Derivatives: From Options to Credit Default Swaps

The Derivative Market

Once the options market was in full bloom, other derivatives (products derived from the price of actual securities) were developed. 

The rational purpose for a derivative is to hedge portfolio risk.  Most derivatives are designed and used for this purpose, and most of the time the capital markets are rational.

But, with the complexity of financial markets, including everything from a Russian government bond default to the resulting divergence in predicted foreign bond prices with US treasuries of similar term, the difference between the anticipated behavior of derivatives and actual market prices were enough to cause the liquidation of even Long Term Capital Management, a hedge fund boasting two Nobel prize winning economists on its board.

Moral

There are no guarantees – even from Nobel prize winners.

Regulated Trading

The vast majority of options are traded on the Chicago Board Options Exchange, which provides buyers and sellers, standardized agreements and pricing. 

Some are traded over-the-counter, which provides the ability to customize contracts, but relies on the ability of the other party to fulfill the trade with no guarantee of execution, no centralized exchange and no clearing house.

Credit Default Swaps

Credit default swaps (CDSs) were born in 1997.  Traded over-the-counter, these are contracts between two parties.  Here’s how they work. 

Say an investor owns a bond (a loan) issued by a company.  That investor assumes the risk that the company may default on the bond.  To hedge this risk, the investor might buy a CDS at, for example, 1.5% of the amount of the bond.  This premium is paid to a third party who agrees pay the face value of the bond to the investor if the bond issuer defaults.

If the company does NOT default on the bond, the third party will collect the premium until the bond matures and the investor is paid in full.

But, what if the bond defaults and the third party is unable to pay? 

In September, 2008, that’s exactly what happened to American International Group.  It sold CDSs without hedging against the possibility that the bonds might decline in value, exposing itself to potential losses in excess of $100 billion.

You may have heard something about the federal bailout paid to keep it afloat.

Swimming Naked

The tide went out, and we saw that AIG was swimming naked.  This giant insurance company granted a type of unregulated insurance without having the money to pay those from whom they collected premiums.

They were an insurance company who couldn’t pay up when the going got bad.

Disbelief

In the 1990’s, I was teaching a Security Analysis class at UCLA, and one of my students asked me to explain why neighboring Orange County was going bankrupt.  Another student said, “This is too complicated for us.  I’ve listened to the news.  It’s very confusing.”

Asking him to allow me to attempt an explanation, I asked him if he understood it when I was finished.  “That’s it?” he asked after hearing the explanation.

This has been an admittedly simplified explanation, but basically, that’s it.  That’s what happened with Credit Default Swaps.

They were big bets with nothing to back them up – rolling the dice at the casino without the money to pay when they “crapped out.” 

If we did this, we’d go to jail.

Why, then, did the Federal government bail out this company?

Is AIG too big to fail?

Yes.  If AIG were to fail, it would cause not just nationwide, but worldwide financial panic.  So many countries, businesses and human beings had money tied up in this insurance giant that the alternative of letting this giant zombie die would be financially ruinous on a global scale.

Now What?

Obviously, had there been oversight, this problem would not have grown to the proportions it had.  So regulation is a big part of the answer.

Insurance companies are state regulated, too.  Every state has slightly different rules.  That makes for confusion in oversight, especially with an enormous company like AIG.

And, speaking of enormous, perhaps it’s time to consider whether to allow a company to grow to a size that’s too big to fail.

You can write to your Senators and Representatives and tell them what you think.  This may be just the perfect time to do that very thing.