposure very hard to calculate, leading to a loss of confidence in almost all of them.

Being an OTC product with no observable market prices, valuation was judgemental and highly questionable. Mathematical models were far away from being standardised, like the Black Scholes model in the interest rate and equity derivatives world.

Counterparties would use different and often secretive models to estimate key parameters like the reference pool’s default rate, prepayment rate and correlation of the loans in the pool. Insurance companies, on the other hand, used actuarial techniques which would throw out completely different values than investment banks.  Worse still, some valuations were performed on opaque CDO, structures where details of the credit pool itself were not transparent to all parties.

Counterparty risk
In Warren Buffet’s Berkshire Hathaway annual report to shareholders, he said: “Unless derivatives contracts are collateralised or guaranteed, their ultimate value depends on the credit worthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses — often huge in amount — in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).”

It was the general belief then that the bundling of property loans into securities had spread risk evenly throughout the system. What was overlooked was that counterparty risk could become complicated fast. A hedge fund could sell protection on the same credit name to different parties again and again, creating a huge concentration of risk.

In the good times, although this risk was acknowledged, it was fended off as negligible especially for counterparties with AAA rating. Was there a lack of oversight to keep this risk in check? This will be investigated in the next article.