.The text analysis of a case should be about 3-5 pages (double-spaced). Your write-up should begin with an opening paragraph that defines the main issues in the case. The remainder of your paper should support your recommendations and conclusions with your analysis based on the facts of the case. Structure is important for your argument to be coherent. The grading will be based on the quality of your analysis and writing.You should present the material in a logical, clear and concise way.Points will be deducted for grammar mistakes and typos. Your case analysis should address the following questions. What is a credit default swap?What was AIG’s role in the process of mortgage securitization?How risky are BBB-tranches in the first layer of securitization?How risky are super-senior tranches in the second layer?Discuss the risk assessment of super-senior tranches and the justification of collateral calls by AIG’s counterparties.What do you learn from AIG’s CDS experience?The case article are instruction are attached.
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Prof. Lin Guo
Case Instructions: From Free Lunch to Black Hole: Credit Default Swaps at AIG
(Available for purchase at https://hbsp.harvard.edu/import/601751)
Due date: March 26
Each group should prepare a written analysis, and hand in one copy of your analysis at
the beginning of class on March 26. Please submit a hard copy only. Each team member
should also bring his/her own copy of the write-up to class, as well as the case itself, so
that we can refer to the specifics in our discussion. People in the same group will receive
the same grade for the case write-up. The text analysis of a case should be about 3-5
pages (double-spaced).
Your write-up should begin with an opening paragraph that defines the main issues in the
case. The remainder of your paper should support your recommendations and conclusions
with your analysis based on the facts of the case. Structure is important for your argument
to be coherent.
The grading will be based on the quality of your analysis and writing. You should
present the material in a logical, clear and concise way. Points will be deducted for
grammar mistakes and typos.
Your case analysis should address the following questions.
1.
2.
3.
4.
5.
What is a credit default swap?
What was AIG’s role in the process of mortgage securitization?
How risky are BBB-tranches in the first layer of securitization?
How risky are super-senior tranches in the second layer?
Discuss the risk assessment of super-senior tranches and the justification of
collateral calls by AIG’s counterparties.
6. What do you learn from AIG’s CDS experience?
For the exclusive use of Y. Wang, 2019.
case W04C41
August 6, 2015
From Free Lunch to Black Hole: Credit Default Swaps at
AIG
Alan Frost, executive vice president for AIG Financial Products (AIGFP), was on vacation when he
received a disturbing email from Andrew Davilman at Goldman Sachs in the evening of July 26, 2007 (see
Exhibit 1).
In the years leading up to 2007, AIGFP had written $75 billon notional value of credit default swaps
(CDS) tied to subprime mortgage-backed securities (MBS). Through these CDS, AIGFP provided credit
insurance to its counterparties, meaning that AIGFP would absorb losses on the MBS underlying the CDS if
homeowners defaulted on their mortgages.1 Goldman Sachs was the counterparty for more than $20 billion
notional value of these CDS contracts.2 For several years, AIG had profited handsomely from these contracts
and had judged that there was a virtually zero risk that AIG would ever have to make a payment on these
CDS. But now, as housing prices started to fall, subprime borrowers began to default in greater numbers,
and market values of the subprime MBS underlying the CDS dropped substantially. In Goldman Sachs’ view,
these circumstances were a clear indication that the marked-to-market value of the CDS contracts with AIG
had shifted in Goldman Sachs’ favor. Referring to the CDS contract terms, Goldman Sachs therefore asked
AIG to provide collateral. On July 27, the day after Frost received the heads-up from Davilman about the
forthcoming margin call, Goldman Sachs formalized its demand for collateral by sending AIGFP a collateral
invoice requesting that the company provide it with collateral worth $1.8 billion.3
American International Group
In 2007, American International Group (AIG) was one of the biggest insurance companies in the world.
It operated in 130 countries and employed close to 100,000 people.
AIG was founded in 1919 as an insurance agency in Shanghai. In wake of the revolution in China,
the company moved to New York City in 1949. AIG went public in 1969, with Maurice R. Greenberg as
CEO. Greenberg led the company through an enormous expansion until he was forced out in 2005 amid
investigations into accounting irregularities by the New York Attorney General. Greenberg remained a large
shareholder in AIG, and contested the charges of accounting irregularities and the circumstances of his
forced departure from AIG.
After Greenberg’s departure, Martin J. Sullivan, a long-time AIG employee, took over as CEO.4
Published by WDI Publishing, a division of the William Davidson Institute (WDI) at the University of Michigan.
