Project on Credit Default Swaps in India

Project by Praveen P. Mishall Welingkar Institute

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Disclaimer: This is a Summers Project done in The Clearing Corporation of India Ltd. as per the requirements of Mumbai University, MMS course. All the information contained in this project is secondary information. And the references are provided to the information provided. I apologize for the unreferenced information found if any. Any modifications and suggestions are welcome!

Praveen P. Mishall

Welingkar Institute of Management Development & Research [email protected]

mailto:[email protected]�


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TABLE OF CONTENT EXECUTIVE SUMMARY ........................................................................................................................ III

RESEARCH METHODOLOGY ................................................................................................................ V

DERIVATIVES ............................................................................................................................................ 1

CREDIT DERIVATIVES ............................................................................................................................ 7

CREDIT DEFAULT SWAPS .................................................................................................................... 12

SUBPRIME CRISIS ................................................................................................................................... 25

ROLE OF CDS IN SUBPRIME CRISIS .................................................................................................. 41

CDS AUCTION .......................................................................................................................................... 52

CDS DATA SOURCES .............................................................................................................................. 57

CENTRAL COUNTERPARTY SETTLEMENT .................................................................................... 61

CREDIT DERIVATIVES MARKET IN INDIA ..................................................................................... 72

CDS & ITS SETTLEMENT IN INDIA .................................................................................................... 78

CONCLUSION ........................................................................................................................................... 81

DRAWBACKS/LIMITATIONS ............................................................................................................... 82

APPENDIX A: CDS PRICING ................................................................................................................. 83

APPENDIX B: SUBPRIME CRISIS ........................................................................................................ 87

APPENDIX C: CDS AUCTION ............................................................................................................... 92

REFERENCES & BIBLIOGRAPHY....................................................................................................... 95

GLOSSARY OF TERMS .......................................................................................................................... 97


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Executive Summary

“Life is either a daring adventure or nothing. Security does not exist in nature, nor do the

children of men as a whole experience it. Avoiding danger is no safer in the long run than

exposure.”

Helen Keller

US blind & deaf educator (1880 - 1968)

The development of financial derivatives in recent past is astounding when we consider

its volume globally. But at the same time the product once created for hedging the risk

currently allows you to bear more risk sometimes making the whole financial system to

tremble. May be that’s why Warren Buffet called it a financial weapon of mass

destruction. Whatever it may be but derivatives have grown exponentially and are

necessary for the market to flourish.

The credit derivatives are nothing but the logical extension to the family of derivatives

and have already made its presence felt globally. The credit derivatives have played a

significant role in the development of debt market but also share a blame for the

proliferation of subprime crisis.

A credit default swap which constitutes the major portion of credit derivatives is similar

to an insurance contract which allows you to transfer your risk to third party in exchange

of a premium. Right from its origin as plain vanilla product for hedging purpose it has

grown to very complex products and now has posed a question mark on its credibility.

The subprime crisis started in what were regarded as the world’s safest and most

sophisticated markets and spread globally, carried by securities and derivatives that were

thought to make the financial system safer. The subprime crisis brings the complexity of

securitized products and derivatives products, the human greedy nature, inability of rating

agencies to gauge the risk, inefficiency of regulatory bodies, etc. to the fore. Although


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CDS was not the cause of the subprime crisis but it had cascading effect on the market

and was considered as the reason for the collapse of AIG.

The lessons from the consequences of subprime crisis have helped in creating awareness

about the regulatory frameworks to be in place which has increased the transparency,

standardization, and soundness in the market. The various measures include formation of

central counterparty for CDS, hardwiring of auction protocol and ISDA determination

committee. On the backdrop of global crisis the movement of CDS is being watched

carefully. The various data sources now provide data even on weekly basis. The efforts

are being paid off and the market size of CDS has reduced considerably. And now with

the central counterparties in place the CDS market will have more transparency and

better control.

After opening up of the economy the equity market of India have grown significantly

bringing in more transparency. But the corporate bond market is still in undeveloped

mode and the efforts being taken on developing it have not provided expected returns.

Under this light, India is now all set to launch Credit Default Swaps which are expected

to ignite the spark which will flourish the corporate bond market. Considering the

cautious nature of RBI and the havoc created by CDS in global market the move by RBI

is significant. From the move of RBI one can say as the knife itself is not harmful but it

depends whether it’s in doctor’s hand or a robber’s hand. Similarly CDS as a product is

certainly not harmful but its utility will depend on the judicious use of the same.

RBI has given clear indications about the launch of CDS. In the words of Helen Keller

the child can no more hide from the danger. It’s the time to face it!


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Research Methodology Objective of the research: The main objective of the project was to understand about Credit Default Swaps, its

global footprint, its role in subprime crisis, its settlement in global arena and to check the

feasible settlement of CDS in India, after its introduction in India, by understanding about

Indian Credit Derivatives market. Research is concerned with the systematic and

objective collection, analysis and evaluation of information about specific aspects to

check the feasible settlement of CDSs in India.

Period of study: The time period was two months for the study, starting from 20th May to 18th July ‘2009.

Data Used: The types of data collected comprises of Primary data and Secondary data.

As CDSs are yet to be introduced in India the project relied mostly on secondary data.

Secondary data for the study has been compiled from the reports and official publication

of the organization, educational institutions (like Stanford University), internet, online

forums, textbooks, etc. which helped in getting an insight of the present scenario in the

settlement of CDSs abroad.

Research Design & Method: The Research design is purely and simply the framework of plan for a study that guides

the collection and analysis of data. The framework included studying the global

derivatives market and the role of credit derivatives in global market and recent turmoil.

Understand about Credit Default Swaps (CDS) and how it had cascading effect on

subprime crisis. Understand the OTC derivatives market, its settlement procedures and

role of Central Counterparty (CCP) in CDS settlement. Understand about Indian

Derivatives market and possible settlement procedures and role of central counterparty

for the settlement of CDSs in India.

Qualitative Research design was used for this research.


CDS | Derivatives MMS 2008-10 1

Derivatives

Derivatives have become increasingly important in financial markets. We have observed

exciting developments in the last 25 years: the most “successful” innovations in capital

markets. “By far the most significant event in finance during the past decade has been the

extraordinary development and expansion of financial derivatives. These instruments

enhance the ability to differentiate risk and allocate it to those investors most able and

willing to take it - a process that has undoubtedly improved national productivity growth

and standards of living” -- Alan Greenspan, (former) chairman, Board of Governors of

the US Federal Reserve System. But again early falls of Baring bank, LTCM (Long-Term

Capital Management), Asian Financial Crisis and the most recent financial crisis posed a

big question mark on the rapid development of Derivatives. Even Warren Buffet said in

Berkshire Hathaway annual report for 2002 that – “derivatives are financial weapons of

mass destruction, carrying dangers that, while now latent, are potentially lethal”. Now

with these conflicting views let’s understand what exactly are derivative and why it

posses a potential threats or potential opportunities in financial markets?

Introduction: Derivatives are financial contracts, or financial instruments, whose prices are derived

from the price of something else (known as the underlying). The underlying price on

which a derivative is based can be that of an asset (e.g., commodities, equities (stocks),

residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates,

exchange rates, stock market indices), or other items. Credit derivatives are based on

loans, bonds or other forms of credit.

The derivative contract also has a fixed expiry period mostly in the range of 3 to 12

months from the date of commencement of the contract. The value of the contract

depends on the expiry period and also on the price of the underlying asset. Usually,

derivatives are contracts to buy or sell the underlying asset at a future time, with the

price, quantity and other specifications defined today. Contracts can be binding for both

parties or for one party only, with the other party reserving the option to exercise or not.



If the underlying asset is not traded, for example if the underlying is an index, some kind

of cash settlement has to take place. Derivatives are traded in organized exchanges as

well as over the counter [OTC derivatives].

Uses of Derivatives: Derivative contracts provide an easy and straightforward way to both reduce risk -

hedging, and to bear extra risk -speculating.

Hedging: Derivatives can be used to mitigate the risk of economic loss arising

from changes in the value of the underlying. This activity is known as hedging.

For example, a wheat farmer and a miller could sign a futures contract to

exchange a specified amount of cash for a specified amount of wheat in the

future. Both parties have reduced a future risk: for the wheat farmer, the

uncertainty of the price, and for the miller, the availability of wheat.

Speculation: Derivatives can be used by investors to increase the profit arising if

the value of the underlying moves in the direction they expect. This activity is

known as speculation. Speculators will want to be able to buy an asset in the

future at a low price according to a derivative contract when the future market

price is high, or to sell an asset in the future at a high price according to a

derivative contract when the future market price is low.

Arbitrage: Individuals and institutions may also look for arbitrage opportunities,

as when the current buying price of an asset falls below the price specified in a

futures contract to sell the asset.

Types of Derivatives: Broadly speaking there are two distinct groups of derivative contracts, which are

distinguished by the way they are traded in market:

Over-the-counter (OTC) derivatives: OTC derivatives are contracts that are

traded (and privately negotiated) directly between two parties, without going

through an exchange or other intermediary. Products such as swaps, forward rate



agreements, and exotic options are almost always traded in this way. The OTC

derivatives market is huge. According to the Bank for International Settlements,

the total outstanding notional amount is USD 592 trillion (as of December 2008).

Because OTC derivatives are not traded on an exchange, they are subject to

counter party risk as each counter party relies on the other to perform.

Exchange-traded derivatives (ETD): ETDs are those derivatives products that

are traded via specialized derivatives exchanges or other exchanges. A derivatives

exchange acts as an intermediary to all related transactions, and takes Initial

margin from both sides of the trade to act as a guarantee. The world's largest

derivatives exchanges (by number of transactions) are the Korea Exchange (which

lists KOSPI Index Futures & Options), Eurex (which lists a wide range of

European products such as interest rate & index products), and CME Group

(made up of the 2007 merger of the Chicago Mercantile Exchange and the

Chicago Board of Trade (CBOT) and the 2008 acquisition of the New York

Mercantile Exchange). According to BIS, the combined turnover in the world's

derivatives exchanges totaled USD 367 trillion during Q1 2009. Some types of

derivative instruments also may trade on traditional exchanges.

Common Derivative Contract Types: Some of the most basic forms of Derivatives are Futures, Forwards, Options and Swaps.

Forward and Future: Forward contracts are agreements by two parties to engage

in a financial transaction at a future point in time. A forward contract is traded in

the OTC market. Future contracts are similar to forward contract but they

normally are traded on an exchange and are standardized. To make sure that the

clearinghouse is financially sound and does not run into financial difficulties that

might jeopardize its contracts, buyers or sellers of futures contracts must put an

initial deposit, called a margin requirement. Futures contracts are then marked to

market every day. What this means is that at the end of every trading day, the

change in the value of the futures contract is added to or subtracted from the



margin account. A final advantage that futures markets have over forward markets

is that most futures contracts do not result in delivery of the underlying asset on

the expiration date, whereas forward contracts do.

Options: An option is a contract between a buyer and a seller that gives the buyer

the right, but not the obligation, to buy or to sell a particular asset (the underlying

asset) at a later day at an agreed price. In return for granting the option, the seller

collects a payment (the premium) from the buyer. A call option gives the buyer

the right to buy the underlying asset; a put option gives the buyer of the option the

right to sell the underlying asset. If the buyer chooses to exercise this right, the

seller is obliged to sell or buy the asset at the agreed price. The buyer may choose

not to exercise the right and let it expire.

There are two types of option contracts: American options can be exercised at any

time up to the expiration date of the contract, and European options can be

exercised only on the expiration date.

Swaps: Swaps are financial contracts that obligate each party to the contract to

exchange (swap) a set of payments (not assets) it owns for another set of

payments owned by another party. There are two basic kinds of swaps. Currency

swaps involve the exchange of a set of payments in one currency for a set of

payments in another currency. Interest-rate swaps involve the exchange of one set

of interest payments for another set of interest payments, all denominated in the

same currency. Most swaps are traded OTC, “tailor-made” for the counterparties.

Risks with Financial Derivatives: The use of derivatives can result in large losses due to the use of leverage, or

borrowing.

Derivatives (especially swaps) expose investors to counter-party risk.

Derivatives control an increasingly larger notional amount of assets and this may

lead to distortions in the real capital and equities markets.



Derivatives massively leverage the debt in an economy, making it ever more

difficult for the underlying real economy to service its debt obligations and

curtailing real economic activity, which can cause a recession or even depression.

New innovations on financial derivatives are too complicated that even some

financial managers are not sophisticated enough to use them.

OTC Derivatives growth: Derivatives market was already a very big in 1998, but it has exploded since then. The

amounts outstanding of OTC derivatives since 1998 are broken down into their various

types as shown below.

As can be seen from above figure the total OTC derivative market was almost $600

trillion. Thus, in 10 years it has gown 826%. Some of the subcategories have grown even

more than simple average (of 826%) like, commodity contracts increased over 2000%,

interest rate contracts (which make up the largest portion, 66% of OTC market) increased

over 900% in last 10 years and CDS (Credit Default Swap) contracts increased over

905% in just three and half years (more about CDS is explained in later chapters).

Factors generally attributed as the major driving force behind growth of financial

derivatives are:



1. Increased Volatility in asset prices in financial markets

2. Increased integration of national financial markets with the international markets

3. Marked improvement in communication facilities and sharp decline in their costs

4. Development of more sophisticated risk management tools, providing economic

agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and

returns over a large number of financial assets, leading to higher returns, reduced

risk as well as transaction costs as compared to individual financial assets.

Although there are risks associated with derivatives there are number of advantages too.

So derivatives can be considered as necessary evils.

The world seems to be dividend into two camps: those who embrace financial derivatives

as the Holy Grail of the new investment area, and those who denigrate derivatives as the

financial Antichrist.

-David Edington

But still many believes derivatives are just a bet on a bet. Around 2002, soon after the

effects of the dotcom collapse ebbed away and Alan Greenspan flooded the world with

cheap credit, another form of betting became possible. This was the credit derivative.

These credit derivatives played a vital role in growing the subprime crisis all the more

and still continuing to do the same with CDS being a frontrunner along with TRS, credit

options, CLN, etc. So it is important to understand about credit derivatives which are

dealt in next chapter.


CDS | Credit Derivatives MMS 2008-10 7

Credit Derivatives

The development of credit derivatives is a logical extension of the ever-growing array of

derivatives trading in the market. The concept of a derivative is to create a contract that

transfers some risk or some volatility. Credit derivatives apply the same notion to a credit

asset. Credit asset is the asset that a provider of credit creates, such as a loan given by a

bank, or a bond held by a capital market participant. A credit derivative enables the

stripping of the loan or the bond, from the risk of default, such that the loan or the bond

can continue to be held by the originator or holder thereof, but the risk gets transferred to

the counterparty. The counterparty buys the risk obviously for a premium, and the

premium represents the rewards of the counterparty. Thus, credit derivatives essentially

use the derivatives format to acquire or shift risks and rewards in credit assets, viz., loans

or bonds, to other financial market participants.

A definition of Credit Derivative: Credit derivatives can be defined as arrangements that allow one party (protection buyer

or originator) to transfer, for a premium, the defined credit risk, or all the credit risk,

computed with reference to a notional value, of a reference asset or assets, which it may

or may not own, to one or more other parties (the protection sellers).

So here the protection buyer continues to hold the reference asset (loan or bond) and

protection seller holds the risk associated with the asset (loan or bond) also called as

holding synthetic asset. The protection seller holds the risk of default, losses, foreclosure,

delinquency, prepayment, etc. and the reward of premium.

There could be two possible ways of settlement in case of credit event. In first case,

physical settlement, protection seller gives the par value of asset to the protection buyer

and protection buyer hands over the asset to the protection seller. Whereas in second

case, cash settlement the difference between the par value of the asset and the market

value of the asset is given by protection seller to the protection buyer.1

1 More details on physical and cash settlement are available in the next chapter on Credit Default Swap.



Types of Credit Derivatives: Some of the fundamental types of credit derivatives are credit default swap, total return

swap, credit linked notes, and credit spread options.

Credit Default Swaps: A credit default swap (CDS) is a credit derivative

contract between two counterparties. The buyer makes periodic payments to the

seller, and in return receives a payoff if an underlying financial instrument

defaults.

Credit default swaps are the most important type of credit derivatives in use in the

market. Credit default swaps are explained in detail in next chapter.

