CDSs & the Bust of the Housing Bubble .pdf

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The Role of Credit Derivatives in the Global Crisis:
With a Special Emphasize to Credit Default Swaps

Karim El Maziati

Abstract
Credit derivatives (CDs) had been the centre of critics during the latest financial crisis.
Proponents of the CDs argue that this instrument participated in increasing the efficiency of
the markets by improving the quality of hedging; while the opponents believe that CDs led to
increasing uncertainty and thus contributed to the happening of the 2008 crisis. During this
study, I picked Credit Default Swaps (CDS) as a representative of the CDs since it was the
most active instrument before the meltdown, and I investigated whether it participated in
increasing the number of subprime mortgages which led the housing bubble to bust. Indeed,
my findings show that CDSs have significantly contributed in stimulating the recession
through inflating the subprime market.

Keywords: Credit Derivatives, Credit Default Swaps, Global Crisis, Hedging, Speculation.

[1]

Table of Contents
1

Introduction: .................................................................................................................................................. 3
1.1

Overview of the crisis ........................................................................................................................... 4

1.2

Breaking down Credit Default Swaps ................................................................................................... 4

1.3

Credit Default Swap’s effect on Cost of Capital ................................................................................... 6

2

Purpose of the Study ..................................................................................................................................... 6

3

Literature Review .......................................................................................................................................... 6

4

5

3.1

Findings of Previous Studies ................................................................................................................. 6

3.2

Assessment of Previous Studies ......................................................................................................... 13

3.3

Synthesis ............................................................................................................................................. 16

Data & Methodology ................................................................................................................................... 16
4.1

Methodology – General-To-Specific Modelling ................................................................................. 16

4.2

Data Collection .................................................................................................................................... 17

4.2.1

Dependent Variable: Notional Amount of the Subprime Residential Mortgage Loans .......... 17

4.2.2

Independent Variables ............................................................................................................... 19

Testing the Ordinary Least Square Assumptions ........................................................................................ 22
5.1

Linearity of the Model ........................................................................................................................ 23

5.2

Testing for Normality: ......................................................................................................................... 24

5.2.1

Normality of the Dependent variable: ....................................................................................... 24

5.2.2

Normality of the Independent Variables: .................................................................................. 24

5.3

Testing for Heteroscedasticity ............................................................................................................ 25

5.4

Testing for Autocorrelation ................................................................................................................ 27

5.4.1

Testing the hypothesis ............................................................................................................... 27

5.4.2

Fixing the Autocorrelation: ........................................................................................................ 27

5.4.3

Autocorrelation in the Financial Markets .................................................................................. 28

5.5
6

7

Testing for Multicollinearity ............................................................................................................... 29

Modifying the Model ................................................................................................................................... 30
6.1

First Adjustment: ................................................................................................................................ 30

6.2

Second Adjustment: ............................................................................................................................ 31

6.3

Third Adjustment ................................................................................................................................ 32

6.4

Hypothesis Testing Outcome .............................................................................................................. 34

Analysing the Findings ................................................................................................................................. 35
7.1

Interpreting the Results ...................................................................................................................... 35

7.2

Answering my Research Question ...................................................................................................... 36

7.3

Comparing my findings to the Literature Review .............................................................................. 36

7.4

Criticizing my Study ............................................................................................................................. 37

[2]

8

Limitations ................................................................................................................................................... 38

9

Recommendations ....................................................................................................................................... 38

10

Conclusion ............................................................................................................................................... 38

11

Bibliography............................................................................................................................................. 39

12

Appendices .............................................................................................................................................. 41

