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Home | Daily Dose | An Economic Threat: Financial Leverage in Credit Default Swaps
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An Economic Threat: Financial Leverage in Credit Default Swaps

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By Dr. Katherine Qin

Qin began her finance career on Wall Street with Merrill Lynch in 1998. Upon completion of her MBA degree in finance, Qin joined Salomon Smith Barney, Citigroup, where she found an increasing market demand for online distance trading. Joined by her partner from Merrill Lynch, Qin later co-funded NASDAQ Level II Trading Company. The company provided market makers access to NASDAQ level II quotes and lighting speed execution. Prior to joining the University of Texas at Dallas, Qin completed extensive market research on the volatility of the Chinese stock market. Since 2013, Qin has taught MBA students risk management topics and financial regulations. Qin holds a doctoral degree in finance and economics.

In September of 2008, the world witnessed the largest financial loss since the Great Depression. The financial crisis nearly brought down every financial institution on Wall Street. The center of the storm is financial derivatives that were written against subprime mortgages. 

Case in Point: AIG

In 2007, insurance giant AIG insured $61 billion mortgage backed securities with exposure to subprime mortgages. Through its credit default swap, AIG transferred default risk from its counterparties to the insurance company itself and therefore guaranteed the value of mortgage backed security would not decline. When the value of the mortgage backed securities deteriorated in 2007, the company was forced to post mounting losses. 

On November 7, 2007, AIG reported $352 million in unrealized losses from its credit default swap portfolio. On December 5, 2007, the insurance company disclosed $1.15 billion in further unrealized losses, a total of $1.5 billion through November. In February 2008, AIG corrected the total unrealized losses for 2007 to $5.96 billion. In March 2008, this number once again was adjusted to $11.5 billion. 

In 2008, losses at AIG continued. On May 8, 2008, AIG reported $9.1 billion unrealized losses by March, for a grand total of $20.6 billion since 2007. On August 6, 2008, AIG posted $14.7 billion unrealized losses by May, for a grand total of $26.2 billion. By November 10, 2008, AIG had estimated $33.2 billion in total unrealized losses from credit default swap contracts. 

AIG also agreed to put up collateral if the value of the mortgage backed securities deteriorated or AIG became less creditworthy. When the mortgage backed security market turned against its positions, AIG was also forced to meet collateral calls. 

Beginning in the summer of 2007, AIG’s counterparties began demanding that AIG put up collateral. In August 2007, Goldman Sachs demanded that AIG post $1.5 billion in collateral to cover some of its exposure. AIG privately agreed to post $450 million. Late October 2007, Goldman asked AIG to post another $3 billion in collateral. AIG privately agreed to post $1.5 billion. 

On February 28, 2008, AIG disclosed that it had posted $5.3 billion in collateral since 2007. On May 8, 2008, AIG disclosed that it had posted a total of $9.7 billion in collateral. On August 6, 2008, AIG reported a total of $16.5 billion in collateral. In September 2008, AIG was forced to raise $14.5 billion in collateral. On November 10, 2008, AIG disclosed that it had posted a total of $37.3 billion in collateral on its swaps portfolios.

In an attempt to save the entire financial system, on September 16, 2008, the Federal Reserve pledged $85 billion to rescue AIG. On October 8, 2008, The Fed pledged another $37.8 billion. In November, the government and AIG announced a $150 billion buyout.

Why were the losses in the credit default swap at AIG were so large? It is because there is a built in financial leverage in credit default swap. The leverage accumulates whenever credit default swap is used. 

Credit default swap is a credit derivative. It shares common characteristics of a financial derivative. A financial derivative allows an investor to buy or sell an underlying asset at a predetermined price within a specific time. It lowers financial risk as the price of the underlying asset varies with time. Therefore financial derivatives are commonly used to hedge financial risk. Risk management is a prudent operation for a financial or non-financial firm to effectively hedge its exposure to the risks in the market it participates. 

However, derivatives are essentially financial instruments. The use of financial derivative itself involves risk. Since the value of a financial derivative is derived from its underlying assets, the market risk inherent in the underlying asset is linked to the financial derivative through derivative contract. A financial derivative therefore can be traded separately; and the underlying asset does not have to be acquired. This feature allows an investor, an individual or a firm, to use a financial derivative to speculate the market direction of a financial asset, market indicator, or market index to make profits. Speculation involves risk. The risk is magnified especially when leverage is used. 