Total Return Swaps: As the name implies, a total return swap is a swap of the

total return out of a credit asset swapped against a contracted prefixed return. The

total return out of a credit asset is reflected by the actual stream of cash-flows

from the reference asset as also the actual appreciation/depreciation in its price

over time, and can be affected by various factors, some of which may be quite

extraneous to the asset in question, such as interest rate movements. Nevertheless,

the protection seller here guarantees a prefixed spread to the protection buyer,

who in turn, agrees to pass on the actual collections and actual variations in prices

on the credit asset to the protection seller. Total Return Swap is also known as

Total Rate of Return Swap (TRORS).

Credit Linked Notes: It is a security with an embedded credit default swap

allowing the issuer (protection buyer) to transfer a specific credit risk to credit

investors.

CLNs are created through a Special Purpose Vehicle (SPV), or trust, which is

collateralized with securities. Investors buy securities from a trust that pays a

fixed or floating coupon during the life of the note. At maturity, the investors

receive par unless the referenced credit defaults or declares bankruptcy, in which

case they receive an amount equal to the recovery rate. The trust enters into a

default swap with a deal arranger. In case of default, the trust pays the dealer par



minus the recovery rate in exchange for an annual fee which is passed on to the

investors in the form of a higher yield on the notes.

Credit Spread Options: A financial derivative contract that transfers credit risk

from one party to another. A premium is paid by the buyer in exchange for

potential cash flows if a given credit spread changes from its current level.

The buyer of credit spread put option hopes that credit spread will widen and

credit spread call buyer hopes for narrowing of credit spread. It can be viewed as

similar to that of credit default swaps but it hedges also against credit

deterioration along with default.

Consider the buyer of credit spread put: he/she pays a premium for the put. If the

bond (the reference entity) deteriorates, the spread on the bond will increase and

the buyer will profit. But if the bond quality increases, the credit spread will

narrow, bond price will decrease, and the put will be worthless (i.e., put buyer has

lost the premium). In summary, the credit spread put buyer wants to hedge against

price deterioration and/or default risk of the obligation.

The payoff is duration (D) x notional (N) x [credit spread minus (-) the strike

spread; CS - K].

Risks of Credit Derivatives:

Various risks associated with credit derivatives are credit risk, market risk, and legal risk.



Credit Risk: The protection seller is having a credit risk related to underlying reference

asset because protection seller synthetically holds the asset and needs to do due diligence

to counter this risk. Another risk is associated is counterparty risk against protection

seller if he fails to make good of his obligations.

Market Risk: Market risk is associated with credit derivatives traders as the prices of the

instruments are a function of interest rates, the shape of the yield curve, and credit spread.

Other types of risks involved are marking to market risk, margin call risks, etc.

Legal Risk: Lack of standard documentation and agreement as to the definitions of credit

event leads to legal risks. Usage of master agreements though has simplified and

homogenized the trading of credit derivatives. More efforts are being taken recently to

counter this risk with International Swaps and Derivatives Association (ISDA) taking

active role in it. The most important legal issues still revolves around the nature of credit

event and the nature of obligations.

Growth of Credit Derivatives:

Within no time credit derivatives have grown to a great extent to be a big part of

derivatives segment after interest rate contracts (82% Q4’08) and foreign exchange

contracts (8.4% Q4’08) as per notional amounts outstanding (Credit derivatives – 7.9%

Q4’08, Data Source: OCC’s Quarterly Report). Securitization, index products and

structured credit trading.

Much of the significance credit derivatives enjoy today is because of the marketability

imparted by securitization. A securitized credit derivative, or synthetic securitization, is a

device of embedding a credit derivative feature into a capital market security so as to

transfer the credit risk into the capital markets. The synthesis of credit derivatives with

securitization methodology has complimented each other. This had allowed keeping the

portfolio of assets on the books but transferring the credit risk associated with it.

The index products have also contributed to the increasing popularity of credit

derivatives. It provides a means to buy or sell exposure to a broad-based indices, or sub-



indices diversifying the risks instead to buying or selling exposure to the credit risk of a

single entity.

The third important factor contributing to the growth of credit derivatives is structured

credit trading or tranching. Here the portfolio of assets is divided into various subclasses

known as tranches (means slice in French) to fulfill the risk appetite of various investors.

The tranches are divided into various levels like senior tranche, mezzanine tranche,

subordinate tranche, and equity tranche with the risk of default rising in a sequence for

these tranches (Tranching is explained in detail in later chapters).

Talking about the growth of credit derivatives from year-end 2003 to 2008, credit

derivative contracts grew at a 100% compounded annual growth rate. But due to the

global turmoil the growth has been curtailed from the end of 2007 (the reasons for which

will be explained in later chapters).

The composition of credit

derivatives is shown in the

figure. As can be seen credit

default swaps dominates the

composition of credit

derivatives followed by total

return swaps. The

composition of credit default

swaps sometimes makes

people believe that credit

derivatives are nothing but

credit default swaps. Considering the importance of Credit Default Swaps we will discuss

about CDS in detail in next chapter.


CDS | Credit Default Swaps MMS 2008-10 12

Credit Default Swaps

Origin of CDS:

By the mid-'90s, JPMorgan's books were loaded with billions of dollars in loans to

corporations and foreign governments, and by federal law it had to keep huge amounts of

capital in reserve in case any of them went bad. But what if JPMorgan could create a

device that would protect it if those loans defaulted, and free up that capital? And the

solution they come up with is nothing but the origin of “Credit Default Swap”.

Credit Default Swap (CDS) is some sort of insurance policy where the third party

assumes the risk of debt going sour and in exchange will receive regular payments from

the bank who issues debt, similar to insurance premiums. Although the idea was floating

for a while JP Morgan was the first bank to make a bet on CDS. They opened up a Swap

desk in mid-‘90s and formally brought the idea of CDS into reality.

Definition:

A credit default swap (CDS) is a credit derivative contract between two counterparties.

The buyer makes periodic payments to the seller, and in return receives a payoff if an

underlying financial instrument defaults.

There are three parties involved in a typical CDS contract –

1. Protection Buyer (Risk Hedger)

2. Protection Seller

3. Reference Entity

Protection buyer is the one who pays a premium (CDS spread, generally a quarterly

premium) to the protection seller for taking credit risk to a reference entity and if the

credit event happens then protection seller will have to payoff. Typical credit events

include – material default, bankruptcy, and debt restructuring. The size of the payment is

usually linked to the decline in the reference asset’s market value following the credit

event. The concept of CDS is explained pictorially below:



The interesting thing about CDS market is you don’t need to own the underlying

reference entity to get into the contract. Such contract is know as naked CDS. Just like

any derivatives market CDS can be used for speculation, hedging and arbitrage purpose.

Significance of Credit Default Swaps: CDS creates Liquidity: The CDS adds depth to the secondary market of

underlying credit instruments which may not be liquid for many reasons.

Risk Management: Credit derivatives makes risk management more efficient

and flexible by allocation of credit risk to most efficient manager of that risk.

Risk Separation: Credit derivatives allows for separation of credit risk from

other risks of the asset.



Reliable funding source: Credit derivatives help exploit a funding advantage or

avoiding a funding disadvantage. Since there is no up-front principal outlay

required for most Protection Sellers when assuming a Credit Swap position, these

provide an opportunity to take on credit exposure in off balance-sheet positions

that do not need to be funded. On the other hand, institutions with low funding

costs may capitalize on this advantage by funding assets on the balance sheet and

purchasing default protection on those assets. The premium for buying default

protection on such assets may be less than the net spread such a bank would earn

over its funding costs.

CDS Premium: Premium prices – also known as fees or credit default spreads – are quoted in basis point

per annum of the contract’s notional value. In case of highly distressed credits in which

CDS market remains open upfront premium payment is a common thing. The CDS

spread is inversely related to the credit worthiness of the underlying reference entity.

CDS Size & Price: There are no predetermined limits on the size or maturity of CDS contracts, which have

ranged in size from a few million to several billions of dollars. In general the contracts

are concentrated in the $10 million to $20 million range with maturities of between one

and 10 years, although 5 years maturities are the most common.

Inevitably, the maturity of a CDS will depend on the credit quality of the reference entity,

with longer-dated contracts of five years and more only written on the best-rated names.

Although there are differences in the quotes given by banks on CDS prices due to some

technical reasons rather than financial reasons, but the CDS premium price more or less

remains the same. Over and above a valuation of credit risk, probability of default, actual

loss incurred, and recovery rate, the various factors in determination of CDS premium are

– liquidity, regulatory capital requirements, market sentiments and perceived volatility,

etc.



Trigger Events: The market participants view the following three to be the most important trigger events:

Bankruptcy

Failure to Pay

Restructuring

Bankruptcy, the clearest concept of all, is the reference entity’s insolvency or inability to

repay its debt. Failure-to-Pay occurs when the reference entity, after a certain grace

period, fails to make payment of principal or interest. Restructuring refers to a change in

the terms of debt obligations that are adverse to the creditors.

Growth of CDS Market: Since the inception of the CDS market its growth has been astounding. The growth of

CDS market over the period has been shown in the figure. As the market matured, CDSs

came to be used less by banks seeking to hedge against default and more by investors

wishing to bet for or against the likelihood that particular companies or portfolios would

suffer financial difficulties as well as those seeking to profit from perceived mispricing;

the rapid growth of index compared with single name CDS after 2003 reflected this

change.



The market size for Credit Default Swaps began to grow rapidly from 2003; by the end of

2007, the CDS market had a notional value of $62 trillion (as seen in the above figure).

But notional amount began to fall during 2008 as a result of dealer "portfolio

compression" efforts, and by the end of 2008 notional amount outstanding had fallen 38

percent to $38.6 trillion.

It is important to note that since default is a relatively rare occurrence (historically around

0.2% of investment grade companies would default in any one year) in most CDS

contracts the only payments are the spread payments from buyer to seller. Thus, although

the above figures for outstanding notional amount sound very large, the net cash flows

will generally only be a small fraction of this total.

Currently CDS dominates the credit derivatives market with its unprecedented growth.

Although after the subprime crisis (which will be discussed later) the credit derivatives

market, in the 4th quarter of 2008, reported credit derivatives notionals declined 2%, or



$252 billion, to $15.9 trillion, reflecting the industry’s efforts to eliminate many

offsetting trades (Reference: OCC’s Quarterly Report).

As shown in the chart above CDS represent the dominant product at 98% of all credit

derivatives notionals. As we can see from the other chart although majority of the CDSs

composition is dominated by the investment grade CDSs sub-investment grade CDSs

also forms a significant part of CDSs (34%) which is considered to be one of prime cause

for subprime crisis. Considering the global OTC market CDS accounts for about 8%.

Types of Credit Default Swaps: The CDSs can be classified as Single-name CDSs or Multi-name CDSs.

Single-name CDS: These are credit derivatives where the reference entity is a single

name.

Multi-name CDS: CDS contracts where the reference entity is more than one name as in

portfolio or basket credit default swaps or credit default swap indices. A basket credit

default swap is a CDS where the credit event is the default of some combination of the

credits in a specified basket of credits. In the particular case of an nth-to-default basket it

is the nth credit in the basket of reference credits whose default triggers payments.



Another common form of multi-name CDS is that of the “tranched” credit default swap.

Variations operate under specifically tailored loss limits – these may include a “first loss”

tranched CDS, a “mezzanine” tranched CDS, and a senior (also known as a “super-

senior”) tranched CDS.

Settlement methods for CDS: The settlement for CDSs can be done in either of two ways: Physical Settlement or Cash

Settlement.

Physical Settlement: The seller of the protection will buy back the distressed reference entity at par. Clearly

given that the credit event will have reduced the secondary market value of the

underlying reference entity, this will result in protection seller (CDS seller) incurring a

loss. This was the most common means for the settlement in CDSs and will generally

take place no later than 30 days after the credit event. Till 2006 ISDA2

allowed

settlement only in the form of physical settlement. But due to increased amount of naked

CDSs in the credit market ISDA has now allowed the choice between cash and physical

settlement.

Cash Settlement: The seller of the protection will pay the buyer the difference between the notional of the

default swap and a final value for the same notional of the reference obligation. Cash

settlement is less prevalent because obtaining precise quotes can be difficult when the

reference credit is distressed. After the Auction process being started for the settlement of

CDSs as per ISDA, this problem has been resolved.

The example for the Physical and Cash settlement shown below will explain the process.

2 International Swaps and Derivatives Association, Inc. (ISDA), which represents participants in the privately negotiated derivatives industry, is among the world’s largest global financial trade associations as measured by number of member firms.



Reference: Federal Reserve Bank of New York Staff Reports

Uses of Credit Default Swaps: As mentioned already CDSs can be used for speculation, hedging or arbitrage. Out of

which we will be considering hedging and speculation in detail.

CDSs for Hedging:

When JP Morgan invented the credit instrument named CDS they meant it to be for

hedging there credit risk. Although market has changed a lot since then but still the use of

CDSs for hedging purpose remains to be a primary reason.

Credit default swaps are often used to manage the credit risk (i.e. the risk of default)

which arises from holding debt. Typically, the holder of, for example, a corporate bond

may hedge their exposure by entering into a CDS contract as the buyer of protection. If



the bond goes into default, the proceeds from the CDS contract will cancel out the losses

on the underlying bond.

For example, if you own a bond of Apple worth $10 million maturing after 5 years and

you are worried about its future then you can create a CDS contract with an insurance

company like AIG which will charge a premium of say 200bps annually for insuring your

bond. In this way you are hedging the risk of losing $10 million in case Apple goes

bankrupt. Here you will be paying $200000 to AIG for insuring your bond. If Apple goes

bankrupt you will receive the par value of bond from AIG and even if does not, you will

lose premium value at the most which is worth transferring the risk to AIG.

Counterparty Risks:

When entering into a CDS, both the buyer and seller of credit protection take on

counterparty risk. Examples of counter party risks:

The buyer takes the risk that the seller will default. If reference entity and seller

default simultaneously ("double default"), the buyer loses its protection against

default by the reference entity. If seller defaults but reference entity does not, the

buyer might need to replace the defaulted CDS at a higher cost.

The seller takes the risk that the buyer will default on the contract, depriving the

seller of the expected revenue stream. More important, a seller normally limits its

risk by buying offsetting protection from another party - that is, it hedges its

exposure. If the original buyer drops out, the seller squares its position by either

unwinding the hedge transaction or by selling a new CDS to a third party.

Depending on market conditions, that may be at a lower price than the original

CDS and may therefore involve a loss to the seller.

As is true with other forms of over-the-counter derivative, CDS might involve liquidity

risk. If one or both parties to a CDS contract must post collateral (which is common),

there can be margin calls requiring the posting of additional collateral. The required

collateral is agreed on by the parties when the CDS is first issued. This margin amount



may vary over the life of the CDS contract, if the market price of the CDS contracts

changes, or the credit rating of one of the party’s changes.

CDSs for Speculation:

Credit default swaps allow investors to speculate on changes in CDS spreads of single

names or of market indexes such as the North American CDX index3 or the European

iTraxx index4

. An investor might speculate on an entity's credit quality, since generally

CDS spreads will increase as credit-worthiness declines and decline as credit-worthiness

increases. The investor might therefore buy CDS protection on a company in order to

speculate that the company is about to default. Alternatively, the investor might sell

protection if they think that the company's creditworthiness might improve. As there is no

need to own an underlying entity to enter into a CDS contract it can be viewed as a

betting or gambling tool.

For example if you feel that Microsoft is not performing well and may go bankrupt in

near future then you might enter into a CDS contract with AIG for a notional value of

$10 million for 5 years even if you don’t own a single share of Microsoft. This kind of

CDS is known as Naked CDS.

Changing Nature of CDS Market towards Speculation: CDS was originally meant for hedging but as market matured the market has moved more

towards using it for speculation purpose. Speculation entered the CDS market in three

forms: 1) using structured investment vehicles such as MBS, ABS, CDO and SIV

securities as the underlying asset, 2) creating CDS between parties without any

connection to the underlying asset, and 3) development of a secondary market for CDS.

3 CDX indices are credit default swap indices. CDX indices contain North American and Emerging Market companies and are administered by CDS Index Company (CDSIndexCo) and marketed by Markit Group Limited 4 iTraxx indices are credit default swap indices. iTraxx indices contain companies from the rest of the world other than CDX indices and are managed by the International Index Company (IIC), and owned by Markit.



Much has been written about the structured investment vehicle market and the lack of

understanding of what was included in the various products. Sellers of protection in the

CDS market more than likely did not have sufficient understating of the underlying asset

to determine an appropriate risk profile (plus there was no history of these products to

assist in determining a risk profile). As it has become clear, the structured investment

vehicle market was a speculative market which was not really understood which led to

speculative CDS related to these products.

