The role played by the Credit Default Swap in the Economic Boom and the Financial Crisis of 2008

Henrik Kiil Persson

Student thesis: Master thesis

Abstract

This thesis aims to draw the big picture on the role played by the Credit Default Swap (CDS) in the midst of the Wall Street financial crisis of 2008. The CDS is a financial derivative that essentially provides the purchaser insurance against default on a series of bond payments by a third party against a series of premium payments. The impact of the CDS on the financial system during the 2000’s is interesting to examine as it has been at the receiving end of much criticism from many parties including academics, politicians and the media. The CDS is a fairly young derivative and its use was largely obscure and trivial until it gained notoriety in its use to build what the Federal Crisis Inquiry Commission called “The Engine that Powered the Mortgage Supply Chain” – known as the Collateralized Debt Obligation (CDO). In this thesis I trace the roots of the CDS and describe the basic functions of the derivative itself, how it trades, where it trades, who the primary users/dealers are and how the market has evolved in size over the years. I find that CDS trading normally happens in fairly illiquid transactions of large denominations between relatively few agents. As a result of this and the newness of the product, over-the-counter trading done directly between large companies or through one or more specialized intermediaries was the name of the game in the 2000’s. For this very same reason, not much data is available to the public, and this along with the short history of the product also explains why the research field on the subject is relatively limited. I come up with a list of generally accepted positive features of the CDS that explains why the derivative even exists, and then a more specific list that sums up the main arguments against the CDS in the context of the credit crisis. In order to examine the different points of critique I then take a closer look at the American mortgage market to explain how the motives of the different agents are aligned, and in what way the CDO changed the game. I find that the CDS was a major component in the CDO that helped fuel the credit bubble and bring about immense exposures towards the housing market on the balance sheets of the major U.S. financial institutions. I also find that the CDO corrupted incentives in a way that left banks extending loans to borrowers whom they knew were very likely to default on their payments, with the intention of reselling these loans. I then turn the attention towards the Credit Rating Agencies that facilitated this through ratings inflation that left the impression of a sound financial system, when in fact much of the mortgage-related investment was extremely risky and left the system under-capitalized. I find incentives were perverted due to the issuer-pays model and ratings arbitrage. 3 Finally I analyze the role played by financial regulatory authorities and come to the conclusion that inadequate legislation that placed an undue amount of trust in rating agencies failed to regulate risk in the markets, partly due to the nature of complicated financial derivatives. The overall conclusion is that although the CDS as a tool played a role in the build-up and bursting of the bubble, it seems very unlikely that the bubble could not have happened without it.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2014
Number of pages82