Leverage

Financial leverage in derivatives is particularly difficult to understand because it is implied. Specifically, leverage in derivatives is implied in two ways: 1) a derivative buyer controls a large notional value of the underlying asset at a fraction of the cost if the underlying asset is otherwise purchased; 2) the derivative seller, on the other hand, does not have to purchase the underlying asset to honor the contract. In this sense, both positions are funded by notional value of the derivative contract. 

Financial leverage is a double edge sword. It magnifies potential gains or losses when the market turns to the opposite direction. The magnitude of potential gains or losses can be very large when notional leverage is used in derivatives. According to most derivative contracts, notional leverage typically is at 99 percent. A derivative contract buyer can effectively control 100 percent of an underlying asset at 1 percent of the cost if the underlying asset is purchased outright.

Large financial leverage also encourages excessive risk taking, especially when the risk can be effectively and inexpensively transferred. Credit default swap allows default risk to be transferred at a cost equal to one percent of the notional value of the contract. This built-in leverage in credit default swap, along with implied higher return when default risk is insured, encourages the protection buyer to invest more in the underlying assets. Zero cost premiums also encourage the protection seller to underwrite more credit default swaps.

Take the AIG case as an example, the credit protection buyer Goldman Sachs used credit default swap to hedge the default risk it had already borne when it invested in mortgage backed securities. However, the credit protection seller AIG bore no preexisting default risk. AIG entered the credit default swap contract only to speculate that the premium it received from Goldman Sachs would be more than the present value of its expected principle payout under the contract.

Goldman Sachs and AIG used credit the default swap for different purposes. However, they both leveraged their positions. Since Goldman Sachs insured its default risk at a fraction of the mortgage principles it invested in mortgage backed securities, it freed up the firm’s fund to invest more in the mortgage backed securities. Since AIG received large sum of premium from Goldman Sachs with zero investment or collateral to ensure its guarantee, AIG, on the other hand, was leveraged to underwrite more credit default swaps.

Before the housing crisis, Goldman Sachs earned cash flows from its investments in the mortgage backed securities. The principles of these investments were insured. Insurance giant AIG received an annual premium equal to 1 percent of the notional value of the contract. When the subprime mortgage holders defaulted on their mortgages, AIG simply could not come up with the notional value of the principles guaranteed by the credit default swap. Goldman Sachs lost the cash flows from its investments and the principles guaranteed by the insurance company. 

Credit default swap gave Goldman Sachs financial leverage to invest more in the mortgage backed securities after the investment bank insured its default risk at a low cost. It also gave AIG the financial leverage to underwrite more credit default swaps. Thus, credit default swap, this prudent risk management tool became a vehicle to the ever expanding mortgage backed security market that was subject to massive default risk.

It is obvious that Goldman Sachs had concerns about the credit risk of its counterparty AIG. To ensure AIG’s obligation to pay principles back to Goldman Sachs should a credit event occur, Goldman Sachs insisted that AIG post cash or other assets as collateral. The credit default swap contract between the two parties also specified that Goldman Sachs demand more collateral should the creditworthiness of AIG decline. 

However, both parties underestimated the possibility of massive default risk. How did sophisticated financial institutions such as Goldman Sachs and AIG miscalculate the default risk? Factors such as a lack of historical data from the market, cognitive bias among risk management professionals, and the faulty assumptions used by computer models may all contribute the miscalculation of default risk. But why the market, risk managers, and the computers were all blind sighted by the upcoming massive default risk in the first place? 

The answer lies in the economic consequences of the use of credit default swap. In a real economy, credit default swap can disguise true default risk by inflating the housing market. Excessive supply of cheap credit inflates home prices and lowers the rate of default on mortgages. 

When Goldman Sachs continued to invest in the mortgage backed securities, it provided the housing market with additional money supply. Home buyers therefore were able to invest more in residential properties, resulting in a booming housing market. With rising home price and low interest, homeowners who could not afford to pay rising property tax simply flipped their homes; those who could afford to keep their homes simply refinanced their mortgages at lower interest rates. The default risk in mortgages was indeed concealed by a rising housing market. As a result, the market lacked data indicating the true affordability of the housing market. Insufficient data led to cognitive bias among risk management professionals who used faulty assumptions that underpriced default risk. 

Today, the use of credit default swaps poses an economic threat because the housing market is financed by credit derivatives. The factious money created by computers in derivative operation can potentially push the housing market to a point where no one is able to afford a new mortgage. 

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