A larger problem is the pure speculation in the CDS market. Many hedge funds and

investment companies started to write CDS contracts without owning the underlying

security, but were just a "bet" on whether a "credit event" would occur. These CDS

contracts created a way to "short" sell the bond market, or to make money on the decline

in the value of bonds. Many hedge funds and other investment companies often place

"bets" on the price movement of commodities, interest rates, and many other items, and

now had a vehicle to "short" the credit markets.

[Actually CDS can be viewed as short in bond and buying a put option. Because in the

case of default protection buyer will have to give the underlying reference entity (bond)

to the protection seller (in case of physical settlement) so shorting the bond. While

protection seller will have to pay the par amount to protection buyer in case of default

hence can be viewed to be a put option. The payout to credit protection buyer can be

described as –

Asset value at the time of swap – Asset market value;

Payout to investor = if default

0; if no default

So above expression can be viewed as binary put option based on two states of the world:

default and no default.]

A still larger problem was the development of a secondary market for both legs of the

CDS product, particularly the seller of protection. The problem may be that a "weak



link" would occur in the chain of sales even if the CDS terms are the same. The "weak

link" is often a speculative buyer that offers to sell protection, but, in fact, is just looking

to quickly turn the product to another investor. This problem becomes particularly acute

when the CDS is based on structured investment vehicles and firms looking for a quick

profit. The reasons for such developments in the secondary market will be discussed

later while dealing with the role CDSs played in the subprime crisis.

An insurance company may unknowingly be pulled into one of these speculative aspects

of the CDS market. The insurance company would be viewed as "the deep pocket" and

may be asked (or sued) to recover losses by the buyer of protection.

CDS is not insurance: In many terms CDS is like an insurance policy where there is a regular premium to be

paid, there is a reference entity and in case of default a pay-off will be paid. But CDS

differs in many aspects from insurance like –

The seller need not be a regulated entity

The seller is not required to maintain any reserves to pay off buyers, although

major CDS dealers are subject to bank capital requirements (because CDS dealers

are generally banks).

Insurers manage risk primarily by setting loss reserves based on the Law of large

numbers, while dealers in CDS manage risk primarily by means of offsetting CDS

(hedging) with other dealers and transactions in underlying bond markets.

In the United States CDS contracts are generally subject to mark to market

accounting, introducing income statement and balance sheet volatility that would

not be present in an insurance contract.

The buyer of a CDS does not need to own the underlying security or other form of

credit exposure; in fact the buyer does not even have to suffer a loss from the

default event. By contrast, to purchase insurance the insured is generally expected

to have an insurable interest such as owning a debt.



CDS Pricing: The main aim of CDS pricing is to calculate the amount of premium to be paid by

protection buyer to the protection seller. For calculating the CDS premium we need to

know the Recovery Rate and Probability of Default. Simple explanation of calculating

CDS premium (spread) for a 1-year CDS contract (with yearly premium) is shown below.

Let S = CDS premium (spread), p = probability of default, R = recovery rate.

The protection buyer expects to pay S. And his expected payoff is (1-R) p.

When the two parties enter a CDS contract, S is set so that the value of swap transaction

is zero. That is,

S = (1-R) p

The pricing for the complicated contracts (with quarterly premium, longer maturities,

etc.) is explained in Appendix A.

Now after understanding the basics of CDS, let’s look at the role played by it in the

subprime crisis by understanding first about subprime crisis and securitization process,

etc.


CDS | Subprime Crisis MMS 2008-10 25

Subprime Crisis Background of Subprime Crisis: The immediate cause or trigger of the crisis was the bursting of the United States housing

bubble which peaked in approximately 2005–2006. High default rates on "subprime" and

adjustable rate mortgages (ARM) began to increase quickly thereafter. An increase in

loan incentives such as easy initial terms and a long-term trend of rising housing prices

had encouraged borrowers to assume difficult mortgages in the belief they would be able

to quickly refinance at more favorable terms. However, once interest rates began to rise

and housing prices started to drop moderately in 2006–2007 in many parts of the U.S.,

refinancing became more difficult. Defaults and foreclosure activity increased

dramatically as easy initial terms expired, home prices failed to go up as anticipated, and

ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006

and triggered a global financial crisis through 2007 and 2008.

In the years leading up to the crisis, high consumption and low savings rates in the U.S.

contributed to significant amounts of foreign money flowing into the U.S. from fast-

growing economies in Asia and oil-producing countries. This inflow of funds combined

with low U.S. interest rates from 2002-2004 resulted in easy credit conditions, which

fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit

card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.

As part of the housing and credit booms, the amount of financial agreements called

mortgage-backed securities (MBS), which derive their value from mortgage payments

and housing prices, greatly increased. Such financial innovation enabled institutions and

investors around the world to invest in the U.S. housing market. As housing prices

declined, major global financial institutions that had borrowed and invested heavily in

subprime MBS reported significant losses. Defaults and losses on other loan types also

increased significantly as the crisis expanded from the housing market to other parts of

the economy. Total losses are estimated in the trillions of U.S. dollars globally.



While the housing and credit bubbles built, a series of factors caused the financial system

to become increasingly fragile. Policymakers did not recognize the increasingly

important role played by financial institutions such as investment banks and hedge funds,

also known as the shadow banking system. Some experts believe these institutions had

become as important as commercial (depository) banks in providing credit to the U.S.

economy, but they were not subject to the same regulations. These institutions as well as

certain regulated banks had also assumed significant debt burdens while providing the

loans described above and did not have a financial cushion sufficient to absorb large loan

defaults or MBS losses. These losses impacted the ability of financial institutions to lend,

slowing economic activity. Concerns regarding the stability of key financial institutions

drove central banks to take action to provide funds to encourage lending and to restore

faith in the commercial paper markets, which are integral to funding business operations.

Governments also bailed out key financial institutions, assuming significant additional

financial commitments.

The risks to the broader economy created by the housing market downturn and

subsequent financial market crisis were primary factors in several decisions by central

banks around the world to cut interest rates and governments to implement economic

stimulus packages. Effects on global stock markets due to the crisis have been dramatic.

Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had

suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to

$12 trillion. Losses in other countries have averaged about 40%. Losses in the stock

markets and housing value declines place further downward pressure on consumer

spending, a key economic engine. Leaders of the larger developed and emerging nations

met in November 2008 and March 2009 to formulate strategies for addressing the crisis.

As of April 2009, many of the root causes of the crisis had yet to be addressed. A variety

of solutions have been proposed by government officials, central bankers, economists,

and business executives.

Now after a brief idea about subprime crisis let’s understand in detail about subprime

crisis which shook the whole world.



Subprime Mortgage Market:

The subprime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in

mortgage delinquencies and foreclosures in the United States, with major adverse

consequences for banks and financial markets around the globe. The crisis, which has its

roots in the closing years of the 20th century, became apparent in 2007 and has exposed

pervasive weaknesses in financial industry regulation and the global financial system.

Let’s understand the problem from both borrower’s and lenders point of view and then

sum it all up.

Borrower’s Side:

A subprime loan is a loan given to borrowers that are considered more risky, or less

likely to be able to make their loan payments, in relation to high quality borrowers

because of problems with their credit history. When you go to get a loan you need to get

a credit check, and what results from this credit check is something that is known as your

FICO score5

In order to understand how these sub prime loans have caused so many problems, we

must first understand what happened in the years leading up to the recent problems.

. A FICO score is a number which represents how credit worthy you are

considered which is based on factors such as the amount of money that you earn, your

record of paying back past debts, and how much debt you currently hold. The higher the

score the better your credit is considered, and the more likely you are to get a loan.

In the years leading up to the sub prime crisis interest rates had been at historical lows as

the fed had aggressively cut interest rates to avoid going into recession after the tech

bubble burst in 2000 and after 9/11 terrorist attack. This had the following effects:

5 FICO Score: A type of credit score that makes up a substantial portion of the credit report that lenders use to assess an applicant's credit risk and whether to extend a loan. FICO is an acronym for the Fair Isaac Corporation, the creators of the FICO score.



1. When interest rates are low in general it causes the economy to expand because

businesses and individuals can borrow money easily which causes them to spend

more freely and thus increases the growth of the economy.

2. What drives interest rates lower is the fact that there is an increase in the supply of

money, meaning that there is more money to go around.

Before the Fed lowered interest rates substantially after the bursting of the NASDAQ

bubble in 2000, if you wanted to get a loan for a house you had to have a relatively good

credit score. Buyers with a FICO score below 620 (generally considered sub-prime)

where in most cases considered too risky to lend to and therefore could not get a loan.

After the fed lowered interest rates to historical lows however there was so much money

(also referred to as liquidity) available that financial institutions started offering loans to

buyers with FICO score’s below 620. Because these borrowers were considered less

likely to be able to pay the loan back than borrowers with higher credit scores, these sub

prime borrowers were charged a higher interest rate.

Things initially went very well for the financial institutions that made these loans because

in the years that followed interest rates stayed low, the economy continued to grow, and

the real estate market continued to expand causing the value of most people’s houses

(including the sub-prime borrower’s houses) to go up in value pretty dramatically. This



made it relatively easy for these borrowers to make payments on their loans as if they ran

into financial trouble they in more cases than not could tap the equity in their home

(which came from the increase in the house price) to refinance at more favorable terms or

to make their mortgage payment. Because a relatively few of these sub prime borrowers

were defaulting on their loans, the financial institutions which held these loans were

enjoying the additional profits earned by charging these borrowers a higher interest rate,

without many problems. Now pause for a minute to understand why financials

institutions were ready to take the risk of giving loans to these subprime borrowers. There

were some underlying assumptions which made it possible for financial institution to take

this step.

1. The prices of house will keep on increasing. (Even Alan Greenspan, former U.S.

Federal Reserve Chairman, backed this theory)

2. The interest rate will keep on falling. (As can be seen in the figure above)

Even government encouraged subprime borrowing. The federal government encouraged

Fannie Mae and Freddie Mac to buy more than $400 billion in subprime mortgage loans

between 2004 and 2006, helping to fuel the boom in risky lending, the Washington Post

reports. Federal Reserve Chairman, Greenspan not only commended homeowners for

their sophisticated approach to "managing their home equity6

" on a routine basis, he

applauded Wall Street and mortgage lenders for their creativity and ingenuity. Of course,

home equity extractions are largely responsible for so many homeowners now owing

more than their homes are worth!

6 Home Equity Loan: Home equity loan is a type of loan which is made available based on the appreciation

of your house value. Let’s say the cost of your house at the time of buying (before two years) was $200000

and now after appraising it, the current price is $220000 then $20000 is your home equity on which you

can get a loan.



After the initial success and profitability for those offering sub prime mortgages the

practice expanded dramatically and the terms which borrowers were given in order to

allow them to obtain loans became all the more creative.

There are now many different types of sub prime loans such as:

1. Interest Only Mortgages: These loans require the borrower to pay only the interest

portion of the loan for the first few years thus keeping the payment relatively low

for the first few years before the interest only component expires and the

borrower must pay the principle and interest component of the mortgage payment

(of course a much higher amount)

2. Adjustable Rate Mortgages: Unlike traditional mortgages have a fixed interest

rate so your payment is the same each month, with an adjustable rate mortgage if

interest rates rise (as they have been recently) your monthly mortgage payment

goes up as well!

3. Low Initial Fixed Rate Mortgages: Mortgages that initially have very low fixed

rates and then quickly convert to adjustable rate mortgages.

Because house prices had increased so rapidly in the last few years many of these sub

prime borrowers took out loans that they could not afford in the anticipation that, when

the mortgage reset to the higher payment, they would be able to refinance at more

favorable rates using the increased value of their home and the equity that they now had

as a result of that. But the point to be noted here is that the lender is aware of the financial

conditions of the borrower and the financial options available to him, but the borrower

may not be aware of the same. And even if the borrower knows about all the options he

might not be able to judge which option is the best option for him. This leads to the

possibility of predatory lending.



Moral Hazards: Moral hazard refers to changes in behavior in response to redistribution of risk. In

managing delinquent loans, the loan servicer7

is faced with a standard moral hazard

problem vis-à-vis the mortgagor. In normal course of action mortgagor pays regular

installments to the servicer. But when the property is close to foreclosure then the

mortgager has little incentive to pay for taxes and insurance. Here the servicer is working

in the investor’s best interest and needs to keep the losses to the minimum, such that after

foreclosure the sales value of the property will remain as high as possible. But the

mortgagor is least interested to maintain the property in good shape which is close to

foreclosure.

7 Loan Servicer: These are companies or divisions of companies that specialize in servicing mortgages (i.e. collecting payments, issuing statements etc.) These companies do this in exchange for a fee which is paid by the mortgage owner and fees which they can charge to the borrower for things such as late payments.



Adjustable Rate Mortgages: An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note

is periodically adjusted based on a variety of indices. Among the most common indices

are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds

Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their

own cost of funds as an index, rather than using other indices. This is done to ensure a

steady margin for the lender, whose own cost of funding will usually be related to the

index. Consequently, payments made by the borrower may change over time with the

changing interest rate (alternatively, the term of the loan may change).

2/28 Adjustable-Rate Mortgage:

A type of adjustable-rate mortgage that has a two-year fixed interest rate period after

which the interest rate on the mortgage begins to float based on an index plus a margin.

The index plus the margin is known as the fully indexed interest rate. Often, a 2/28 ARM

is designed as a short-term financing vehicle that provides borrowers with time to repair

their credit before they refinance into a mortgage with more favorable terms.



The ARMs are also known as teaser loans. Teaser loans are considered an aspect of

subprime lending, as they are usually offered to low-income home buyers. Unfortunately,

when these borrowers try to refinance the loan before the rate increases, most will not

qualify for standard mortgages. This leaves borrowers with increased monthly payments,

which many cannot afford. This method of loaning is considered risky, as default rates

are high.

As can be seen above these all factors contributed for the reckless borrowing and the

share of Subprime and Alt-A8

8 Alternative A borrowers (“Alt-A”), are just a drop below prime. For variety of reasons, they may not

be able to document there income (e.g. someone leaving a secured job and starting a business)

borrowers increased considerably.



Lender’s Side: One of the reasons why this is such a big problem is because so many different types of

financial firms and investors have exposure to these subprime loans. To understand how,

we must understand something which is known as securitization. Securitization in simple

terms means taking a bunch of assets, pooling them together, and offering them out as

collateral for third party investment.

Up until relatively recently when you went to get a loan for a house from a bank, they

would lend you the money and then hold your loan, earning money from the fees they

charge you to give you the loan and the interest that you pay the bank on that loan. As the

money the bank was lending out was the money that people were depositing in the bank,

the bank was limited on how many loans it could do by how much money it had on

deposit. As the bank was holding all of the loans on its books so to speak it also held all

the risk for those loans.

As a way of diversifying risk and allowing the banks to make more loans (thus earn more

fees) investment bankers came up with a process for securitizing mortgages so they could

be sold off to other financial institutions and investors in a secondary market.



Securitization Process: Securitization is the transformation of an illiquid asset into a security. For example, a

group of consumer loans can be transformed into a publicly-issued debt security.

The overview of the securitization process is shown above. One of the prime reasons for

the subprime crisis is the complicated procedures developed over the years for issuing

loans. The new and complex methods for generating the loan were made all the more

risky than these were traditionally.

As can be seen in the figure above, in traditional loan life cycle, the key entities were the

lender and borrower. The key loan processes were loan origination, loan servicing and

collections and the loan remained for entire life cycle on the books of the lender. The life

cycle is sometimes referred to as originate-and-hold approach. The credit risk

measurement is applied during loan origination for measuring the credit-worthiness of

borrower.

With the growth of the securitization market or the market for the pool of loans or

mortgage backed securities, this model changed introducing a third entity – the pooling

underwriter. The pooling underwriter is normally a separate financial institution that

builds a Special Purpose Vehicles (SPVs) like CDOs that are securitized by loans. The

use of SPVs allows the loans to be removed from the books. The pooling underwriter



breaks the instrument into various tranches (meaning slice in French) – each tranches

representing a pool of loan with similar exposure. These tranches are then sold to third

party, the investor, for immediate cash. This also benefits the lender in another critical

way – helps lender transfer its credit risk. This life cycle is also known as originate-and-

distribute approach. In this approach, credit risk measurement is now applied at two

levels: at origination during the underwriting process of loan and the pooling process

when the risk measurement has to be applied to calculate the risk of each tranche. This

can be better understood with the help of an example.