Table of Figures
Figure 1: Notional Amount of Home Mortgage and Other Loans ......................................................... 7
Figure 2: Acceleration of RMBS after the Introduction of New Regulations ...................................... 14
Figure 3: US Interest Rate Fluctuation ................................................................................................. 17
Figure 4: True Data of the Number of Subprime Mortgages ............................................................... 18
Figure 5: Estimation of the Number Outstanding of the Subprime Mortgages .................................... 19
Figure 6: True Data of the Notional Amount of the Credit Default Swaps.......................................... 20
Figure 7: Estimation of the Notional Amount of Credit Default Swaps .............................................. 20
Figure 8: White Test Outcome ............................................................................................................. 26
Figure 9: Correlation Matrix for the Independent Variables in Equation (2) ....................................... 29
Figure 10: Descriptive Statistic Table Including the Independent Variables in Equation (2) .............. 30
Figure 11: Correlation Matrix for the Independent Variables in Equation (5) ..................................... 31
Figure 12: Descriptive Statistic Table Including the Independent Variables in Equation (5) .............. 31
Figure 13: Correlation Matrix for the Independent Variables in Equation (6) ..................................... 32
Figure 14: Descriptive Statistic Table Including the Independent Variables in Equation (6) .............. 32
Figure 15: Correlation Matrix for the Independent Variables in Equation (7) ..................................... 33
Figure 16: Descriptive Statistic Table Including the Independent Variables in Equation (7) .............. 34

Table of Tables
Table 1: OLS Assumptions .................................................................................................................. 23
Table 2: Hypothesis Testing Outcome ................................................................................................. 34

Table of Equations
Equation 1: Unrestricted Model............................................................................................................ 23
Equation 2: Transformed Model ........................................................................................................... 25
Equation 3: Regression of the Residuals ............................................................................................... 28
Equation 4: Module for the GLS Procedure ......................................................................................... 28
Equation 5: Module After First Adjustment .......................................................................................... 30
Equation 6: Module After Second Adjustment ...................................................................................... 31
Equation 7: Module After Third Adjustment ......................................................................................... 33

[3]

1 Introduction:
1.1 Overview of the crisis
The 2008 financial crisis was a hard downturn to the economy and affected the global financial
system severely. The output of this past recession was crucial by disturbing the core aspects of
a healthy economy which lay in its production, quality of life, employment, and inflation. In
fact, after the dot-com crash, the former head of the Federal Reserve, Alan Greenspan, decided
to decrease the interest rate from 6.5% to as low as 1% which led to the beginning of The Cheap
Money Era. However, during these booming years, the demand for housing was increasing and
had encouraged most of the banks to offer loans to clients with low creditworthiness_ or
subprime mortgages. Afterward, these loans were added to a pool of other debts including car
loans, credit cards, students’ loans and so on which were then repackaged into tranches to be
sold to investors. These pools of loans included Mortgage Backed Securities (MBS) and
Collateralised Debt Obligations (CDO).
During the good days, a plethora of investors believed that the expansion would last for an
extended period; thus, they have placed a lot of their money into innovative financial
instruments like CDOs and MBS (Young, McCord, and Crawford, 2010). However, as a way
to limit the risk exposure they adopted the use of Credit Defaults Swaps (CDS) to transfer the
risk they are facing to another party. This hedging practice could have been a very efficient tool
for companies to manage their portfolios; on the contrary, many investors were entering risky
positions they would not have borne if CDS was not a choice. Thus, many experts believe that
this speculation was a pillar in the creation of the subprime mortgage bubble (Friedman,2011).
This massive exposure to risky debts has resulted in the fall of many financial institutions like
Lehman Brothers and the American International Group (AIG). The former, however, had
received a bailout from the US Government to prevent the financial system from a disaster
because of a potential chain in credit defaults. Goldman Sachs was one of the institutions to
dramatically suffer from an AIG Bankruptcy due to the vast amount of money tied into the
American Multinational Insurance.

