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Credit default ‘swap‘ (CDS) aka credit derivative contract

Charlie Mudrick BA 543. Credit default ‘swap‘ (CDS) aka credit derivative contract. Definition (background context) Mechanics of a CDS Examples Historical Context Examples Checkpoint Questions Throughout Questions Work Cited Useful Links. Flow of Presentation.

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Credit default ‘swap‘ (CDS) aka credit derivative contract

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  1. Charlie Mudrick BA 543 Credit default ‘swap‘ (CDS)akacredit derivative contract

  2. Definition (background context) • Mechanics of a CDS • Examples • Historical Context • Examples • Checkpoint Questions Throughout • Questions • Work Cited • Useful Links Flow of Presentation

  3. Swap: is a derivative where counterparties exchange cash flows of one party’s financial instrument (seller – mortgage %) for those of the other party’s financial instrument (buyer – cash payments). • cash flows = ‘legs’ of the CDS • Credit Default Swap: bi-lateral OTC derivative contract. (swap based on credit defaulting) • Protection seller (investment bank) will compensate the Protection buyer (original lender) if the event of a loan default (or other credit event) occurs. Definitions

  4. CDS were designed to shift risk from primary lender to an ‘insurance’ entity • debt holders enabled to hedge Purpose

  5. Corporate credit instruments • We are swapping for asset quality issues • (ratings) Mechanics Example:

  6. Traditional CDS Quality Match Risk Taker • Not Regulated like insurance • Enter: greed, speculation, mismanagement

  7. How would AIG manage their CDS risk? • ABCDS (asset backed CDS) • Use an asset (house) to ensure some payment • aka MBS (mortgage backed securities) Checkpoint 1 (deep thoughts)

  8. MBS & CDS Quality Match Risk Taker

  9. CDS were designed to shift risk from primary lender to an ‘insurance’ entity • debt holders enabled to hedge • Speculators used CDS to profit from defaults • Investment banks = ‘the prey’ Purpose (perversed)

  10. This is were the gambling begins Speculative CDS (binomial options) Example: Fourth Market MARKET

  11. Speculative CDS Quality Match Risk Taker

  12. How can we prevent the CDS speculation? • Set mandatory disclosing of ‘secret liens’ & identify complex financial instruments • Investment bank disclose debt claims in exchange for payment priority (not just their books) • Essentially Investment banks’ leverage disclosure Checkpoint 2 (deep thoughts)

  13. How we be (no protection)

  14. Goldman Sachs Group Inc. (GS) • bet against (shorted) the U.S. Sub-Prime Mortgage housing market crash • made Billions of $$$ Historical Context • Donald R. Mullen Jr.: ex-head of global credit and mortgages then • currently into single family rentals • REO LLC CEO • now stands to profit again

  15. Did GS ‘bet against’ the market failing • Or ‘make the market’ fail… Historical Context

  16. Historical Context

  17. Sub-primed mortgage market • Welcome Sub-Prime Mortgage Crash Historical Context

  18. How GS purportedly ‘played’ the market Wolf-Vision Example

  19. CDS are financial instruments (swaps) • Can become very complex (2nd , 3rd , etc. swaps) • Can be traded in private (4th ) market • Simplest form: shift loan default risk between parties • Speculation creates an unregulated market • If mismanaged, financial crises could ensue • E.g. Sub-Prime Mortgage Crash • CDS can be high stacks corporate gambling • Zero sum game (GS ‘won’; AIG & others ‘lost’) • Don’t be a player! • CDS are ‘safer’ if backed by collateralized assets • ABCDS offer protection when legitimate Summary

  20. CDS are a: • Derivative • 1980’s digital media format • financial instrument • bi-lateral contract • All of the above • True/False: Credit Default Swaps • May match parties’ underlying asset quality needs • Were designed to shift risk • Are traded on the 4th market Questions

  21. Kahn Academy Series: 1, 2, 3, 4, 5 Investopedia: video as well Wikipedia: general info GS: CDS 101 (pdf) Useful Links

  22. Derivative definition • Swap definition • Corporate Credit Ratings • Asset Quality Rating • ABCDS definition • Credit Default Contract • Secret Liens article • Goldman Sachs profit • Donald Mullen Jr. • Interesting MBS and CDS slideshare Work Cited

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