Let’s start with a $100 portfolio of ABS bonds which yield 7%. This is called the

collateral portfolio. The collateral portfolio has an average rating of BBB. In order to

fund the purchase of this portfolio, 5 different securities are sold. The amount, credit

rating and interest rate of the first four are as follows.

$75 Class A, rated AAA, yields 5.51%

$10 Class B, rated AA, yields 5.80%

$5 Class C, rated A, yields 7.20%

$5 Class D, rated BBB, yields 9.00%

These are called the debt tranches. Some of you may notice that those yields for Class C

and D are far in excess of what typical bonds with similar ratings yield.

The fifth security sold is the equity tranche which is generally retained rather than getting

sold as it gives higher returns. Here equity branch is another $5.

Why are the tranches rated differently? Because interest and principal are paid

sequentially starting with Class A and ending with the equity tranche. Only once Class A

has been paid what its due does Class B get paid, and so on.

So our portfolio of bonds pays $7 per year in interest. The CDO then owes interest on the

debt it sold:



Class A: $4.13

Class B: $0.58

Class C: $0.36

Class D: $0.45

That makes a total of $5.52. So there is $1.48 left over. In a deal like this, the manager

probably charges around 0.20%, and there is another 0.05% for admin fees. So net of fees

there is $1.23 (Excess Spread). That passes through to the equity. Notice the return on the

equity is a quite attractive 24.6%. So equity branch turns out to be the most lucrative one

and this was the reason for changing the framework of loan process. This can be

visualized well from balance sheet CDO shown below:

So that's how it works if you have zero defaults, but of course, that's not going to happen.

Let’s say there are 30% default. So now we have a portfolio of $70 with a $4.90 yield. So

we can pay interest for class A, class B but won’t be able to pay interest thereon leading

to a big problem to originators. And look at the situation as against the previous situation.

Previously originator was getting a healthy yield of 24.6% from the whole process and

now he as zero returns against equity whereas he needs to pay for the rest unpaid from his



pocket. So in case of no default it was a fantastic investment which could have turned

sour if things go wrongs. And this is what happened.

Predatory Borrowing and Lending: Many of the investment banks like Lehman Brothers were in a lead to make this whole

process work. This was the shadow banking which was getting dominant. They used to

do the securitization process in order to earn maximum from equity assuming there won’t

be many defaults. Because even if there would have been normal defaults there were

enough incentives to go for securitization considering its huge returns. This forced the

investment banks to hold more of the securities. They pressurized the commercial banks

to lend more and lend generously. This led to the cycle of lending more even though

there were no enough evidences of the credit-worthiness of the borrowers, and to new

ways of lending like automated lending. This provided enough motives for the banks to

lend more as they were not having the credit risk to be held. So they started concentrating

on volumes rather than quality of borrowings. This is where predatory lending (the lender

convinces the borrower to borrow “too much”) or predatory borrowing (the borrower

convinces the lender to lend “too much”) started. This allowed people to have loans even

with no papers.

To take it to one level further mortgage brokers were added to the system which did not

bother to check the credit history of the borrower and concentrated on lending more as

there incentives were based on volumes rather than quality of borrowing. To give as

example this thirst to get more borrowers grown to such an extent that a woman living on

social security of $1800 was having a loan of $9 million to be repaid.

There were many others involved too. Investment banks were selling these portfolios to

investors like hedge funds, pension funds, etc. But the question arises why one would buy

subprime collateral backed securities? The answer to that lies in tranches as mentioned

above. One more entity involved in this securitization process was rating agencies. The

mortgage backed securities were divided into tranches as –



Senior tranche

Subordinate tranche (Mezzanine tranche)

Equity tranche

Now what is the point in dividing collaterals in this way? Senior tranches were the ones

which were paid interest first from the underlying mortgage payments then subordinate

and finally the equity. This way senior tranches were made secured through this process

because senior tranches will default only if both equity and subordinate tranches default.

So this way the credit risk of senior tranche was reduced. This tranches also served the

purpose of fulfilling the appetite of investors having different ability and willingness to

handle risk. So senior tranche will provide low yield with low credit risk and subordinate

will provide higher yield for higher risk. These tranches can again be subdivided into

many levels. Now where do credit rating agencies come into picture? Credit rating

agencies were the ones which used to provide rating to these tranches (AAA/AA for

senior tranches, A/BBB for subordinate tranches). So this way BBB rated subprime

mortgages could be made investment grade instruments. Again these credit agencies were

paid by the investment bankers who were doing the securitization so there were enough

incentives to make those securities investment grade securities (conflict of interest).

Adverse Selection: There is an important information asymmetry between the arranger (like Lehman

Brothers) and the third-parties (like hedge funds or Moody’s) concerning the quality of

mortgage loans. As the arranger is having more information about the quality of the

mortgages, arranger can securitize the bad loans (lemons) and can keep the good ones.

Also in case of credit rating agencies, their opinion is vulnerable to the lemons problem

as the arranger still knows more than credit rating agencies and credit rating agencies

only conduct limited due diligence.

Moral Hazards: The servicer can have a significantly positive or negative effect on the losses realized

from the mortgage pool. This impact of servicer quality on losses has important



implications for both investors and credit rating agencies. Investor wants to minimize the

losses whereas credit rating agencies wants to minimize the uncertainty about the losses

to make accurate opinion.

The servicing fee is a flat percentage of the outstanding principal balance of mortgage

loans. So servicer always has an incentive to keep the mortgage on his book as long as

possible. Due to this servicer will try for modifying the terms of delinquent loans and will

try to defer the foreclosure. Second problem here is that in the event of foreclosure the

servicer has to pay all the expenses till the property gets liquidated and then these

expenses are reimbursed. So servicer tries to inflate the expenses in good times when the

recovery rates for the property are high.

Different view on Credit Rating Agencies: In analyzing the credit risk by rating agencies there is a different thought flow which

states that credit rating agencies simply failed to understand the consequences of defaults

in money market by understanding it to be very similar to that of insurance. In case of

insurance if one person fails to pay the EMI that has no effect on the other person making

defaults. But in money market the whole market has dependencies on many other market

components so if one defaults it can have ripple effect (domino effect) on the other

instruments leading to systemic risk. And many believe credit rating agencies did not take

this into consideration.

Different effects of subprime crisis, indicating its reach and perforation, on the number of

bankruptcy filings, fed bailouts and various write downs are indicated in Appendix B.

Now after learning about the causes of subprime crisis it is clear that the crisis was

originated and caused by the flaws in US mortgage market, the securitization of

mortgages, etc. But there was one more factor involved in subprime crisis which had a

cascading effect, which is Credit Default Swaps. We will understand about the role of

these CDSs in next chapter.


CDS | Role of CDS in Subprime Crisis MMS 2008-10 41

Role of CDS in Subprime Crisis We already learned about the basics of Credit Default Swaps. Let’s now understand the

role played by CDSs in the subprime crisis.

Source:YieldCurve.com

We learnt about the securitization process in which the collateral of borrowings was

pooled and tranches at different levels were created. The subprime crisis is the unraveling

of a stupendously leveraged speculative bubble on real estate that built itself up for about

seven years from the beginning of this decade (and century); this speculative bubble was

mediated by fancy financial instruments fashioned by Wall Street, running all the way

from sub-prime mortgages, asset backed securities (ABS) and mortgage backed securities

(MBS), collateralized debt obligations (CDO) to credit default swaps (CDS).

Let’s understand with real life example to know where exactly CDS fits in. Suppose you

take a loan from Countrywide Financial (the largest US mortgage lender) for purchasing

a house. Many such loans are collateralized, put into many tranches, rated by Moody’s as

investment grade securities and bought by Lehman Brothers. Now Lehman Brothers sells



these securities to some of the hedge funds like JPMorgan Asset Management. For that

Lehman needs to convince about the credit-worthiness of the securities. This is done in

two ways: one with tranches and their high ratings. The other is by insuring the

underlying securities. And this can be done with the help of CDSs. These securities can

be insured from AIG making CDS contracts. Now these securities backed by insurance

can be sold again & again and the chain continues. In this way there can be many CDS

contracts on the same underlying assets. Even CDS contracts could be used for un-

hedged betting purpose (naked/leveraged CDSs) also which constitutes the large part of

CDS market in subprime crisis. Now look at the gravity of situation today, Countrywide

Financial was acquired by Bank of America in October 2008, Lehman Brothers went

bankrupt on 15th September 2008 (largest bankruptcy in the history of USA), AIG was

provided a government aid of $85 billion and there are many other companies which

made CDSs as buyer or seller and are in deep trouble as there are not enough funds to

realize these contracts9

. This clearly indicates how severely the market was interlinked

and perforated.

As mentioned earlier while

describing CDSs although

CDSs were invented for

hedging purpose (that’s why

Protection Buyer is also know

as Risk Hedger), the changing

nature of CDSs resulted in

many naked CDS contracts.

This is pretty evident from the

fact that the CDS market was

worth $62 trillion but the

underlying mortgages were not

worth the same. The main

9 Note: CDS contracts are not the cause for the debacle of these companies. CDSs just had the cascading effect on the already sinking ships.



problem with naked CDS was that the protection seller need not have to allocate

collateral for fulfilling the contract. That means when AIG is insuring a contract worth

$10 million then it does not need to maintain collateral worth $10 million to get into

contract as long as it maintains AAA rating. That means it can have CDS contracts worth

billions of dollars without even bothering to have that much of funds. So when the

delinquencies increased as shown in the figure there were many contracts which

remained unfulfilled as there were not enough funds to fulfill the same.

Over-the-counter (OTC) Market: The main problem with CDS at the time of subprime crisis was that it was an OTC

market. The deals were not very transparent, and were unregulated. So when Bear Stern

faltered in March 2008 it created negative vibes and shook the confidence of investors.

And September 2008 was the worst month for US when Lehman Brothers filed for the

biggest bankruptcy in the history of US; Merrill Lynch was sold to Bank of America

amidst fears of a liquidity crisis; $85 billion were lent to AIG from US Federal Reserve;

Federal took over of Fannie Mae and Freddie Mac and Washington Mutual’s banking

assets were sold to JP MorganChase for $1.9 billion. Here Lehman and AIG had a large

amount of CDSs created by them or against their name and in some cases they acted as

an intermediate entity. Let’s quantify these CDSs. In September the bankruptcy of

Lehman Brothers caused a total close to $400 Billion to become payable to the buyers of

CDS protection referenced against the insolvent bank. Also in September American

International Group (AIG) required a federal bailout because it had been excessively

selling CDS protection without hedging against the possibility that the reference entities

might decline in value, which exposed the insurance giant to potential losses over $100

Billion. As recent as in case of GM, DTCC Warehouse records indicate the gross notional

value of CDS single-named reference entities on GM that was registered in the

Warehouse amounts to approximately US$35.3 billion as of May 29, 2008. Even today

there are huge amounts of CDSs in the market. The table below shows some of the

statistics regarding the number of contracts and notional values (The data in the table is a

stale data and is for indicative purpose).



Source: Infectious Greed

The figures above indicate CDS has become a huge market with potential risks as it is an

OTC market. Let’s now understand what the disadvantages of OTC market are –

1. Prior to entering the contract, the parties must assess each others creditworthiness.

This adds an element of cost to the transaction and also implies a certain amount

of risk. Institutions with small balance sheets are often considered to be too high a

credit-risk for the major banks and are therefore excluded from the market, or

receive less favorable pricing than bigger companies.

2. Parties to a contract are not able to sell their contractual obligation to a third party.

Once a contract has been entered into, the only way that a party can get out of its

obligation is by way of early settlement of the contract (if this is catered for) or to

default.

3. OTC market is a dealer market where the dealers act as market makers.

4. The contract is not valued by an independent valuation agent. This means that

each party to the contract may attach its own value to the derivative position. It is

not uncommon for two parties to assign vastly different value to the same OTC



contract - a nightmare for auditors and a practice that has resulted in several cases

of fraud.

Due to these disadvantages a need for the central counterparty (CCP) was highlighted.

And post subprime crisis the CDS clearing was allowed to be done through CCP like

IntercontinentalExchange (ICE). Now before understanding the CCP clearing let’s first

understand about the various credit indices used.

Credit Derivative Indices (CDX/ iTraxx): The introduction of credit derivative indices has been a milestone for the credit markets.

Credit derivative indices provide building blocks for structuring portfolio products such

as index linked tranches and index swaptions. They have made the credit markets more

transparent and liquid, but also potentially more volatile.

Benefits:

Tradability: Credit indices can be traded and priced more easily

Liquidity: Significant liquidity is available in indices and has also driven more

liquidity in the single name market

Operational Efficiency: Standardized terms, legal documentation, electronic

straight-through processing

Transaction Costs: Cost efficient means to trade portions of the market

Industry Support: Credit indices are supported by all major dealer banks, buy-side

investment firms, and third parties

Transparency: Rules, constituents, fixed coupon, daily prices are all available

publicly

There are currently two main families of CDS indices: CDX and iTraxx. CDX indices

contain North American and Emerging Market companies and are administered by CDS

Index Company (CDSIndexCo) and marketed by Markit Group Limited, and iTraxx

contain companies from the rest of the world and are managed by the International Index

Company (IIC), also owned by Markit. The current set of CDX/ iTraxx indices can be



divided into North America – Investment Grade, North America – High Yield and

Crossover, Emerging Markets, Europe and Asia.

Geographic Concentration Main Index Name Main Index Composition

North American investment

grade Dow Jones CDX NA IG 125 corporate names

North American high yield Dow Jones CDX NA HY 100 corporate names

Europe Dow Jones iTraxx Europe 125 corporate names

Japan Dow Jones iTraxx CJ Japan 50 corporate names

Asia ex-Japan Dow Jones iTraxx Asia ex-

Japan

50 corporate and sovereign

names

Australia Dow Jones iTraxx Australia 25 corporate names

Emerging Market Dow Jones CDX EM 15 sovereign names

Emerging market diversified Dow Jones CDX EM

Diversified

40 sovereign and corporate

names

The composition of the new indices is chosen by participating dealers based on the

liquidity of individual contracts, i.e. the most actively traded names are included. The

compositions of the indices are changed every six months, a process known as "rolling"

the index. These indices are tradable instruments in their own right, with pre-determined

fixed rates, and the prices set by market demand.

BIS Recommendations for OTC Derivatives Settlements: The Bank for International Settlements (BIS) is an international organization which

fosters international monetary and financial cooperation and serves as a bank for central

banks. The BIS carries out research and analysis to contribute to the understanding of

issues of core interest to the central bank community. The BIS also comments on global

economic and financial developments and identifies issues that are of common interest to

central banks. In such efforts, Committee on Payment and Settlement Systems (CPSS)

and the Eurocurrency Standing Committee (ECSC) conducted a comprehensive survey

and analysis on the practices and procedures for documenting, processing and settling



that participants in OTC market use to manage the counterparty risk, to identify any

weaknesses in practices that appear to worsen the counterparty risk and to consider

changes needed in practices to mitigate those risks. The committees come up with the

following recommendations10

–

With respect to delays in documenting and confirming transactions:

Derivatives counterparties should review the backlogs of unsigned master

agreements and outstanding confirmations, assess the risks entailed, and take

appropriate steps to manage the risks effectively.

Derivatives counterparties should assess the potential for reducing backlogs and

associated risks through the use of existing or new systems for the electronic

exchange or matching of confirmations.

Prudential supervisors should review the backlogs and associated risks at

institutions they supervise (especially derivatives dealers), assess the effectiveness

of the institutions’ policies and procedures for limiting the associated risks, and

encourage improvements in practices where appropriate.

With respect to the expanding use of collateral:

Derivatives counterparties should assess the legal risks (including those arising in

cross-border arrangements), operational risks, liquidity risks and custody risks

associated with their use of collateral and ensure that these risks are managed

effectively.

Prudential supervisors should consider developing supervisory guidance on the

use of collateral as a means of reducing credit risk, including guidance on

operational risks and on legal due diligence.

Derivatives counterparties, prudential supervisors and central banks should

encourage governments to take action where necessary to reduce legal uncertainty

about the enforceability of collateral agreements.

10 The recommendations are reproduced from “OTC Derivatives: Settlement Procedures And Counterparty Risk Management” - Report by the CPSS & ECSC of the central banks of the Group of Ten countries



With respect to the potential use of clearing houses:

Derivatives counterparties should assess the potential for clearing houses for OTC

derivatives to reduce credit risks and other counterparty risks, taking into account

the effectiveness of the clearing house’s risk management procedures and the

effects of clearing on their bilateral credit risks on contracts that are not cleared.