©2015 Stefan Nagel. This case was written by Stefan Nagel (Michael Stark Professor of Finance at the Ross School of Business) at
the University of Michigan to be the basis for class discussion rather than to illustrate either the effective or ineffective handling
of a situation. Secondary research was performed to accurately portray information about the featured organization. Company
representatives were not involved in the creation of this case.
This document is authorized for use only by Yizhuo Wang in Risk Management and Financial Institutions Spring 2019 taught by LIN GUO, Suffolk University from Jan 2019 to May 2019.
For the exclusive use of Y. Wang, 2019.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
W04C41
Exhibit 1
Email from Andrew Davilman to Alan Frost
Source: Financial Crisis Inquiry Commission. .
AIG Financial Products
Earlier, looking for new business opportunities, AIG created its AIG Financial Products (AIGFP) subsidiary
in 1987. AIG was looking for ways to profitably exploit its AAA credit rating and its strong capital base.
Its objective in starting AIGFP was to participate in the growing over-the-counter markets for financial
derivatives.5
It hired a group of traders from Drexel Burnham Lambert, the firm that had pioneered the junk bond market
in the U.S. The firm was in deep trouble at the time amid allegations of insider trading and investigations by
Rudy Giuliani, the U.S. attorney for the Southern District of New York.6 One member of this group was Joseph
Cassano, who first served as chief financial officer of AIGFP and, from 2001, as head of AIGFP.7
AIG located its AIGFP unit in London, but its business was nevertheless subject to U.S. regulation.
Because AIG owned a small savings and loans institution, it was able to choose the Office of Thrift Supervision
(OTS) as its federal regulator for its non-insurance businesses (which included AIGFP). OTS was therefore also
responsible for supervision of the AIGFP subsidiary (AIG’s U.S. insurance business was supervised by state
regulators). Since AIGFP agreed to supervision by OTS, it avoided regulation by the U.K. Financial Services
Authority (FSA). OTS, typically responsible for supervision of small savings and loans institutions, had little
expertise in the type of business conducted by AIGFP.8
AIGFP engaged in transactions with interest-rate swaps, derivatives on commodities, and many other
derivatives products. In the 1990s, AIGFP expanded its activities into the nascent market for credit default
swaps (CDS). AIGFP’s earnings rose from $150 million in 1993 to $323 million in 1998 and to $758 million
in 2001.9
2
This document is authorized for use only by Yizhuo Wang in Risk Management and Financial Institutions Spring 2019 taught by LIN GUO, Suffolk University from Jan 2019 to May 2019.
For the exclusive use of Y. Wang, 2019.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
W04C41
Credit Default Swaps
Credit default swaps (CDS) were invented in the 1990s as an instrument for transferring credit risk
between financial institutions. For example, a bank that made a loan to a company could use CDS to transfer
to another party (e.g. an insurance company) the risk that this company might default on the loan. The
bank in this example is the credit-protection buyer and the insurance company is the credit-protection seller.
To compensate the insurance company for assuming the default risk of this loan, the bank makes a small
periodic payment, as long as the company does not default on the loan. In the event of default, the insurance
company is required to make a payment to the bank to cover the bank’s losses on the loan. The same idea was
soon applied to corporate bonds, mortgage-backed securities, and other securities, for which CDS provided
credit protection in the event that the borrower defaulted on the obligations under these securities.
More precisely, a CDS pays out to the credit-protection buyer if a credit event occurs with respect to the
underlying reference entity (e.g., the company that received the loan in the above example). What exactly
constitutes a credit event is defined in the terms of the CDS contract. A credit event can involve outright
default of the underlying reference entity, but it can also be an event involving some restructuring of the
debt, for example. Many CDS are conducted on the basis of terms laid out in a master agreement by the
International Swaps and Derivatives Association (ISDA).
As an example, suppose that IBM has a floating-rate bond outstanding with more than seven years
remaining until maturity that trades at par. Suppose party A, the credit-protection buyer, enters into a CDS
with party B, the credit-protection seller, with seven years maturity. The notional value of the CDS contract
is $1 million. In the CDS contract, the two counterparties agree that as long as IBM does not default on
this bond during the next seven years, A pays B an annual payment of u% (the “CDS rate,” which would be
specified as a specific number in the contract) of the notional value of $1 million. In the event that IBM
defaults, B makes a payment to A equal to the notional value of $1 million times the “loss given default”
and the contract terminates. For example, if IBM defaults, and subsequent to the default event, the IBM
bonds are trading at 60% of their face value, then the loss given default is 40%, and the required payment
would be 40% times $1 million = $400,000. Thus, the credit-protection buyer would be fully insured against
the default risk inherent in a $1 million position in these IBM bonds. Exhibit 2 illustrates these cash flows
patterns schematically for a floating-rate bond with face value F, time of default d, CDS rate u, CDS maturity
T, and market value Pd of the underlying bond in the event of default.
