Later on, in the next module, I'm going to show you that the CDS spread S is approximately one minus R times H where R is the recovery rate and H is the hazard rate. So, for a fixed value of R, the CDS spreads are directly proportional to the hazard rate H. The hazard rate is the conditional probability of default. So you end up getting that the conditional probability of default is approximately equal to S divided by one minus R. Therefore CDS spreads end up giving you a very good handle on the probability that a particular company or a particular country or sovereign is going to default in the next period. So here just as an illustration, I'm showing you what happened to the 5-year CDS spreads for Ford, GM, and AIG in the first nine months of 2008. This data up here is all in basis points. So it started around a thousand basis points, and it started rising as the dates went by and neither of these two companies actually defaulted, but the probabilities of default are going very high because the spreads are going high. AIG went all the way up to 3500 basic points before coming back down because this is where the bailout events started to happen. The only idea that I want you to take away from this picture is the fact that CDS spreads react to news events. AIG was very low, and then suddenly it started to shoot up because there was feeling in the market that the default is going to happen. Using the formula that H is approximately equal to S divided by one minus R, we can back out what is the probability of default from the spread rates. In this slide, the y-axis is in percentages and not in basis points. It gives you a sense of the creditworthiness of different countries. So if you look at Greece, Greece all the way went up to 25 percent default on around 25 percent spread around January 12th. So if the recovery rate is let's say approximately 50 percent, then H which is S divided by one minus R will turn out to be approximately a 50 percent default probability. So the market thought that the probability that Greece is going to default is going to be very very high. The next one over is Portugal, but it's only at around 1.5 percent which is the period over here, and Germany which is exactly flat down here is pretty close to zero. So in some sense, it's going to be considered the most safe or risk-free of the countries. Just to give you a sense of what the development and the applications of CDS, I'm going to trace some of the history. The development of the modern version of the CDS is credited to Blythe Masters of JP Morgan. It was created in 1994 to cover JP Morgan for the $4.8 billion credit line that it had issued to Exxon to cover the possible punitive damages in the Exxon Valdez spill. So after extending the credit line, JP Morgan protected itself by buying protection from the European Bank for Reconstruction and Development using a CDS, the CDS market since then has grown tremendously. By the end of 2007, the CDS market had a notional value of 62 trillion. Since then things have become better. The DTCC estimates that the gross notional amount, gross years stands for the fact that after netting of offsetting CDS agreements, the notional amount in 2012 was about 25 trillion, so 2007, was before the financial crisis 2012 after this financial crisis and things have started to come down. CDSs' were initially developed for hedging. They allow to hedge concentrations of credit risk privately. So take the example of JP Morgan and Exxon. JP Morgan makes a loan to Exxon, it wants to protect itself, so there are two possibilities. One it could write the loan off to somebody else, in this case, the European Bank of Reconstruction and Development but that would mean that it would have to inform Exxon to the loan has been written to another corporation that might affect the relationship of JP Morgan and Exxon. Instead, you could create a CDS contract and effectively still remove that credit off of your balance sheet. You can hedge credit exposures when no publicly traded debt exists, and this is because CDSs can be written on anything pretty much and it's a contract. It's not really a bond or a cash bond and therefore you can use this construct to hedge against situations where bonds or publicly traded debt is not available. Although CDS can be used to protect against losses it's very different from an insurance contract. It's a contract that can be written to cover anything. You can buy protection even when you don't hold the underlying debt. In order to buy insurance you have to hold the underlying quantity, to buy an insurance of the house you have to be the owner of the house, to buy insurance on a bond, you need to hold the bond. You can buy a CDS on a bond without even holding the bond. CDSs' are easy to create and until recently completely unregulated. Because of these reasons, investing and in some cases speculation became the main application very soon. CDSs' provide an unfunded way to create credit risk. So in order to take a credit risk on a particular company, you either have to take, buy the bond or you have to short sell the bond, short selling bonds is very difficult. On the other hand, by writing a CDS on the particular company you can expose yourself with a credit risk. You can tailor the credit exposure to match the precise requirements, this is because CDSs' are contracts and you can precisely define the contract that you want. CDSs' allow you to take views on the credit quality of the reference credit. If you think that the credit quality is going to go down you're going to buy protection. If you think that the credit quality is going to go up then you're going to sell protection. So in both directions, you can take a view, a positive view or a negative view. Buying protection, which means that when you have a negative view in a market is often easier than shorting the asset. So CDSs' became the real easy way of taking negative bets on various Corporations. Another way CDSs' started to be used is to arbitrage between the reference bond and the CDS spreads. It's not coupon but the reference bond and the CDS spreads gave another opportunity to find an investment opportunity, to make the difference. CDSs' have been blamed for the financial crisis and the debt crisis, and there are many reasons why this happen. CDS positions are not transparent. The riskiness, of financial intermediaries, therefore, cannot be accurately evaluated because dispositions don't show up on a balance sheet. Because of that, because of the fact that you could not accurately evaluate the riskiness of financial intermediaries, it threatened the trust in all counter-parties. Since no one knew who face losses, when a crisis event happened, all the counter-parties were suspect and entire trading came to a halt. CDS were treated on an OTC market. Because of that, it was impossible for any dealer to know what previous deals a customer had made, resulting in situations where some dealers could make lots of CDS deals without putting up enough collateral. So AIG was able to leverage its high credit rating to sell approximately $500 billion worth of CDSs', without putting up there enough collateral. Because it was in the OTC market and because these trades were opaque, it allowed a small number of CDS traders to take on huge amounts of risk. It also allowed them to be very severely interconnected in terms of their obligations and as a result of this interconnectedness, the dealers led to worries about contagion. CDSs' also have been blamed, during the financial crisis to adversely affect the cost of borrowing of a form in a country and recently more so in the European debt crisis, CDS have been blamed for the fact that the cost of borrowing of countries have gone tremendously high. So the story here is the speculator purchase CDS without holding the underlying debt, sometime called a naked CDS. Once a lot of these speculators actually start buying these naked CDS, this drives the spread higher. When the spread goes high because the market perceives the spread as the riskiness of a particular company or a particular country, the firms start appearing risky, and the cost of borrowing of the firm increases, the cost of borrowing of the sovereign increases, and this can lead to collapse. Various policy decisions have been made in recent past to try to correct all of these problems, try to get CDS positions from balance sheets trying to move the CDS at least to a clearinghouse and then to an exchange-traded situation. Disallow naked CDSs', many of these are things that are in play, some of them completed, some of them are still being discussed. But CDSs' have played a role and well, unless something is done will continue to be a risky part of the economy.