Central banks and prudential supervisors of counterparties should ensure that

there are no unnecessary legal or regulatory barriers to the establishment of

clearing houses for OTC derivatives. They should also ensure that clearing houses

adopt effective risk management safeguards, including arrangements for covering

losses from the failure of any participant.

After understanding the various methods adopted in OTC market to estimate the risk and

the various measures taken to mitigate that risk we will now understand about the current

measures being taken to cope up with the issues associated with the nature of CDS

contracts. There were fundamental changes that happened recently in CDS market due to

subprime crisis. The bankruptcy of Lehman Brothers made reducing systemic risks in

credit derivatives a priority for Wall Street.

“Since then, the industry has pushed through 10 years worth of changes in just a few

months,” said Athanassios Diplas, managing director at Deutsche Bank. “This is a

complete transformation of the CDS industry.”

The changes: In response to pressure from regulators, dealers in the CDS market are proposing three

key changes to the way the CDS market operates.

Central counterparty: a clearing house would act as counterparty to all single

name and index trades. This means that market participants would not take each

other’s counterparty risk. It would also allow market participants to net all of their



offsetting trades, since they would now have only single counterparty. It is

important to note that this would not be a trading platform or exchange.

Hardwiring the auction protocol: it would become compulsory to cash settle credit

events via an auction process, and physical settlement by delivering bonds outside

of the auction process would no longer be allowed. This will affect existing

contracts as well as new ones.

ISDA Determination Committee: a committee of eight global CDS dealers, two

regional CDS dealers for each region, and five non-dealers would decide if and

when credit events and succession events had occurred and which bonds could be

delivered into an auction. These decisions would be legally binding on all market

participants. A pool of five legal firms would resolve any disputes.

What is Central Counterparty? In connection with transactions in various financial instruments, there is a risk that one

party does not meet its obligations. When a central counterparty (CCP) is used in

connection with the settlement, the parties’ positions in relation to each other are replaced

by positions against the central counterparty through the process of novation as shown in

the figure. The main function of CCP is it guarantees the execution of the settlement.

Internationally, CCPs are used in the settlement of equities, bonds, derivatives and

commodities.

A CCP has various means of reducing

the probability of participants’ default,

reducing the size of potential exposures

against participants and ensuring that it

has adequate resources to meet

obligations. Central counterparties set

requirements with regard to participants’

credit worthiness and liquidity. A

general requirement therefore is that

participants make margin payments both



when contracts are signed and when contract prices change. This is the central

counterparty’s first line of defense. In special situations, additional financial resources

may also be required. To reduce losses when a participant defaults on its obligations the

CCP must have procedures that ensure rapid closing or safeguarding of positions.

Risk is reduced when a CCP of high quality replaces counterparties of variable quality.

The existence of CCPs that operate in accordance with high quality standards is in the

interest of securities market participants. Due to the potential centralization of risk in

CCPs, these institutions are subject to government requirements concerning authorization

and supervision. The use of central counterparties may also increase the liquidity in the

market concerned as well as reduce the need for liquidity in connection with settlements.

If a central counterparty is unable to fulfill its obligations, its activities will be terminated

for a shorter or longer period. The significance of this for financial stability depends on

the direct and indirect importance of the market concerned as well as the possibility of

clearing and settlement through alternative channels. Another risk is reputation risk,

where market participants facing a weak central counterparty question the quality of the

other parts of the financial infrastructure. It is, therefore, important to have efficient, safe

clearing and settlement systems, including central counterparties that are organized in

such a way that risk is limited.

After understanding what CCP does and how it could be beneficial to reduce the

counterparty default it makes sense why SEC (Securities and Exchange Commission)

promptly granted an exemption for the ICE (IntercontinentalExchange) to begin

guaranteeing CDS as CCP. Also the International Swaps and Derivatives Association,

Inc. (ISDA) on 19th February 2009 announced that major industry participants have

committed to the use of central counterparty clearing for CDS in the European Union

(EU). Nine of the leading dealer firms in the CDS industry have signed a letter to

European Commissioner, Charlie McCreevy, confirming their engagement to use EU-

based central clearing for eligible EU CDS contracts by end-July, 2009. The co-

signatories of the letter are: Barclays Capital, Citigroup Global Markets, Credit Suisse,

Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley and UBS. As can



be seen from the table most of the big players in CDS market are ready for central

counterparty clearing. Also Bank of America, Barclays Capital, Citigroup, Credit Suisse,

Deutsche Bank, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan Stanley and UBS

have supported the establishment of the clearing house for CDS transactions, and are the

initial clearing members of ICE Trust. The early months of 2009 saw several fundamental

changes to the way CDSs operate, resulting from concerns over the instruments' safety

after the events of the previous year.

Even though the efforts are made to move the CDS market towards CCP clearing there

are still bilateral contracts existing in the market. As the confidence in CCP clearing will

enhance and the firms will be convinced of the benefits of CCP clearing, the footprint of

CCP clearing will increase significantly. But what is to done about the existing CDSs of

the firms? When a credit event occurs on a major company on which a lot of CDS

contracts are written, an auction (also known as a credit-fixing event) may be held to

facilitate settlement of a large number of contracts at once, at a fixed cash settlement

price. This Auction process is explained in detail in the next chapter.


CDS | CDS Auction MMS 2008-10 52

CDS Auction The rapid growth of the credit default swap (CDS) market and the increased number of

defaults in recent years have led to major changes in the way CDS contracts are settled

when default occurs. Auctions are increasingly the mechanism used to settle these

contracts, replacing physical transfers of defaulted bonds between CDS sellers and

buyers.

Rationale behind Auction Process: When credit default swaps (CDS) were first developed, the intended use was to hedge

cash debt positions with the derivative. With that in mind, the settlement method

developed to settle credit events was what is known as ‘physical settlement’. After a

default, the protection buyer delivers the defaulted asset and receives in return the due

amount outstanding from the defaulted entity.

But the rapid development of the CDS market has led to a situation where some entities

have more CDS protection on them than there are actual bonds. This is because, while the

CDS buyer may desire to pay a premium to insure the value of the bond he owns, there is

no requirement that he own the bond. For example, the Depository Trust and Clearing

Corporation (DTCC), which collect data on a large fraction of the CDS market, recently

reported that the notional value of CDS contracts on General Motors’ debt summed to

$65 billion, which is about $20 billion more than the face value of the debt owed by GM.

Many of the CDS contracts were not purchased by debt investors but by other investors,

who may have purchased GM’s stock (and hedged the default risk with the CDS) or who

hold strong views on GM’s ability to repay its debt11

. The disconnect between the size of

claims owed by the defaulting corporation and the aggregate notional value of CDS

contracts covering the firm’s obligations complicates the way in which CDS claims are

settled.

11 GM filed for bankruptcy protection on 1st June 2009. The auction for GM happened on 12th June and 18th June was the auction settlement date. The final settlement price was 12.5%.



With the CDS outstanding greater by multiples than the volume of bonds issued, the

bonds would have to be “recycled” a number of times through the market to settle all the

CDS trades. Investors recognizing this would rush to source bonds, artificially raising the

price of the bonds higher than the expected recovery value, and increasing the volatility

of the bonds post-default, which is undesirable for a number of reasons.

Cash settlement was widely regarded to be the best alternative, but unlike the basic

mechanism already in place for CDS contracts, a mechanism was required to set a

transparent, trustworthy price the whole market could use.

The answer the market came up with was credit event auctions. The benefit of auctions to

settle CDS contracts is to allow for more transparency in the process giving everyone an

equal opportunity to participate.

Another benefit of the auction is the setting of a market-wide price. The use of the same

price to settle all trades across the market eliminates basis risk for investors. For example

an investor with hedged positions, e.g. index Vs single-name, or tranche Vs index, may

have physically settled at different times, and sourced/sold bonds at different times to

settle their trades.

Cash Vs Physical Settlement in the Auction: The investors can choose between cash and what effectively physical settlement in the

auction is. This option is made possible by the ability to trade bonds or loans in the

auction.

All of the actual CDS trades in the auction are cash settled. The physical settlement

segment is made up by trading the underlying cash obligation so that the net payment to a

protection buyer adds up to par and they also get the equivalent par amount of obligations

off of their books.



As an example, consider a $10m long protection investor. Assuming a 40% recovery rate,

they would be compensated 60% of par ($6m in this case), and sell $10m par of

bonds/loans. As the bond/loan trades in the auctions take place at the final price, they

receive $4m for the bonds/loans, in total receiving $10m, and pass off $10m par of

bonds/loans to a buyer in the auction.

Protection sellers would make requests to buy bonds/loans in the auction (as normally

they would be delivered bonds/loans in physical settlement). Investors wishing to cash

settle do not make a physical settlement request and simply cash settle their trade. Hence,

the investor’s net position after auction settlement is the same as their position after

physical settlement.

Note physical settlement requests are constrained by the investor’s derivative position –

the request an investor can make is between zero and the amount of bonds/loans they

would trade to fully physical settle their position. As an example a $10m long protection

buyer can only submit a sell request between 0 and $10m face value of underlying. They

cannot make a buy request as they would never be delivered bonds to settle their trade.

Overview of CDS Auction Process: In the event that a large reference entity is the subject of the credit event, ISDA in

conjunction with Markit Group Limited (“Markit”) and Creditex Securities Corp

(“Creditex”) will generally administer an auction to determine a market price by which

the types of credit default swaps specified in the protocol written on the reference entity

can be settled. The auction is a voluntary process by which market participants agree to

be governed by a protocol issued by ISDA (separate protocol for each reference entity).

The auction is comprised of 2 parts.

CDS Auction – Stage 1: The inputs into the first part of the auction are:



1. A 2-way market supplied by dealers for the defaulted assets, of a pre-defined

maximum spread, and with a pre-defined quotation size associated with it. The

spread and quotation sizes are subject to specification prior to each auction and

may vary for each auction depending on the liquidity of the defaulted assets.

2. Physical Settlement Requests: These are the requests to buy or sell bonds/loans (at

the final price), which as described when combined with the cash settlement of

their CDS trade adds up to be equivalent to physical settlement.

The dealer markets submitted are used to create an ‘inside market midpoint’ (IMM)

which is used in the second stage of the auction to constrain the final price. The ‘inside

market midpoint’ is set by discarding crossing/touching markets, and taking the ‘best

half’ of the bids and offers and calculating the average. The best half would be,

respectively, the highest bids, and the lowest offers.

The second step in this section is to sum the buy and sell physical settlement requests,

and tally the difference to determine the “open interest” (difference between the

aggregate buy and sell requests). This open interest to buy or sell bonds/loans is carried

into the second stage of the auction.

There is also a possible penalty in place for submissions that are off-market. If a dealer

supplies a bid or offer that is the wrong side of the inside market midpoint (e.g. a bid that

is higher than the IMM), and the open interest suggests it shouldn’t be (e.g. if a bid is

higher than the IMM, and the open interest is to sell suggesting the price should go down

so they shouldn’t be bidding high), then the dealer in question has to pay the quotation

amount times the amount that their price differed from the IMM. This amount is termed

an ‘Adjustment Amount’. This is not paid if the bid or offer in question did not cross with

any other offer or bid respectively. Adjustment amount is used to cover the costs

associated with the auction process and the remaining amount is distributed pro-rata to

the participating bidders.

Following this process, Markit and Creditex will then publish –



1. The inside market midpoint

2. The size and direction of the open interest

3. Any Adjustment Amounts.

CDS Auction – Stage 2: The second stage of the process is to match the open interest and create a final price. This

is achieved by participating bidders submitting “limit orders” with respect to open

interest and matching of limit orders or inside bids/offers against the open interest.

If the open interest is to buy, we review the lowest ‘sell’ limit order submitted and match

it to the amount of open interest that is equivalent to the size associated with the limit

order. If the open interest was to sell, we use ‘buy’ limit orders and start at the highest.

As the open interest direction is published prior to the second stage, only limit orders of

the relevant type are gathered and submitted for the second part of the auction.

We then take the next lowest order (in the case of buy open interest) and match that. We

continue to run through this process until we have matched all the open interest, or run

out of limit orders. In the case of the former, the last limit order used to match against the

open interest is the final price.

At this point the ‘inside market midpoint’ is reviewed and checked against the price of

the last limit order used to match the open interest. If the final limit order is more than the

‘cap’ amount (typically 1% of par) higher (in case of sell open interest) or lower (in the

case of buy open interest) than the inside market midpoint, the final price will be set to be

the inside market midpoint plus or minus the cap respectively. This is to avoid a large

limit order being submitted off-market to try and manipulate the results, particularly in

the case of a small open interest.

To understand the process in a better way, refer to the Lehman Brother’s auction process

explained in the Appendix C.


CDS | CDS Data Sources MMS 2008-10 57

CDS Data Sources There are various international organizations which monitors the activities in the CDS

market. Various organizations and their role in CDS are as follows:

International Swaps and Derivatives Association (ISDA): ISDA, which represents participants in the privately negotiated derivatives industry, is

the largest global financial trade association, by number of member firms. ISDA Master

Agreements are ingrained into the fabric of the derivatives market worldwide. According

to its mission statement, ISDA’s primary purpose is to encourage the prudent and

efficient development of the privately negotiated derivatives business by:

Promoting practices conducive to the efficient conduct of the business, including

the development and maintenance of derivatives documentation

Promoting the development of sound risk management practices

Fostering high standards of commercial conduct

Advancing international public understanding of the business

Educating members and others on legislative regulatory, legal, documentation,

accounting, tax, operational, technological and other issues affecting them and

Creating a forum for the analysis and discussion of, and representing the common

interest of its members on, these issues and developments.12

Adherence to ISDA policies is voluntary among the contracting parties; however, there is

an understanding among the financial markets that ISDA continuously stays on top of all

derivative issues and attempts to incorporate these issues into policy and advice for

structuring agreements. Hence, most derivative deals utilize ISDA Master Agreements

and Definitions.

12 ISDA Mission statement More information on http://www.isda.org/

http://www.isda.org/�



Role of ISDA in CDS:

Establish a secure framework of robust documentation and legal certainty by

enforcing such documentation (Master Agreement) and attendant mechanisms as

collateralization and netting. ISDA in conjunction with Markit and Creditex generally administer an auction to

determine a market price by which the types of credit default swaps specified in the

protocol written on the reference entity can be settled. ISDA “Determination Committee” decides if and when credit events and succession

events had occurred and which bonds could be delivered into an auction. From 2001, ISDA began surveying outstanding (notional amount) of credit default

swaps, which consist of single-name credit default swaps, default swaps on baskets

of up to ten credits, and portfolio transactions of ten or more credits, displaying

reports (of survey) semiannually.

Bank for International Settlements (BIS): The Bank for International Settlements (BIS) is an international organization which

fosters international monetary and financial cooperation and serves as a bank for central

banks. Established on 17 May 1930, the BIS is the world's oldest international financial

organization.

Role of BIS in CDS:

From December 2004 BIS releases semiannual data on credit default swaps

(CDS) including notional amounts outstanding and gross market values for single-

name and multi-name instruments.

From December 2005 information on CDS by counterparty, sector and rating has

been made available by BIS.

For semiannual statistics from BIS – http://www.bis.org/statistics/derstats.htm

http://www.bis.org/statistics/derstats.htm�



The Office of the Comptroller of the Currency (OCC): The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises

all national banks. It also supervises the federal branches and agencies of foreign banks.

The objectives of OCC are –

To ensure the safety and soundness of the national banking system.

To foster competition by allowing banks to offer new products and services.

To improve the efficiency and effectiveness of OCC supervision, including

reducing regulatory burden.

To ensure fair and equal access to financial services for all Americans.

Role of OCC in CDS:

To generate quarterly report on bank derivatives activities in US indicating CDS

activities (notionals by counterparty and maturity, composition of CDSs, etc.)

OCC acts as a leading source of regulatory knowledge sharing for the financial

services industry (for example OCC shared the information on CDS after its

introduction to market).

The report can be accessed from http://www.occ.treas.gov/deriv/deriv.htm

British Bankers' Association (BBA): The BBA is the leading association for the UK banking and financial services sector,

speaking for 223 banking members from 60 countries on the full range of UK or

international banking issues and engaging with 37 associated professional firms.

Role of BBA in CDS:

BBA generates reports every two years on credit derivatives activities in London/

Europe indicating market growth, market participants, product range, rating of

underlying assets, etc.

