PROJECT ISSUE ANALYSIS DECEMBER 2008 MERRILL LYNCH THE IMPACT OF CREDIT DEFAULT SWAPS ON THE FINANCIAL MARKETS

JOO LUCAS ODEBRECHT

With increasing defaults on the American mortgage market the bearish trend took over on the world financial markets as many important economic indicators suggested that the biggest and most important economy in the globe was going towards a major recession. Indicators such as unemployment rate, jobless claims, inflation, industrial activity, consumer confidence started to rise substantially combined with a big lack of liquidity and confidence as well as major investment banks and commercial banks announcing significant losses. With a brief scenario of the current economy situation a derivative instrument called Credit Default Swap CDS emerge on the world financial markets. A derivative is a financial instrument, usually a contract that has its value based on something else and more specific a CDS is an insurance-like contract that promise to cover losses on certain securities in the event of a default so if a investor owns a corporate bond of Company A the bond holder

could insure the investment by buying a CDS of Company A, so in case of default the value of the bond would decrease substantially, however the premium on the CDS would pay off the loss so the investor would be hedged. Credit Default Swaps usually apply to corporate debt, municipal bonds, government bonds and mortgage securities and are negotiated by banks, hedge funds and others. The buyer of the credit default swap pays premiums over a period of time in return of safety, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft. Essentially, contracts can be traded or swapped from investor to investor and can be bought and sold from two ends, the insured and the insurer. The financial instrument was invented in 1997 by a team working for JPMorgan Chase. With the Commodity Futures Modernization Act of 2000, CDSs became legal and illegal to regulate. Warren Buffett once defined CDS as financial weapon of mass destruction as the CDS market is unregulated meaning that there is no official clearing house overseeing the trades, regulating the level of leverage of the market players, and ensuring that in case of a potential loss from any side there will be resources to cover the damage. In the past with a more stable economy and a perspective of growth worldwide and a small number of corporate defaults, CDS were seen as troublefree money for banks as they were selling the derivative, being the insurer end of the contract collecting the premium and earning some extra cash, however the economy has downturns and leverage positions on the wrong side is causing big

losses for many commercial and investment banks as this institutions are among the most active in this market. With a downturn in the economy the CDS market created a huge opportunity for speculative investors, hedge funds and others to buy and sell the contracts without having any direct relation to the main investment as the CDS market is unregulated. Companies like AIG soon began to not only insure houses but also insure the mortgages on those houses by issuing credit default swaps and by the time AIG was bailed out, the company held over $400 billion of CDS contracts. The apparently mistake of AIG was to apply traditional insurance methods to the CDS market, however there is no correlation on the insurance events, so for instance if a house burns in an accident does not mean that the house next door will have a higher risk consequently a higher cost to insure, but on the financial markets world if a bank, for example defaults a chain of reactions happens in the same second and the risk aversion increases towards other banks and even other companies, contributing to the panic. To exemplify and understand the current scenario regarding the stock prices and the credit default swaps, the next pages shows 4 charts of the stock price of 3M, McDonalds, Saks 5th Avenue, Petrobras, and the respective 10Y CDS of each company. To understand what the CDS spread means, the first chart shows the McDonalds stock price of 1 year along with the CDS with an approximately spread of 93 basis points meaning if an investor has a McDonalds bond for 10 years and wants to insure that investment the cost would be 0.93% a year or $93 thousand a year to insure a $10 million investment. So it is relatively

cheap to insure corporate bonds of McDonalds as well 3M with a CDS spread close to 130 basis points meaning that for many reasons investors have a fairly good perspective for McDonalds and 3M even with the current economic scenario. Taking a closer look at Saks 5th Avenue CDS spread is over 1700 basis points meaning that to ensure a $10 million investment would cost over $1.7 million a year so the risk aversion for that company is very high, even the stock price year to date is down almost 80% meaning investors dont have a good perspective on the luxury department stores in times of economic slow down. Now Petrobras CDS has a spread of over 450 basis points, it is based and operates in emerging markets which tends to be more volatile with higher risk. The chart bellow shows the 1 year performance of the equity price of the fast-food company McDonalds versus the 10Y CDS spread which in the begging of December reached over 90 basis points.

The chart bellow shows the 1 year performance of the equity price of the industrial conglomerates 3M versus the 10Y CDS spread which in the begging of December reached over 130 basis points.

The chart bellow shows the 1 year performance of the equity price of the retail store Saks 5th Avenue versus the 10Y CDS spread which in mid-November reached over 1900 basis points.

The chart bellow shows the 1 year performance of the equity price of the oil company Petrobras Petroleo Brasileiro versus the 10Y CDS spread which in mid-November reached over 500 basis points.

In conclusion, as CDSs' played an important role in this market collapse, it's likely that the federal government will start regulating them as Wall Street and Washington are starting to combine efforts to prevent future financial crisis. In addition, if a well regulated CDS market emerges in the near futures the derivative swap should be a great financial instrument for the market in general but as in Wall Street the innovators are always ahead of regulators the CDS was not healthy for the markets.