described by caption and surrounding text."/>Clearly, the CDS seller is betting on the borrower’s not defaulting or – more generally, as insurance companies operate – that the total payouts it is responsible for are less than the total payments collected. Of course, most insurance companies are able to do this by having reliable actuarial statistics, diversifying their risk, and selling some of the risk to other insurance companies. Actuarial statistics are typically quite solid. Average claims for life, health, and casualty insurance are well documented, and insurers can normally set premiums to cover losses and operate at a reasonable profit. Although insurance companies try to manage some of their risks at the micro level (e.g., charging smokers more for life and health insurance), most of their risk management is at the macro level, wherein they attempt to make sure their risks are not concentrated. Thus, they avoid selling too much homeowners insurance to individuals in tornado-prone areas. If they have such an exposure, they can use the reinsurance market to sell some of the risk to other companies that are not overexposed to that risk. Insurance companies attempt to diversify their risks and rely on the principle of uncorrelated risks, which plays such an important role in portfolio management. A well-diversified insurance company, like a well-diversified portfolio, should be able to earn a return commensurate with its assumed risk in the long run.
Credit default swaps should operate the same way. Sellers of CDSs should recognize when their credit risk is too concentrated. When that happens, they become buyers of CDSs from other parties or find other ways to lay off the risk. Unfortunately, during the financial crisis that began in 2007, many sellers of CDSs failed to recognize the high correlations among borrowers whose debt they had guaranteed. One well-known CDS seller, AIG, is a large and highly successful traditional insurance company that got into the business of selling CDSs. Many of these CDSs insured against mortgages. With the growth of the subprime mortgage market, many of these CDS-insured mortgages had a substantial amount of credit risk and were often poorly documented. AIG and many other CDS sellers were thus highly exposed to systemic credit contagion, a situation in which defaults in one area of an economy ripple into another, accompanied by bank weaknesses and failures, rapidly falling equity markets, rising credit risk premiums, and a general loss of confidence in the financial system and the economy. These presumably well-diversified risks guaranteed by CDS sellers, operating as though they were insurance companies, ultimately proved to be poorly diversified. Systemic financial risks can spread more rapidly than fire, health, and casualty risks. Virtually no other risks, except those originating from wars or epidemics, spread in the manner of systemic financial risks.
Thus, to understand and appreciate the importance of the CDS market, it is necessary to recognize how that market can fail. The ability to separate and trade risks is a valuable one. Banks can continue to make loans to their customers, thereby satisfying the customers’ needs, while laying off the risk elsewhere. In short, parties not wanting to bear certain risks can sell them to parties wanting to assume certain risks. If all parties do their jobs correctly, the markets and the economy work more efficiently. If, as in the case of certain CDS sellers, not everyone does a good job of managing risk, there can be serious repercussions. In the case of AIG and some other companies, taxpayer bailouts were the ultimate price paid to keep these large institutions afloat so that they could continue to provide their other critical services to consumers. The rules proposed in the new OTC derivatives market regulations – which call for greater regulation and transparency of OTC derivatives and, in particular, CDSs – have important implications for the future of this market and these instruments.
EXAMPLE 4 Options and Credit Derivatives
1. An option provides which of the following?
A. Either the right to buy or the right to sell an underlying
B. The right to buy and sell, with the choice made at expiration
C. The obligation to buy or sell, which can be converted into the right to buy or sell
2. Which of the following is not a characteristic of a call option on a stock?
A. A guarantee that the stock will increase
B. A specified date on which the right to buy expires
C. A fixed price at which the call holder can buy the stock
3. A credit derivative is which of the following?
A. A derivative in which the premium is obtained on credit
B. A derivative in which the payoff is borrowed by the seller
C. A derivative in which the seller provides protection to the buyer against credit loss from a third party
Solution to 1: A is correct. An option is strictly the right to buy (a call) or the right to sell (a put). It does not provide both choices or the right to convert an obligation into a right.
Solution to 2: A is correct. A call option on a stock provides no guarantee of any change in the stock price. It has an expiration date, and it provides for a fixed price at which the holder can exercise the option, thereby purchasing the stock.
Solution to 3: C is correct. Credit derivatives provide a guarantee against loss caused by a third party’s default. They do not involve borrowing the premium or the payoff.
Although these instruments are covered in more detail in the fixed-income material, we would be remiss if we failed to include them with derivatives. But we will give them only light coverage here.
As discussed earlier, derivatives take (derive) their value from the value of the underlying, as do mutual funds and exchange-traded funds (ETFs). A mutual fund or an ETF holding bonds is virtually identical to the investor holding the bonds directly. Asset-backed securities (ABSs) take this concept a step further by altering the payment streams. ABSs typically divide the payments into slices, called tranches, in which the priority of claims has been changed from equivalent to preferential. For example, in a bond mutual fund or an ETF, all investors in the fund have equal claims, and so the rate of return earned by each investor is exactly the same. If a portfolio of the same bonds were assembled into an ABS, some investors in the ABS would have claims that would supersede those of other investors. The differential nature of these claims becomes relevant when either prepayments or defaults occur.
Prepayments mostly affect only mortgages. When a portfolio of mortgages is assembled into an ABS, the resulting instrument is called a collateralized mortgage obligation (CMO). Commonly but not always, the credit risk has been reduced or eliminated, perhaps by a CDS, as discussed earlier. When homeowners pay off their mortgages early due to refinancing at lower rates, the holders of the mortgages suffer losses. They expected to receive a stream of returns that is now terminated. The funds that were previously earning a particular rate will now have to be invested to earn a lower rate. These losses are the mirror images of the gains homeowners make when they proudly proclaim that they refinanced their mortgages and substantially lowered their payments.
CMOs partition the claims against these mortgages into different tranches, which are typically called A, B, and C. Class C tranches bear the first wave of prepayments until that tranche has been completely repaid its full principal investment. At that point, the Class B tranche holders bear the next prepayments until they have been fully repaid. The Class A tranche holders then bear the next wave of prepayments.14 Thus, the risk faced by the various tranche holders is different from that of a mutual fund or ETF, which would pass the returns directly through such that investors would all receive the same rates of return. Therefore, the expected returns of CMO tranches vary and are commensurate with the prepayment risk they assume. Some CMOs are also characterized by credit risk, perhaps a substantial amount, from subprime mortgages.
When
The reference to only three tranches is just a general statement. There are many more types of tranches. Our discussion of the three classes is for illustrative purposes only and serves to emphasize that there are high-priority claims, low-priority claims, and other claims somewhere in the middle.