Financial institutions had a variety of motivations for entering into CDS. Part of it was to lay off credit
risk to institutions that could better diversify these risk exposures. For example, if a bank makes a large
loan to a company, this bank may have a large concentrated credit risk exposure to this single counterparty.
By entering into a CDS, the bank can transfer all or part of this credit risk exposure to another financial
institution that is in a better position to bear the risk. For many CDS transactions, the motivation, however,
was driven by regulation. For example, European bank regulators calculated the amount of equity capital a
bank needed to hold as a buffer against possible losses based on the risk exposure of the bank’s assets. By
laying off credit risk to an entity like AIG through a CDS transaction, the bank could reduce the amount of
capital it was required to hold. To the extent that the payments that AIG charged for taking on the credit
risk were lower than the cost that banks perceived for putting up more equity capital against risk exposures,
banks were happy to enter such trades. At the time, this credit-risk transfer was also welcome by regulators,
as it transferred credit risk away from highly levered banks, which enjoyed, to some extent, implicit and
explicit government (i.e., taxpayer) support to institutions like AIG outside the regulated banking sector
that had large amounts of equity capital and which were perceived at the time not to enjoy similar incentivedistorting government support.
3
This document is authorized for use only by Yizhuo Wang in Risk Management and Financial Institutions Spring 2019 taught by LIN GUO, Suffolk University from Jan 2019 to May 2019.
For the exclusive use of Y. Wang, 2019.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
W04C41
Exhibit 2
CDS Cash Flows from Perspective of Credit-Protection Buyer
Source: Created by the author of the case.
Until the early 2000s, AIG’s credit risk exposure through its CDS transactions was mostly to corporate
credit. However, this took a drastic turn, as financial innovation in the mortgage market involved AIG as a
key player.
Synthetic Securitization
The set of participants in the credit default swap market was relatively narrow. Most of the counterparties
in credit default swaps were banks (including investment banks), hedge funds, and some insurance companies.
In the mid-1990s, several banks were developing ideas on how to transfer credit risk from bank balance
sheets to a broader investor population. In 1997, J.P. Morgan set up its groundbreaking transaction called
BISTRO (Broad Index Secured Trust Offering). In a BISTRO structure, a bank that originated a portfolio of
loans bought credit protection for this portfolio from J.P. Morgan via a CDS. J.P. Morgan in turn bought credit
protection on this portfolio of loans from a special purpose vehicle (SPV), a shell company set up by J.P.
Morgan only for the purpose of this BISTRO transaction.10
For example, in the first BISTRO deal in 1997, the SPV takes on the credit risk of a loan portfolio worth
$9.7 billion.i In return, the SPV receives a regular payment (based on the CDS rate) from J.P. Morgan. If
a credit event occurs on the underlying portfolio, the SPV has to make a payment that compensates J.P.
Morgan for the loss in value on the loans associated with the credit event. To have assets available that can
be used for these payments in case of credit events, the SPV issues notes in capital markets. The amount
raised from the issuance of these notes is invested in safe securities such as government obligations until
it is needed to make any payments on the CDS due to credit events in the underlying portfolio of loans
that the SPV insured. Thus, just like in traditional securitization, the credit risk of the underlying loans was
transferred from the originating bank to capital market investors, but in this case not by transferring the
actual loans from the originating bank’s balance sheet, but instead by just transferring the credit risk of
these loans, using CDS contracts (see Exhibit 3). This process is called synthetic securitization.11
i The originating bank would bear the first 1.5% loss on the underlying loan portfolio. The author ignores this feature in this illustrative
discussion.
4
This document is authorized for use only by Yizhuo Wang in Risk Management and Financial Institutions Spring 2019 taught by LIN GUO, Suffolk University from Jan 2019 to May 2019.