BBA Credit Derivatives Reports can be accessed from –

http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=341

http://www.occ.treas.gov/deriv/deriv.htm�

http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=341�



The Depository Trust and Clearing Corporation (DTCC): DTCC, through its subsidiaries, provides clearing, settlement and information services

for equities, corporate and municipal bonds, government and mortgage-backed securities,

money market instruments and over-the-counter derivatives. DTCC Deriv/SERV (a

subsidiary of DTCC) is the leading provider of automation solutions for the global, over-

the-counter (OTC) derivatives market. It offers a family of services that brings greater

efficiency and reduces the risk of processing a wide range of credit, equity and interest

rate derivatives products.

Role of DTCC in CDS:

DTCC provides much wider role than just acting as a data source by providing

services like Trade Information Warehouse (TIW), Matching and Confirmation

service, Novation Consent, etc.

The Trade Information Warehouse (a service offering of DTCC Deriv/SERV

LLC, a wholly-owned subsidiary of DTCC) is the market’s first and only

comprehensive trade database and centralized electronic infrastructure for post-

trade processing of OTC derivatives contracts over their multi-year lifecycles,

from confirmation to payment calculation and netting to final settlement.

TIW reports provide weekly information regarding credit derivative products,

transaction types (single-name, index/index tranches), etc.

TIW reports can be accessed at –

http://www.dtcc.com/products/derivserv/data/index.php

Apart from these there are many other data sources like Credit Derivatives Research

LLC, Bloomberg, Markit, etc. The credit rating agencies like Fitch Ratings, Standard &

Poor’s, and Moodys also provide data on CDSs.

http://www.dtcc.com/products/derivserv/data/index.php�


CDS | Central Counterparty Settlement MMS 2008-10 61

Central Counterparty Settlement We understood the concept of central counterparty (CCP) while understanding the role of

CDS in subprime crisis. A CDS is a bilateral contract. If you sell protection to

counterparty, and buy protection from counterparty then economically you may be

hedged but you are exposed to two legs of counterparty risks which brings difference

between the gross and net notional values as shown below.

One way of addressing this risk in chains of trades is a service called TriOptima13

, which

takes trades from multiple counterparties simultaneously and reduces chains to their end

counterparties and eliminates the circle completely. As shown above the trade between A

through E gets reduced to trade between A & E, of course by the consent of all the

parties. During 2008, TriOptima eliminated USD30.2tn of CDS notional trades

(TriOptima press release, 12 January 2009) and USD5.5tn in first quarter of 2009

(TriOptima press release, 8 April 2009).

A more comprehensive solution would be to establish a central counterparty such that

both protection buyer and seller would be dealing only with CCP acting as counterparty

(as illustrated in the figure). The benefit of having single counterparty is that offsetting

trades would be netted together. Thus if you bought and sold protection on identical

13 TriOptima is an international financial technology company that is solving some of the most challenging post-trade processing problems in the OTC derivatives market.



terms, the two contracts would cancel out and you would end up with no outstanding

contracts, rather than two separate contracts. This would eliminate the vast majority of

counterparty risk.

Of course, all trades between counterparty and the central counterparty would be

collateralized and subject to daily margining as the mark-to-market of those trades

moved. It is likely that the central counterparty would demand initial margin as well.

There are four firms either trying or has been successful to set up a central counterparty

for CDS. They are –

ICE Trust

NYSE Euronext & LCH.Clearnet SA

CME Group Inc./ Citadel Investment Group (CMDX)

Eurex AG.

IntercontinentalExchange Trust: ICE Trust is a limited purpose bank that serves as a central clearing facility for credit

default swaps (CDS). Although it is an ICE subsidiary, ICE Trust membership, Board of

Directors, officers and operating staff are separate from ICE's other exchange, clearing

house and brokerage operations.



ICE Trust's clearing services are provided by The Clearing Corporation (TCC). TCC was

acquired by ICE on March 6, 2009. ICE Trust has also entered into an agreement with

Markit to produce daily pricing data required for mark-to-market pricing, margining and

clearing.

CDS Clearing:

Source: ICE Trust

ICE Trust is designed to accommodate the clearing of all North American CDS indices,

initially focusing on the most active indices. ICE Trust has surpassed $1 trillion in

cleared credit default swaps (CDS) since operations began on March 9, 2009. ICE Trust

also set a weekly clearing record of $247 billion in notional value for the week ending

June 12, on transaction volume of 2,330 contracts. Since launch, the total number of

transactions cleared is 12,050 [data till 15 June 2009]. ICE Trust offers open architecture

connectivity and interoperability model. It has integration and co-existence with other

elements of CDS processing infrastructure, including DTCC Trade Information

Warehouse (TIW) and buy-side access to independent warehouse record.



The monthly statistics on the notional values

cleared by ICE trust is shown in the figure.

[Source: ICE]

Separately, even ICE Clear Europe has announced

its intention to clear European CDS contracts by

mid-2009.

NYSE Euronext LIFFE & LCH.Clearnet SA: NYSE Euronext (NYX) is the world’s leading, most liquid and diverse exchange group.

It offers a broad and growing array of financial products and services in cash equities,

futures, options, exchange-traded products, bonds, market data, and commercial

technology solutions to meet the needs of investors and financial institutions. Liffe is the

international derivatives business of Euronext, a subsidiary of NYSE Euronext.

LCH.Clearnet is the leading independent central counterparty group (CCP) in Europe,

serving major international exchanges and platforms, as well as a range of OTC markets.

On December 22, 2008, in partnership with derivatives exchange NYSE Euronext Liffe,

LCH.Clearnet launched a clearing service for Markit iTraxx Europe CDS indices in UK

on Bclear. With this launch Liffe became the first exchange to offer clearing of CDS

contracts.

LCH.Clearnet SA is a French subsidiary of LCH, dedicated to Eurozone CDS clearing.

LCH.Clearnet SA will launch a credit default swap (CDS) clearing offering in eurozone

in December 2009. The full scope of the offering is being finalized after extensive

consultation with members and regulators. The service will be launched in phases; the

first phase (planned for December 2009) will cover iTraxx European indices. Single

names and US indices will be considered in the second phase (planned for H1 2010).



The main details of the service are –

Novation within a Eurozone legal framework

LCH.Clearnet SA will act as the CCP (position management & netting, risk

management)

ISDA standardized CDS contracts will be cleared

ISDA will be the authority regarding credit events and related auctions

Markit will be used for pricing and product reference data

DTCC Trade Information Warehouse will be the central registrar

LCH.Clearnet SA will receive for clearing trades registered as golden records in

the DTCC Trade Information Warehouse.

CME Group Inc/ Citadel Investment Group (CMDX): Citadel Investment Group and the CME Group (as clearing house) have partnered in

creating a clearing and exchange solution for credit default swap market, called the Credit

Market Derivatives Exchange, or CMDX. CMDX is an open-architecture electronic

trading and migration platform for credit default swaps (CDS) open to all qualified

commercial market participants. Trades executed, booked or migrated through CMDX

are processed directly to CME Clearing.


The CMDX platform has an open architecture, enabling market participants to

execute or book CDS trades through party-to-party negotiation, IDB brokered,

CMDX Request for Quote (RFQ) platform, or other electronic matching venues.

CME leverages its position as world-leading diversified clearing house (with ~7B

guarantee fund available for CDS), versus other proposals’ intention to create new

clearing houses with new funding isolated on CDS risk.

CMDX provides a Migration Utility to migrate existing bilateral over-the-counter

(OTC) contracts to standardized, centrally cleared contracts.

CMDX and CME Clearing intend to support the trading and clearing of the most

extensive CDS product set in the industry, covering 75% of index and single

name notional value on day 1.



CME Clearing’s margin framework and methodology has been tested and

validated on a variety of portfolios and across a wide range of stress scenarios.

CMDX is the only one which includes a clearing house and an electronic

execution platform.

Criticism:

As CME plans to use its existing clearing house to clear CDS there are concerns like

mixing the funds will jeopardize the entire financial system as per Thomas Peterffy of

Interactive Brokers Group Inc. The same concern has shared by GME group members

including Penson GHCO Chief Executive Officer Chris Hehmeyer (Source: Bloomberg).

Eurex AG: Eurex Credit Clear is the Eurex Clearing’s European OTC clearing solution for CDS

(European index and single name CDS) which is currently in simulation phase making it

available to future credit clear members for testing of workflow and risk processing.


Comprehensive European product scope including Single Name CDS.

Leverage of existing OTC CDS and Eurex Clearing infrastructure. No additional

technical connectivity required for existing Clearing Members, STP processing

with the DTCC Deriv/SERV Trade Information Warehouse.

Separate clearing license with dedicated clearing fund for CDS, state-of-the-art

risk model specifically designed for CDS.

Efficient use of existing Clearing Member collateral deposits - leverage of margin

credits across all Clearing Member licenses.

Novation of eligible trades on T+1.

Daily valuation price based on input from market participants and multiple third-

party data providers. Negotiations with Markit for CDS pricing are going on.

Eurex clear is expected to start clearing their European index and single name CDS

business by 31st July 2009.



Comparison of clearing houses: Parties ICE Trust/ CCorp NYSE Euronext CME Group/Citadel Eurex AG

Program Type CCP CCP E-trading & CCP CCP Presence in US/ Europe Europe Europe/ US Europe Started on 09/03/2009 22/12/2008 Yet to start Yet to start

Products

Currently - North American CDX

indices Proposed -

American single names in 3Q09

European iTraxx indices in 2Q09 European single names in 3Q09

Currently - iTraxx Europe CDS indices in UK

Proposed - iTraxx European indices

by Dec 2009 US indices by

H12010

Proposed – CDX indices, iTraxx indices, and single name CDS

Proposed - European index and single name CDS

Pricing by Markit Markit Markit Eurex clearing pricing team,

Markit

Features

Open architecture connectivity and interoperability

model, Integration and co-existence with other

elements of CDS processing

infrastructure (like DTCC)

Novation within a Eurozone legal

framework LCH.Clearnet SA to act as the CCP

ISDA documentation

compliance DTCC TIW as central registrar

Open architecture, enabling market

participants to execute or book CDS trades

through party-to-party negotiation, IDB brokered, CMDX Request for Quote (RFQ) platform, or

other electronic matching venues

Migration Utility to migrate existing

bilateral OTC contracts to standardized, centrally cleared

contracts

Leverage of existing OTC CDS and Eurex Clearing

infrastructure No additional

technical connectivity

required for existing Clearing Members,

STP processing with the DTCC

Deriv/SERV Trade Information Warehouse

Dedicated clearing fund for CDS

Risk Management

Membership criteria, Initial

margin requirement, MTM margin

requirement, Intra-day risk monitoring,

Guarantee fund (includes

participation from ICE), Limited one

Membership criteria, Initial

margin, Additional initial

margin asymmetry for short holder,

MTM/Variation margin,

Guarantee fund

Membership criteria, MTM margin,

Margining on existing & new positions,

Periodic default drills, Stress testing, Review of account level P&L,

Guarantee fund, Collateral

Admission criteria, credit event margin, Accrued premium

margin, MTM margin, next day margin, liquidity

margin, Collateral requirements, CDS

clearing fund contribution,



time assessment Reserve fund of Eurex clearing, Clearing fund

contribution of non-defaulting CCMs

Volume Handled Over $1 trillion

No volume reported (till March 2009)

NA NA

General Global Settlement Procedure: Functional Model

All the clearing houses CDS solutions are linked to DTCC TIW (Trade Information

Warehouse) as shown below. The TIW (Warehouse) is a global credit infrastructure

already available and operational. It delivers the trade capturing, confirmation and

settlement. The OTC CDS solution by central counterparty provides position and risk

management, margining and payments.

Before novation the clearing house checks various criteria like –

Each party of the trade is registered at CCP.

Party to the trade is not in default or suspension.

The transaction is routed through some authorized source like DTCC.

The contract is eligible for central clearing.



Minimum duration between the novation date and scheduled termination date is

greater than specified duration.

Clearing member has sufficient collateral to clear the trade, etc.

Trade Lifecycle:

DTCC submits the trade for OTC CDS clearing to the respective clearing houses

if flagged accordingly.

The clearing house will calculate the margin required and check for margin and

collateral for its sufficiency.

If the collateral is sufficient then clearing house will perform the process of

novation. In the process it will act on behalf of clearing member and will

terminate the original trade to create two new trades with CCP acting as seller to

buyer and buyer to seller. This termination and new trade entry will be sent to

DTCC Deriv/SERV where this will get reflected in TIW.

The netting advantage will be provided by the clearing house to the requested

clearing members.

In case of credit event DTCC “Determination Committee” declares credit event

and will decide whether to hold the auction or not.

If the auction is held the auction price will be applicable to all the CCP

transactions and will be used to determine the cash settlement amount. Future

fixed coupon payments will be adjusted. Affected index trades will be adjusted.

Reconciliation for calculated cash amounts and affected trades between DTCC

records and clearing house records will be performed.

Pricing

Almost all the clearing houses use Markit CDS pricing information. CCP will provide

Markit with details of cleared product with open interest by clearing participant. Markit

provides the proposed settlement prices, matched interest trades, and raw EOD price

quotes. Markit will receive clearing participant’s intraday price runs. And also will be

furnished with official EOD settlement prices.



Apart from Markit pricing Eurex Clearing also plans to have their own Eurex clearing

pricing team which will be collecting data from members (quotes, traded levels & EOD

pricing), data extracted from various data vendors, cross checking with different sources,

having a time series check (comparing current spread with the past time series) and if no

satisfying data is available obtaining theoretical quote to obtain the CDS spread.

Risk Management Model

There are legal, capital, operational requirements etc. and each clearing house has its own

risk management model. The legal requirement checks whether the CDS contracts fits in

the regulations governed by regulatory bodies, like Eurex clearing will be checking

whether the clearing member is EU domiciled. And the clearing house for US will have

corresponding checks. The clearing house will be asking to fulfill the capital

requirements. They will be asking for margins and collaterals. This again varies as per

clearing house. CME clears a diverse set of products under the protection of its guaranty

fund, which tends to provide overall capital efficiencies whereas Eurex clearing has

separate dedicated clearing fund for CDS business. All the clearing houses ask for daily

mark-to-market margin, initial margin, and guarantee fund.

End of Day Processing

All clearing houses will provide reports to the clearing members of their current positions

(pending, rejected, accepted, etc.), margin summary, collateral reports, settlement

instructions etc.

Criticism on Central Counterparty: As per the paper written by Darrell Duffie and Haoxiang Zhu of Stanford University

(“Does a Central Clearing Counterparty Reduce Counterparty Risk?”), the use of CCP

won’t serve the purpose of reducing the risk in CDS market. As per the research the

market for CDS is not big enough to substantiate the need for CCP. Although Darell

Duffie, a member of the Financial Advisory Roundtable of the New York Federal

Reserve Bank, supported the idea of CCP and still supports the same but with some

reservations regarding the implementation of CCP. He says the market for CDS is small



and is highly dealer based. CCP will be serving dealers and with insufficient number of

dealers the model is not supposed to give expected results. He suggest the proposed CCPs

are only supposed to provide clearing for simple CDS contracts but many of the contracts

are complicated to be cleared by CCPs. He suggests having a common CCP across the

multiple OTC products to improve multilateral netting. He is also against the idea of

having multiple CCPs for CDS market both in Europe and US. Rather he supports the

usage of single CCP across US and EU resulting in better multilateral netting.

But there are different thoughts which go against the opinions of Duffie and Zhu. There is

a strong belief that having multiple CCPs gives a choice of freedom and also forces the

CCPs to compete with each other. Also a single monopolistic CCP may not be preferred

from a risk concentration point of view. All CCPs are planning to add different products

lined up for the future releases to have central clearing. And as mentioned earlier having

a single CCP for many OTC products can jeopardize the financial system as the

mechanisms for various products are different and the risk associated with it is also

different to judge.

Conclusion: The acceptance of ICE acting as CCP has proved the need for the CCPs. And the

regulators have always backed the need for the CCPs. So even with criticisms CCPs have

found a place in the market. Having an economic interest in ICE has hampered the

development of NYSE Euronext acting as CCP which has even been accepted by NYSE

Euronext officials. Due to these internal economic issues the operation of NYSE

Euronext is yet to pick up and with the resolution of issues market for NYSE Euronext

will pick up. Now with this background it will be interesting to see how market accepts

CME Groups and Eurex AG as CCPs.

But with the successful launch of CCPs and with ICE surpassing the 1 trillion mark one

can say the CCPs are going to be there settling CDS contracts. And having a support

from regulators and dealers is an added benefit.