1.2 Breaking down Credit Default Swaps
Credit default swap was one derivative instrument that gained a lot of popularity since late
1990’s. First, let us define what a CDS is: It is a contract between two parties where one
provides insurance against the risk of a credit event, or default in payments (i.e. bond’s coupon
payment), from a particular company referred to as a Reference Entity (Hull, 2008). Therefore,
[4]

the buyer of the CDS obtains the right to receive the face value of the debt if the reference entity
default; whereas the seller of the CDS has an obligation to pay the face value of the bond if a
credit event occurs.
This innovative instrument offers a variety of features that the market players are eager to
exploit. CDS provides a hedging tool for institutions seeking to limit their risk exposure and
avoid significant losses if the counterparty happens to default. Some investors view the CDS
Market as a safe way to cash-in high yields, without tolerating a higher risk. In fact, it is
plausible to provide loans to clients with low credit scores; then, hedge these positions through
CDS. On the other hand, the sellers of the CDS regard this new derivative tool as an easy way
to make money because the economy was on expansion. Thus, the probability of companies to
default was relatively small.
Another point to consider in CDS is its double-edged function; in fact, it is possible to enter a
position in the credit default swap market without owning a debt. Consequently, speculators
can bet on whether a company in financial distress will default in the next payment or not. This
practice has magnified the value of the market significantly, according to Bank of International
Settlement (BIS) the value of the CDSs jumped from $6 Trillion in 2004 to around $57 Trillion
by mid-2008. It exceeded, indeed, the outstanding worth of the US corporate debt amounting
to $6.2 Trillion (Young, McCord, and Crawford, 2010).
CDS has an evil side that affected the relationship between bondholders and the reference
entities. Lenders, usually, hope that the counterparties will keep a good solvency, so they
receive their payments on due date. However, if they own protection against default, they would
be less willing to accept a restructuring of debt obligation if the borrower has financial
difficulties; thus, they would prefer to drag the company into bankruptcy to provoke a credit
event.
Another negative aspect of the CDS market is the probability of a Default Black Hole. During
a steep recession like the 2008 crisis, it is likely that the sellers of CDSs will not be able to
cover all the positions they have taken which would lead the investors to endure the loss due to
default in both: the bond payments the CDS insurance. AIG is an example of a company that
had insufficient funds to assure all the short positions. This factor brings me to the lack of
regulation in this market. In fact, it is not required by any organization that the issuer of the
CDS has to keep aside a minimum amount of money to ensure their ability to meet their
financial obligations.
[5]

1.3 Credit Default Swap’s effect on Cost of Capital
The cost of capital for companies in financial distress has increased after the CDS gained a
substantial weight in the financial system. Usually, banks set the line of credit depending on the
short-term interest rate; however, many of these lenders started considering the credit default
swap instrument as well. Consequently, if the price of the CDS of a, say, company X increases,
it will lead the banks to ask for a higher premium; thus, a higher cost of debt for the company
X. This practice could be a fair for the banks as long as the CDS reflects the intrinsic default
risk of the company; yet, because of some speculators, the CDS may underestimate the ability
of some firms to meet their obligations leading to higher values of the CDS.

2 Purpose of the Study
Given the progress of the financial markets, many econometricians have developed new
financial instruments, known as credit derivatives; to help making the markets more resilient
and more efficient. However, many experts have warned the excessive use of these devices and
argued that they might increase the systematic risk of the market. Warren Buffet, one of the
most successful investors in the world views derivatives as a bomb and can ultimately damage
its users as well as the economic system. Consequently, after the 2008 crisis, the debate over
whether the credit derivatives were responsible for the recession has taken a serious tone.
Therefore, the purpose of this study is to examine the hypothesis that Credit Default Swaps,
one of the most prevalent credit derivatives, had significantly contributed to the increase of
Subprime Mortgages which caused the credit crisis.

3 Literature Review
3.1 Findings of Previous Studies
Blundell-Wignall and Atkinson (2008) do not believe that the derivatives instruments (i.e.
CDS), credit rating agencies, risk modeling, and other economic and financial criteria were
primary causes of the housing crisis. They insist that those factors were only part of business
models implemented by the banks to take advantage some opportunities created during that
period by governmental organizations such as the Federal Reserve and the Office of Federal
Housing Enterprise Oversight (OFHEO). Instead, some decisions taken by the government
were the slice of the pie that deserves most of the spotlight directed toward the different
potential causes. The two analysts, de facto, blamed two principle factors for of the financial
[6]

crisis. Some general factors which affected the liquidity of the financial system and some
regulations which transferred the uncertainty into the mortgage securitization process as well
as the off-balance sheet activities.
The two economists argue that the risk of a deep recession was triggered in 2004 when four
main events happened and started inflating the housing bubble. Thus, they presented the actions
to demonstrate the causality between them and the turmoil.
Figure 1: Notional Amount of Home Mortgage and Other Loans