For the exclusive use of Y. Wang, 2019.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
W04C41
In the first BISTRO deal, the SPV issued only $700 million worth of notes, an amount much smaller than
the notional value of the loan portfolio ($9.7 billion) that the SPV insured. Up to losses of $700 million,
any credit losses on the loan portfolio would be borne by the capital market investors that bought the notes
issued by the SPV. If losses on the loan portfolio exceeded $700 million, the capital market investors would
be wiped out, and J.P. Morgan would bear the additional losses.
The loans underlying BISTRO deals were, on average, of investment-grade quality, and hence the risk
that losses on a diversified portfolio of such loans might exceed $700 million was judged to be miniscule.
This risk was seen as smaller than the risk of loss on a typical AAA credit. For this reason, this remaining
credit exposure that J.P. Morgan was exposed to was labeled to be “better than triple-A” or “super-senior.”12
Exhibit 3
BISTRO Deal
Source: Created by the author of the case.
This super-senior risk was mostly correlation risk: For the losses on the loan portfolio to exceed $700
million, many borrowers would have to default at the same time. Assessing the super-senior risk therefore
required a judgment about the degree of correlation in borrowers’ defaults. Based on a long history of data
on corporate defaults, the correlation of defaults appeared sufficiently low so that super-senior losses
seemed extremely unlikely.
Partly because of pressure from regulators in some jurisdictions to hold some amount of reserve capital
against this super-senior risk, and partly because of concerns about the potentially huge (even though
unlikely) magnitude of the risk exposure, J.P. Morgan was looking for some counterparty to insure this supersenior risk. A suitable counterparty would have to have a strong balance sheet and a triple-A credit rating.
Enter AIG.
AIG’s Financial Products division was willing to insure J.P. Morgan’s super-senior risk. AIGFP would enter
into a CDS contract with J.P. Morgan to assume the super-senior risk and, in return, earn a small periodic
fee. For the first deals, AIGFP was paid 0.02% of the insured amount per year. In the initial BISTRO deal,
this would amount to $1.8 million per year for insuring a notional value of $9 billion of super-senior risk
exposure. In subsequent deals, AIGFP managed to contract a higher rate of 0.11%.13
Mortgage Securitization and Collateralized Debt Obligations
In the early 2000s, Wall Street started applying the same credit-risk transfer technology not just to
corporate credit, but also to consumer credit such as automobile loans, student loans, credit-card debt,
5
This document is authorized for use only by Yizhuo Wang in Risk Management and Financial Institutions Spring 2019 taught by LIN GUO, Suffolk University from Jan 2019 to May 2019.
For the exclusive use of Y. Wang, 2019.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
W04C41
and mortgages. These consumer loans were transferred from originating lenders to capital market investors
through the creation of asset-backed securities (ABS) or mortgage-backed securities (MBS).
Until the early 2000s, most securitization of mortgages was carried out by government-sponsored
enterprises Fannie Mae and Freddie Mac, which took on the credit risk of the mortgages that were securitized.14
In the early 2000s, however, Wall Street started to securitize mortgages that did not satisfy the eligibility
criteria required by Fannie Mae and Freddie Mac, for example, because borrowers had low credit scores and/
or lacked documentation of income, the loan-to-value ratios were high, or the size of the mortgage exceeded
set limits. (See Exhibit 4).
Exhibit 4
Role of AIG in Mortgage Securitization
Source: Created by the author of the case.
In these “private-label” mortgage securitizations, MBS are issued by an SPV, and the SPV uses the
proceeds from MBS issuance to purchase mortgages from an originating bank (or from an intermediary that
was “warehousing” the loans for a brief period). The MBS are often issued as tranches that differ in credit
quality. If credit losses occur on the underlying portfolio of mortgages, the (unrated) equity (or “first-loss”)
tranche bears the first losses. In the example shown in Exhibit 4, the BBB-tranche starts to suffer any losses
only if the equity tranche is completely wiped out. The AAA-tranche is the last one to suffer losses, which
occurs only if all the other lower-rated tranches have been wiped out. The AAA-tranche would typically
account for the bulk of the notional value of the MBS, often around 80%. Thus, roughly speaking, investors
in the AAA-tranche suffer losses only if the losses on the underlying portfolio of mortgages exceed 20% of
the combined face value of the underlying loans.15
6
This document is authorized for use only by Yizhuo Wang in Risk Management and Financial Institutions Spring 2019 taught by LIN GUO, Suffolk University from Jan 2019 to May 2019.
For the exclusive use of Y. Wang, 2019.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
W04C41
While there was plenty of demand for higher-rated tranches, BBB-rated tranches were difficult to sell.
As a consequence, it became common in …
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