CDS | Credit Derivatives Market in India MMS 2008-10 72

Credit Derivatives Market in India Banks are major players in the credit market and are, therefore, exposed to credit risk.

Credit market is considered to be an inefficient market with market players like banks

and financial institutions mostly have loans and little of bonds in their portfolios while

mutual funds, insurance companies, pension funds and hedge funds have mostly bonds in

their portfolios, with little access to loans, depriving them of high returns of loans

portfolios. The market in the past did not provide the necessary credit risk protection to

banks and financial institutions. Neither did it provide any mechanism to the mutual

funds, insurance companies, pension funds and hedge funds to have an access to loan

market to diversify their risks and earn better return. Credit derivatives were, therefore,

developed to provide a solution to the inefficiencies in the credit market. Internationally,

banks are able to protect themselves from the credit risk through the mechanism of credit

derivatives. However, credit derivative has not yet been used by banks and financial

institutions in India in a formal way.

Benefits from Credit Derivatives: Banks and Financial Institutions currently require a mechanism that would allow them to

provide long term financing without taking the credit risk if they so desire. Currently

banks and financial institutions need to hold their portfolios on books depriving them of

diversifying the portfolio as well as making them forgo some of the opportunities. Also

non-banking institutions looses on some of the opportunities of holding high yielding

portfolios like loans.

Credit derivatives would help resolve these issues. Banks and the financial institutions

derive four main benefits from credit derivatives, namely:

Credit derivatives allow banks to transfer credit risk and hence free up capital,

which can be used in productive opportunities.

Banks can conduct business on existing client relationships in excess of exposure

norms and transfer away the risks.



Banks can construct and manage a credit risk portfolio of their own choice and

risk appetite unconstrained by funds, distribution and sales effort. Banks can

acquire exposure to, and returns on, an asset or a portfolio of assets by simply

writing a credit protection.

Credit risk would be diversified – from banks/FIs alone to other players in the

financial markets and lead to financial stability.

Apart from above mentioned benefits credit derivatives also provides better liquidity than

the existing mechanisms of managing the risks like insurance, guarantee, securitization,

etc. It also allows financial intermediaries to gain access to high gain portfolios.

Participants in the Indian Market In order to ensure that the credit market functions efficiently, it is important to maximize

the number of participants in the market to encompass banks, financial institutions,

NBFCs (all regulated by RBI), mutual funds, insurance companies and corporates.

Minimum Conditions: As per Report of the Working Group on Introduction of Credit Derivatives in India by

Department of Banking Operations and Development the bank should fulfill minimum

conditions relating to risk management processes and that the credit derivative should be

direct, explicit, irrevocable and unconditional. These conditions are explained below.

Direct: The credit protection must represent a direct claim on the protection

provider.

Explicit: The credit protection must be linked to specific exposures, so that the

extent of the cover is clearly defined and incontrovertible.

Irrevocable: Other than a protection purchaser’s non-payment of money due in

respect of the credit protection contract, there must be no clause in the contract

that would allow the protection provider unilaterally to cancel the credit cover.



Unconditional: There should be no clause in the protection contract that could

prevent the protection provider from being obliged to pay out in a timely manner

in the event that the original obligor fails to make the payment(s) due.

Draft CDS Guidelines: Reserve Bank of India (RBI) has come out with draft guidelines on Credit Default Swap

(CDS) per notification dated May 2007. The details of which are as follows:

Participants allowed:

Protection Buyers:

Commercial banks and Primary dealers

A protection buyer shall have an underlying credit risk exposure in the form of

permissible underlying asset / obligation

Protection Sellers:

Commercial banks and Primary dealers

RBI will consider allowing insurance companies and mutual funds as protection buyer or

protection seller as and when their respective regulators permit them to transact in credit

default swaps.

Product Requirements:

Structure: A CDS may be used –

By the eligible protection buyers, for buying protection on specified loans and

advances, or investments where the protection buyer has a credit risk exposure.

By the eligible protection sellers, for selling protection on specified loans and

advances, or investments on which the protection buyer has a credit risk exposure.

Settlement Methods:

Physical Settlement

Cash Settlement

Fixed Amount Settlement (binary CDS)



Documentation:

1992 or 2002 ISDA Master Agreement compliance.

2003 ISDA Credit Derivatives Definitions and subsequent supplements to

definitions compliance.

Documenting the establishment of the legal enforceability of the contracts in all

relevant jurisdictions before undertaking CDS transactions.

Credit Events:

Bankruptcy

Obligation Acceleration

Obligation Default

Failure to pay

Repudiation/ Moratorium

Restructuring

Minimum Requirements:

A CDS contract must represent a direct claim on the protection seller and must be

explicitly referenced to specific exposures of the protection buyer, so that the

extent of the cover is clearly defined and indisputable. It must be irrevocable.

The CDS contract shall not have any clause that could prevent the protection

seller from making the credit event payment in a timely manner after occurrence

of the credit event and completion of necessary formalities in terms of the

contract.

The protection seller shall have no recourse to the protection buyer for losses.

The credit events specified in the CDS contract shall contain as wide a range of

triggers as possible with a view to adequately cover the credit risk in the

underlying / reference asset and, at a minimum, cover –

o Failure to pay

o Bankruptcy, insolvency or inability of the obligor to pay its debts

o Restructuring of the underlying obligation involving forgiveness or

postponement of principal, interest or fees that results in a credit loss event



CDS contracts must have a clearly specified period for obtaining post-credit-event

valuations of the reference asset, typically no more than 30 days

The credit protection must be legally enforceable in all relevant jurisdictions

The underlying asset/ obligation shall have equal seniority with, or greater

seniority than, the reference asset/ obligation.

The protection buyer must have the right/ability to transfer the reference/

deliverable asset/ obligation to the protection seller, if required for settlement (in

case of physical settlement).

The credit risk transfer should not contravene any terms and conditions relating to

the reference / deliverable / underlying asset / obligation and where necessary all

consents should have been obtained.

The credit derivative shall not terminate prior to expiration of any grace period

required for a default on the underlying obligation to occur as a result of a failure

to pay. The grace period in the credit derivative contract must not be longer than

the grace period agreed upon under the loan agreement.

The identity of the parties responsible for determining whether a credit event has

occurred must be clearly defined. This determination must not be the sole

responsibility of the protection seller. The protection buyer must have the

right/ability to inform the protection seller of the occurrence of a credit event.

Where there is an asset mismatch between the underlying asset/ obligation and the

reference asset/ obligation then:

o The reference and underlying assets/ obligations must be issued by the

same obligor (i.e. the same legal entity)

o The reference asset must rank pari passu or more junior than the

underlying asset/ obligation; and

o There are legally effective cross-reference clauses between the reference

asset and the underlying asset.

Risk Management:

Banks should consider carefully all related risks and rewards before entering the

credit derivatives market. They should not enter into such transaction unless their



management has the ability to understand and manage properly the credit and

other risks associated with these instruments. They should establish sound risk

management policy and procedures integrated into their overall risk management.

Banks which are protection buyers should periodically assess the ability of the

protection sellers to make the credit event payment as and when they may fall

due. The results of such assessments should be used to review the counterparty

limits.

Banks should be aware of the potential legal risk arising from an unenforceable

contract, e.g. due to inadequate documentation, lack of authority for a

counterparty to enter into the contract, etc.

The credit derivatives activity to be undertaken by bank should be under the

adequate oversight of its Board of Directors and senior management (via a copy

of a resolution passed by their Board of Directors or via adequate MIS).

Procedures: The bank should have adequate procedures for:

Measuring, monitoring, reviewing, reporting and managing the associated risks.

Full analysis of all credit risks to which the banks will be exposed, the

minimization and management of such risks.

Ensuring that the credit risk of a reference asset is captured in the bank’s normal

credit approval and monitoring regime.

Management of market risk associated with credit derivatives held by banks in

their trading books by measuring portfolio exposures at least daily using robust

market accepted methodology.

Management of the potential legal risk arising from unenforceable contracts and

uncertain payment procedures.

Determination of an appropriate liquidity reserve to be held against uncertainty in

valuation.

Now after understanding the need for credit derivatives and the draft guidelines provided

by RBI we will now understand the possible settlement procedures to be adopted for CDS

contracts.


CDS | CDS & its settlement in India MMS 2008-10 78

CDS & its settlement in India The Reserve Bank of India (RBI) has taken the first step towards introducing credit

default swaps (CDS) to India’s financial markets by sending out feelers to a number of

banks with a view to gauging the acceptability of CDS contracts. The questionnaire sent

by RBI to the banks enquires about bankers’ expectations from the derivative instrument.

Although CDSs for the Indian companies like ICICI Bank, Tata Motors, SBI etc. are

already traded in US and some Asian market it is yet to be traded in Indian market. And

RBI is looking at CDS for debt issued in the domestic market. The move by RBI to

launch CDS in India is considered significant considering its cautious nature and the role

CDS played in subprime crisis. The move is welcomed by some of the banks. “There is

surely a need for such a product (CDS)” said Ashish Vaidya, head of interest rate trading

at HDFC Bank. “Indian regulators have the benefit of learning from the difficult

experience (in derivatives) in the West and can build in a robust system that effectively

curtails the concentration of risks in a few hands”. RBI expects to develop the corporate

bond market through the introduction of CDS contracts. [Source: “RBI warms up to

credit default swaps”, The Economic Times, dated 30 June 2009]

CDS Settlement in India: The CDS market will be an OTC market in India which means the deals between

the protection buyer and the protection seller will be bilateral deals making them

do the negotiation and pricing for the CDS contracts.

In the infancy stage of CDS market in India one can have a trade reporting

platform which will be gathering all the information about the trades happening.

This will provide the required transparency and help in gaining the confidence in

the product.

Once the market matures one can think of having an electronic order matching

platform with central counterparty settlement (like CCIL).



Role of CCIL: The Clearing Corporation of India (CCIL) was set up with the prime objective to improve

efficiency in the transaction settlement process, insulate the financial system from shocks

emanating from operations related issues, and to undertake other related activities that

would help to broaden and deepen the Money, Gilts and Forex markets in India. The role

of CCIL is unique as it provides settlement of three different products under one

umbrella. It has been instrumental in setting up and running electronic trading platforms

like NDS-OM, NDS-Call and NDS-Auction system for the central bank that had helped

the Indian market to evolve and grow immensely. It had also immensely bolstered CCIL's

image in terms of ability to provide transparent, efficient, robust and cost effective end to

end solutions to market participants in various markets. The introduction of ClearCorp14

Repo Order Matching System (CROMS), an anonymous Repo trading platform, has also

changed the trading pattern in Repo market i.e. shifting of interest from specific security

to basket of securities. The success of its money market product 'CBLO' has helped the

market participants as well as RBI to find a solution to unusual dependence on

uncollateralized call market. The total settlement volume during 2009-10 in government

securities, forex market and CBLO stood at Rs.14934 billion, Rs.25424 billion, and

Rs.20433 billion respectively.

The CCIL already has the necessary infrastructure for the settlement of OTC products

like interest rate swaps and forward rate agreement. CCIL already has a trade reporting

platform for IRS which provides non-guaranteed settlement for the reported trades. Now

CCIL is moving towards the guaranteed settlement of IRS which will involve trade

matching, initial and MTM margining, exposure check, novation, multilateral netting,

default handling etc. On this backdrop one can say CCIL is well equipped with all its

experience to act as central counterparty for the settlement of CDS contracts.

14 Clearcorp Dealing Systems (India) Limited (Clearcorp), a wholly owned subsidiary of CCIL, was incorporated in June, 2003 to facilitate, set up and carry on the business of providing dealing systems/platform in Collateralized Borrowing and Lending Obligation (CBLO), Repos and all money market instruments of any kind and also in foreign exchange, foreign currencies of all kinds.



But before the introduction of CDS contracts in India, there are some issues that need to

be handled for the effective CDS market. Those are –

Although RBI has allowed insurance companies and mutual funds as protection

buyer or protection seller, the permission of respective regulators needs to be

addressed quickly before making CDS market open. Otherwise it may obstruct the

stipulated expeditious growth of the CDS in India and will also defeat the purpose

of CDS, i.e., to maximize the number of participants in the market and transmit

the credit risk from the banking system to other risk seeking financial entities.

As per the draft guidelines provided by RBI restructuring is considered as a credit

event which has created many legal disputes in the global CDS market.

Considering the complexities associated with the restructuring, restructuring as a

credit event has been removed from North American CDS contracts. So more

clear information on restructuring as credit event is required.

As CDS contract in India is only allowed if the protection buyer bears the loss

making it similar to insurance. Considering this close proximity of CDS contract

with that of insurance contract, CDS contract should be made to be out of the

purview of regulations of insurance contract making it incontrovertible.

Although CDS has helped in perforation of subprime crisis which has created negative

vibes about CDS but CDS as in instrument is very effective means of hedging your risk.

And in India it is expected to provide the needed push to the corporate bond market. So it

won’t be long for the CDS market to pick up in India.


CDS | Conclusion MMS 2008-10 81

Conclusion When JPMorgan created CDS they never must have thought that the same will bring

them the write downs worth $5.5 billions. When CDS were launched they were meant to

separate the risk and providing new avenues of generating business/profit. But during the

evolution of CDS it turned to many complex products which were difficult to understand

even for those dealing in it. Being an OTC market many problems did not came to fore.

Once the market reached a huge volume the problems became eminent.

The efforts are being taken to bring in more regulation to CDS market and to preserve its

credibility. After all the products were never bad it’s just that the users were incompetent.

Many of the auctions are conducted by ISDA, the determination committee has resolved

the legal conflicts to a great deal, the central counterparties have already started their

operations and gaining good response. With many other CCPs to follow the transparency,

price discovery, liquidity will improve.

With the feedback being asked for by RBI on the launch of CDS to the banks, India is all

poised to introduce CDS. The lessons learnt from the west will allow India to do away

with the drawbacks or the product and to exploit the advantages. So with Basel II norms

adopted by India and clearing house/ regulations to be in place, India will be launching

the CDS soon.

The west has already experienced the glory and perils of CDS. India is now set to launch

the Credit Default Swaps and for India this is just a new beginning.


CDS | Drawbacks/Limitations MMS 2008-10 82

Drawbacks/Limitations

The research included in this project may not be reflecting true picture as it is a secondary

data and it may have contradictory opinions or so.

Data collected and included in this research is taken from various available sources and

may not be up to date. Particularly considering the severity of the situation after subprime

crisis and the role played by CDS contracts in perforating the subprime crisis, rapid

changes are happening to bring more regulation, transparency, standardization, soundness

to the CDS market making the data used stale.

The possible settlement of CDS contracts suggested in the project can have different and

may be contradictory opinions.


CDS | Appendix A: CDS Pricing MMS 2008-10 83

Appendix A: CDS Pricing A typical CDS contract usually specifies two potential cash flow streams – a fixed leg

and a contingent leg. On the fixed leg side, the buyer of protection makes a series of

fixed, periodic payments of CDS premium until the maturity, or until the reference credit

defaults. On the contingent leg side, the protection seller makes one payment only if the

reference credit defaults. The amount of a contingent payment is usually the notional

amount multiplied by (1 – R), where R is the recovery rate, as a percentage of the

notional. Hence, the value of the CDS contract to the protection buyer at any given point

of time is the difference between the present value of the contingent leg, which the

protection buyer expects to receive, and that of the fixed leg, which he expects to pay, or,

Value of CDS (to the protection buyer) = PV [contingent leg] – PV [fixed (premium) leg]

In order to calculate these values, one needs information about the default probability of

the reference credit, the recovery rate in a case of default, and risk-free discount factors.

A less obvious contributing factor is the counterparty risk. For simplicity, we assume that

there is no counterparty risk. [We assume that the parties involved in the contracts do

their due diligence and are involved in the contract only when there is high credit rating

(AAA) virtually eliminating counterparty risk.]

On each payment date, the periodic payment is calculated as the annual CDS premium, S,

multiplied by di, the accrual days (expressed in a fraction of one year) between payment

dates (i.e. di S). However, this payment is only going to be made when the reference

credit has not defaulted by the payment date. So, we have to take into account the

survival probability q(t), or the probability that the reference credit has not defaulted on

the payment date. Then, using the discount factor for the particular payment date, D(ti),

the present value for this payment is D(ti)q(ti)Sdi . Summing up PVs for all these

payments, we get

N ∑ D(ti) q(ti) Sdi -- (1)

i=1



However, there is another piece in the fixed leg - the accrued premium paid up to the date

of default when default happens between the periodic payment dates. The accrued

payment can be approximated by assuming that default, if it occurs, occurs at the middle

of the interval between consecutive payment dates. Then, when the reference entity

defaults between payment date ti-1 and payment date ti, the accrued payment amount is

Sdi/2. This accrued payment has to be adjusted by the probability that the default actually

occurs in this time interval. In other words, the reference credit survived through payment

date ti-1, but NOT to next payment date, ti. This probability is given by

{q(ti-1)- q(ti)}.