Source: Blundell-Wignall and Atkinson (2008)
(1) The American dream of zero equity mortgage proposal came to be operative. The primary
objective of this scheme directed by Bush Administration was to offer to the low-income
household in the US the possibility to acquire home loans. Figure 1 shows an increase in the
value of home mortgages issued; amongst these loans, a significant portion was considered to
be subprime mortgages which are more exposed to default in payment. Basel II Accord was
operative. This agreement intended to monitor the amount of capital a bank has to hold to limit
the risk it faces, especially from its front office activities. Unfortunately, this regulation has
pushed the banks to look for alternative means to enter risky positions causing them to use the
off-balance sheet activities aggressively. (3) The other reason that stimulated the upsurge of
home mortgages was the action taken by the OFHEO. In fact, the watchdog of the Fannie Mae
and Freddie Mac enforced these two government mortgage securitisation agencies to increase
their capital requirement and had tightened the control on their balance sheet. This action was
an attractive opportunity for the investment banks to enter the market and issue more home
[7]

loans. (4) The consolidated supervised entities program introduced by the SEC had given the
investment banks more freedom when it comes to using their capital. As a matter of fact, before
2004, the brokers were allowed to a maximum of 15:1 debt to net equity ratio. However, after
introducing the new scheme, the banks were able to increase the debt to equity ratio up to 40:1;
further to this, no legal authority was necessitating the financial companies to report their
earnings and capital or to maintain a level of liquidity. Indeed, Blundell-Wignall and Atkinson
argue that these factors had led to a dramatic increase in the subprime mortgages and
participated in detonating the 2008 financial crisis.
Wallison (2009) advocates that the CDS is not the vehicle to blame for what caused the housing
bubble to bust. The researcher criticizes the studies pointing out the hypotheses that CDS has
magnified the systematic risk in the market; on the contrary, he argues that the vehicle in
question has participated in spreading the risk amongst the participants instead of concentrating
it in a single point. Mr. Wallison has evoked three essential points to support his belief: First,
he called to mind us about the interconnection between the credit markets where the money is
usually moving from where it is static to where it will be of greater use. He, then, defended the
CDS and rejected the idea to blame it for destabilizing the market saying that the instrument is
a simple tool to transfer risk from an entity that cannot handle a default in its expected payments
to a counterparty that has enough financial resources, in exchange for a premium. And finally,
the CDS supporter has claimed there is little evidence that the financial system has collapsed
mainly due to dealing with credit default swaps. Mr. Wallison illustrated his point by bringing
up the case of Lehman Brothers which was a major dealer of the CDS instrument. He states the
fact that when Lehman entered bankruptcy, there was no “discernible effect on its swap
counterparties.” On one hand, the intermediary dealers have settled the agreements on the swaps
for which the bank was a part of; and on the other side, the Depository Trust and Clearing
Corporation had cleared the $72 Billion swaps written on Lehman Brothers. Thus, he believes
there is no evidence showing that Lehman’s failure had caused a rise in the systematic risk due
to its commitments in the credit default swap market. Another case he aroused is the one of the
A.I.G. which was bailed out by the government. In fact, this huge bank had to pay only $6.2
Million as its exposure to Lehman’s risk through the credit default swaps. This criterion
accentuates the real cause of A.I.G. tragedy according to O’Harrow and Dennis (2008) which
is the excessive use of credit models that failed in assessing the risk the company was facing.
Plus, A.I.G had an AAA debt rating which gave it a cutback from providing any collateral that
would ensure its exposure to the positions taken in the mortgage market.
[8]


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