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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Let's think about the different use cases for credit default swaps. So let's say that I have some company over here, and it's given a BB credit rating. And this rating, of course, comes from a credit rating agency, sometimes called a ratings agency or a rating agency. I've seen it every different way. So this would be like Moody's or Standard and Poor's or whatever else. And they look at this company, and they look at its business, they look at its balance sheet, and they say, OK, it's not super safe, but it's not super risky either. We give it a BB rating. And let's say that there's an investor over here who wants to lend money to this company. So he might lend them some money and get some interest in return. But this investor doesn't like this level of safety. He wants to make sure that he's made whole even if this company goes out of business. So he can go to a writer of a credit default swap, and the most famous of those credit default swap writers is or was AIG. And he'll say, hey, AIG, I'm going to pay you a little bit every year. You could view that as an insurance premium. And in exchange, you are essentially going to ensure me in the case of a default by this company. And what we already said, it's a little bit shady because it was not regulated like insurance. So AIG did not have to set anything aside. And what was powerful here for AIG is that the rating agencies continued to give AIG a very high rating. So let's say it had a AA rating. So despite the fact that it kept taking on all these liabilities, the credit rating agency says, hey, we'll still give you a AA. So they were able to use this AA rating to keep writing these contracts, to keep writing insurance and not setting anything aside, and essentially just getting, almost you could view it, free money with having to pay the piper eventually. Now this is one scenario. Another scenario is maybe an investment bank creates some type of special purpose entity or some collateralized debt obligation right over here. And they have their different tranches. And maybe for the senior tranche over here, just so that they can sell them to pension funds who can only buy AA rated debt, pension funds. The investment bank goes to AIG and says, hey, can this entity right over here buy credit default swaps? Can we enter into credit default swap agreements on you, so that in case any of this stuff were to default, you will also insure that? And once we do that, then a rating agency. So this is a security. This is a senior tranche of a collateralized debt obligation now, the senior tranche, and now that that senior tranche is essentially insured by AIG, a credit rating agency, once again, will assign this a AA rating. Even though this thing might be made up of a bunch of sub-prime mortgages and all of the rest, although it is a senior tranche so it'll be made whole first, but now pension funds can buy this type of thing. The last use case is maybe you have a hedge fund out here who doesn't want to lend anybody any money, but is convinced that a whole bunch of these companies, maybe this company over here or maybe this company over here, that has some other rating. So this is another company. This hedge fund is convinced that these companies are going to default on their debt, that there's going to be a credit crisis of some kind. Well, then this hedge fund can enter into credit default swap agreements to essentially get insurance, but not having anything to insure. It's like getting car insurance on someone else's driving or someone else's car, and you kind of are starting to hope that they have to have a car accident. Because now if this guy has a credit default swap on this company right over here, despite the fact that they didn't lend out to them, the hedge funds is going to pay a little bit every year and get the insurance. And they are essentially going to hope that this company goes out of business, because if it does, then they're going to get the insurance payment. They're going to get the same payment that this investor would have, but they would have never had to lend the money. So you could use it as a side bet, you could use it as a way of making lower-rated securities all of a sudden acceptable to pension funds, or you could use it as a straight-up way of insuring debt that you're lending to someone else.