Accordingly, for a particular interval, the expected accrued premium payment is

{q(ti-1)- q(ti)}Sdi /2.

Therefore, present value of all expected accrued payments is given by

N ∑ D(ti) {q(ti-1) - q(ti)} Sdi/2 -- (2)

i=1

Now we have both components of the fixed leg. Adding (1) and (2), we get the present

value of the fixed leg:

N N PV [fixed leg] = ∑ D(ti) q(ti) Sdi + ∑ D(ti) {q(ti-1) - q(ti)} Sdi/2 --(3) i=1 i=1

where,

D(ti) = Discounting Factor

q(ti) = Survival Probability

S = CDS Premium (Spread)

di = Accrual days expressed in a fraction of a year

{q(ti-1) - q(ti)} = Survival Probability till credit default event

Next, we compute the present value of the contingent leg. Assume the reference entity

defaults between payment date ti-1 and payment date ti. The protection buyer will receive



the contingent payment of (1-R), where R is the recovery rate. This payment is made only

if the reference credit defaults, and, therefore, it has to be adjusted by {q(ti-1)- q(ti)}, the

probability that the default actually occurs in this time period. Discounting each expected

payment and summing up over the term of a contract, we get

N PV [contingent leg] = (1-R) ∑ D(ti) {q(ti-1) - q(ti)} --(4)

i=1

where,

D(ti) = Discounting Factor

R = Recovery Rate

{q(ti-1) - q(ti)} = Survival Probability till credit default event

Plugging equation (3) and (4) into the equation in the beginning, we arrive at a formula

for calculating value of a CDS transaction.

When two parties enter a CDS trade, the CDS spread is set so that the value of the swap

transaction is zero (i.e. the value of the fixed leg equals that of the contingent leg). Hence,

the following equality holds:

N N N ∑ D(ti) q(ti) Sdi + ∑ D(ti) {q(ti-1) - q(ti)} Sdi/2 = (1-R) ∑ D(ti) {q(ti-1) - q(ti)} i=1 i=1 i=1

Given all the parameters, S, the annual premium payment is set as:

N (1-R) ∑ D(ti) {q(ti-1) - q(ti)}

i=1

S = 15

N N

∑ D(ti) q(ti) di + ∑ D(ti) {q(ti-1) - q(ti)} di/2 i=1 i=1

Example: Consider a 2-year CDS with quarterly premium payments. Spread is 160 bps and the

discount factors and the survival probability for each payment date are as shown below:

15 Note: Source for CDS pricing is Credit Default Swap (CDS) Primer by Nomura Fixed Income Research.



(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Month Discount

Factor

Survival

Probability

to period

(%)

Fixed

Periodic

Payment

(bps)

Expected

Value of

Fixed

Payment

(bps)

(2) x (3)

PV of

Fixed

Payment

$1M x

(4) x (1)

Default

Probability

for the

period (%)

Expected

Accrued

Payment

(bps)

(3)/2 x

(6)

PV of

Accrued

Payment

$1M x

(7) x (1)

Expected

Contingent

Payment

(bps) at

R = 40%

(1-R) x (6)

PV of

Contingent

Payment

$1M x

(9) x (1)

0 1 100 0 0 0 0.0 0 0 0 0

3 0.99 99.9 40 39.96 3956 0.1 0.02 1.98 6 594

6 0.98 99.6 40 39.84 3904 0.3 0.06 5.88 18 1764

9 0.97 99 40 39.60 3841 0.6 0.12 11.64 36 3492

12 0.96 98.1 40 39.24 3767 0.9 0.18 17.28 54 5184

15 0.95 97 40 38.80 3686 1.1 0.22 20.90 66 6270

18 0.94 95.8 40 38.32 3602 1.2 0.24 22.56 72 6768

21 0.93 94.5 40 37.80 3515 1.3 0.26 24.18 78 7254

24 0.92 93.2 40 37.28 3430 1.3 0.26 23.92 78 7176

Sum of PV ($) 29751 Sum of PV 128.34 Sum of PV 38502

Notional amount = $1 million

PV [fixed (premium) leg] = PV [periodic payment] + PV [accrued payment]

= $29751 + $128.34

= $29879 (approx)

And,

PV [contingent leg] =$38502

Hence, we can find the value of this CDS to the protection buyer when the spread is 160

bps per annum as:

Value of CDS (to the protection buyer) = PV [contingent leg] – PV [fixed (premium) leg]

= $38502 - $29879

= $8623 for the notional value of $1 million.

From above table we can conclude if the recovery rate drops down even further (say

30%) then the value of CDS to the protection buyer will increase and if the recovery rate

is very high (say 90%) then the value of CDS to the protection seller will be positive.


CDS | Appendix B: Subprime Crisis MMS 2008-10 87

Appendix B: Subprime Crisis US Bankruptcy Filings:

Quarterly Business Bankruptcy Filings

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

Series1

Series1 4,086 4,858 5,284 5,586 6,280 6,705 7,167 7,985 8,713 9,743 11,504 12,901

06Q1 06Q2 06Q3 06Q4 07Q1 07Q2 07Q3 07Q8 08Q1 08Q2 08Q3 08Q4

Due to surge in the house prices the mortgagor found it difficult to payoff their debt. This

led to the increase in individual’s bankruptcy as well as to the business bankruptcy filings

as shown in the figures.



Quarterly Non-Business Bankruptcy Filings

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

Series1

Series1 112,685 150,975 165,862 177,599 187,361 203,744 211,742 218,428 236,982 266,767 280,787 288,436

06Q1 06Q2 06Q3 06Q4 07Q1 07Q2 07Q3 07Q8 08Q1 08Q2 08Q3 08Q4



Bailout Timeline:



Write-downs on the value of loans, MBS and CDOs due to the subprime mortgage crisis

Company Business Type Loss (Billion USD)

UBS AG (Switzerland) Bank $37.7 bln

Citigroup (USA) Bank $39.1 bln

Merrill Lynch (USA) Investment Bank $29.1 bln

Morgan Stanley (USA) Investment Bank $11.5 bln

Crédit Agricole (France) Bank $4.8 bln

HSBC (UK) Bank $20.4 bln

Bank of America (USA) Bank $7.95 bln

CIBC (Canada) Bank $3.2 bln

Deutsche Bank (Germany) Bank $7.7 bln

Mizuho Financial Group (Japan) Bank $5.5 bln

Barclays Capital (UK) Investment Bank $3.1 bln

Bear Stearns (USA) Investment Bank $2.6 bln

Royal Bank of Scotland (UK) Bank $15.2 bln

Washington Mutual (USA) Savings And Loan $2.4 bln

Swiss Re (Switzerland) Re-Insurance $2.04 bln

Lehman Brothers (USA) Investment Bank $3.93 bln

LBBW (Germany) Bank $1.1 bln

JP Morgan Chase (USA) Bank $5.5 bln

Goldman Sachs (USA) Investment Bank $1.5 bln

Freddie Mac (USA) Mortgage GSE $4.3 bln

Credit Suisse (Switzerland) Bank $9.0 bln

Wells Fargo (USA) Bank $2.9 bln

Wachovia (USA) Bank $11.1 bln

RBC (Canada) Bank $1.2 bln

Fannie Mae (USA) Mortgage GSE $0.896 bln

MBIA (USA) Bond Insurance $3.3 bln



Hypo Real Estate (Germany) Bank $0.580 bln

Ambac Financial Group (USA) Bond Insurance $3.5 bln

Commerzbank (Germany) Bank $1.1 bln

Société Générale (France) Bank $3.0 bln

BNP Paribas (France) Bank $0.870 bln

WestLB (Germany) Bank $2.74 bln

American International Group (USA) Insurance $11.1 bln

BayernLB (Germany) Bank $6.7 bln

Natixis (France) Bank $1.75 bln

Countrywide (USA) Mortgage Bank $4.0 bln

DZ Bank (Germany) Bank $2.1 bln

Fortis (Belgium) Bank $2.3 bln

ICICI Bank (India) Bank $0.264 bln

IKB Deutsche Industriebank (Germany)

Bank $3.45 bln

Aozora Bank (Japan) Bank $0.397 bln

Dresdner Bank (Germany) Bank $3.49 bln

HBOS (UK) Bank $7.06 bln

Lloyds TSB (UK) Bank $1.32 bln

Bank of China (China) Bank $2.0 bln

ICBC (China) Bank $0.448 bln The amounts of write downs indicated and the number of countries involved could

explain better about the reach and gravity of subprime crisis.


CDS | Appendix C: CDS Auction MMS 2008-10 92

Appendix C: CDS Auction Auction Process: Lehman Brothers The auction for Lehman Brothers senior bonds provides a good illustration of the general

auction mechanism. Lehman Brothers entered Chapter 11 bankruptcy on September 15,

2008, and a CDS settlement auction was scheduled for October 10. In the days prior, 358

parties signed up to adhere to the terms of the auction protocol. These parties took part in

the auction process as customers of 14 securities dealers who chose to participate directly

in the auction.

Stage 1: On the morning of the auction, each dealer submitted a bid price and an offer price at

which they were willing to trade the standard “quotation size” of $5 million (par value) in

eligible Lehman bonds if necessary. Each dealer also submitted a physical settlement

request to buy or sell bonds at the final auction price, for its own account and on behalf of

its customers. Prices are expressed relative to a par value of 100. A dealer’s bid and offer

price may not differ by more than 2, and the pair is referred to as the dealer’s “inside

market”. Physical settlement requests must be in the same direction as, and not in excess

of, a party’s market position.



The auction administrators sort the bids and offers in ascending order. If the highest bid is

greater than or equal to the lowest offer, both are removed from the pool, and this process

is repeated until every remaining bid is lower than every remaining offer. Then the

administrators calculate the arithmetic mean (rounded to the nearest 1/8) of the highest

50% of bids and the lowest 50% of offers (shaded above). This first-stage price is

referred to as the “inside market midpoint”, and it was equal to 9.75 in the Lehman

Brothers auction. The net sum of all physical settlement requests is referred to as the

“open interest”. In this case, it was $4.92 billion to sell.

HSBC’s bid price of 10 was higher than the inside market midpoint of 9.75, and it

crossed with offer prices from other dealers that were also 10. Furthermore, the open

interest was to sell bonds, which suggests that dealers should be bidding below the inside

market midpoint rather than above it. So HSBC had to pay a penalty (“Adjustment

Amount”) to ISDA equal to the standard quotation size times the difference between its

bid and the inside market midpoint ( $12,500).

Stage 2 If the open interest is zero, the inside market midpoint becomes the final auction

settlement price. But otherwise, a second stage is conducted in which each dealer can

submit any number of limit orders to meet a portion of the open interest at a particular

price, either for its own account or on behalf of its customers. In the Lehman auction, the

open interest was to sell bonds, so participants submitted limit orders in the form of offers

to buy. Second-stage prices are capped at 1 unit above the inside market midpoint (or 1

unit below, if the open interest is to sell) in order to avoid manipulation of the final

auction price.

In the Lehman Brother auction, participants submitted 453 offers to buy, ranging from

small offers at the cap price of 10.75 to large and very optimistic offers at a price of only

0.125. The median price was 7.5 and the median volume was $50 million. These offers

are sorted and then matched against the open interest in descending order. The price of

the final matched offer becomes the final auction settlement price. In this case, there were



second-stage limit orders summing to $4.92 billion (meeting the first-stage open interest)

at prices of 8.625 or higher, so the final settlement price was 8.625. All physical

settlements arranged in the auction were executed at this price, and all cash settlements of

CDS contracts between parties adhering to the auction protocol were executed at this

price too.


CDS | References & Bibliography MMS 2008-10 95

References & Bibliography 1. Adam B. Ashcraft, & Til Schuermann. “Understanding the Securitization of

Subprime Mortgage Credit”. Federal Reserve Bank of New York Staff Reports.

March 2008. Retrieved on 15 June 2009.

2. Balaji Yellavalli, et al. “FINSights: Governance, Risk & Compliance”. Infosys

Technologies Ltd. Retrieved on 18 June 2009.

3. “BIS Quarterly Review”. Bank for International Settlement. Retrieved on 28 May

2009. <http://www.bis.org/statistics/derdetailed.htm>

4. “CDS Trading and Clearing Solution”. CME Group. 27 Oct. 2008. Retrieved on 25

June 2009.

5. Chris Nelson. “The Subprime Crisis”. April 2009. Retrieved on 12 June 2009.

<http://www.navigantconsulting.com/downloads/Nelson_Contingencies.pdf>

6. “Credit Default Swap”. Wikipedia. Retrieved on 16 June 2009.

<http://en.wikipedia.org/wiki/Credit_default_swap>

7. Darrell Duffie, & Haoxiang Zhu. “Does a Central Clearing Counterparty Reduce

Counterparty Risk?”. 12 Feb. 2009. Retrieved on 22 June 2009.

8. David Waring. “A simple explanation of the subprime crisis”. InformedTrade. 3

Dec. 2007. Retrieved on 13 June 2009. <http://www.informedtrades.com/2699-

simple-explanation-subprime-crisis-part-1-a.html>

9. Denis Pelletier. “Introduction to various derivatives”. North Carolina State

University. 22 Aug. 2006. Retrieved on 26 May 2009.

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<http://en.wikipedia.org/wiki/Derivative_(finance)>

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Qt2.htm>

12. Dominic Kini. “CDS: changing the contract”. HSBC Global Research. 5 Feb. 2009.

Retrieved on 25 June 2009.

13. Dr. Dayong Zhang. “Derivatives: An overview”. Research Institute of Economics and

Management Southwestern University of Finance and Economics. Retrieved on 26

May 2009.

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CDS | References & Bibliography MMS 2008-10 96

14. “Draft CDS Guidelines”. RBI. Retrieved on 28 June 2009.

15. “European OTC Clearing Solution for Credit Default Swaps (CDS)”. Eurex Clearing.

23 March 2009. Retrieved on 25 June 2009.

16. “How does a CDO work?” Seeking Alpha. 12 March 2007. Retrieved on 15 June

2009. <http://seekingalpha.com/article/48283-how-does-a-cdo-work>

17. Jean Helwege, et al. “Credit Default Swap Auctions”. Federal Reserve Bank of New

York Staff Reports. May 2009. Retrieved on 18 June 2009.

18. John C. Hull. “Options, Futures and Other Derivatives”. Prentice Hall, New Jersey.

Retrieved on 1 June 2009.

19. Lieven Van den Brande Partner. “Clearing and risk management for derivatives

markets”. FIA Asia Derivatives Conference. 11 Aug. 2005 Retrieved on 24 June

2009.

20. Matthew Leising. “Peterffy Says CME Group Credit Swap Plan Puts Billions at

Risk”. Bloomberg.com. 22 Oct. 2008. Retrieved on 24 June 2009.

<http://www.bloomberg.com/apps/news?pid=20601110&sid=a2pK9HrK58_Y>

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Research. 12 May 2004. Retrieved on 24 June 2009.

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CDS | Glossary of Terms MMS 2008-10 97

Glossary of Terms

This abbreviated glossary covers only the most commonly encountered terms.

ABS Asset Backed Securities

ARM Adjustable Rate Mortgage

BBA British Bankers' Association

BIS Bank for International Settlements

CCIL The Clearing Corporation of India Ltd.

CCP Central Counterparty

CDO Collateralized Debt Obligations

CDS Credit Default Swap

CDX Credit Derivative Index

CLN Credit Linked Note

CME Chicago Mercantile Exchange

DTCC Depository Trust and Clearing Corporation

ETD Exchange Traded Derivative

ICE IntercontinentalExchange

IMM Inside Market Midpoint

ISDA International Swaps and Derivatives Association

MBS Mortgage Backed Securities

OCC The Office of the Comptroller of the Currency

OTC Over the counter

RBI Reserve Bank of India

SIV Structured Investment Vehicle

SPV Special Purpose Vehicle

STP Straight through processing

TIW Trade Information Warehouse also known as “Warehouse”

TRS Total Report Swap

Documents

Project on Credit Default Swaps in India