WHAT IS CREDIT DEFAULT SWAP?

A Credit Default Swap (CDS) is

A contract

Where a buyer pays a payment to a seller to take on the

credit risk of a third party.

In exchange, the buyer receives the right to a payoff from

the seller.

If the third party goes into default or on the occurrence of a

specific credit event named in the contract (such as
bankruptcy or restructuring).

An Example
Person B (Borrows Money from A)

Person C (takes on
the credit risk of B)

Person A (lends money to B &

enters into a contract with C)

Now, imagine two situations

Situation A: Person B pays back Rs. 1000 to person A. Since
person B has not defaulted, the transaction ends between
persons A & B, and also between persons A & C.
Situation B: Person B defaults in his payment to person A.
Now, according to the contract between persons A & C, It
becomes the obligation of person C to pay back Rs. 1000 to
person A.

Therefore
This contract, which:
Transfers the credit risk from one person to another
Is exercised when one party defaults in its payment
Consists of a swap of a buyer and a seller (in our
example, person A is a seller to person B and a buyer to
person C)
is called a Credit Default Swap.

FALLEN

GIANT

Case Study of American International Group, Inc.

OVERVIEW

American International Group,

Inc. (AIG) is a world leader in
insurance and financial
services.

It is headquartered in New York

City, and operates in more than
130 countries and jurisdictions.

Its primary activities include

General Insurance and Life
Insurance & Retirement
Services.

 In 2006, AIG had sales of

$113 billion and 116,000
employees.
According to the 2008
Forbes Global 2000 list, AIG
was once the 18thlargest public company
in the world.
It was listed on the Dow
Jones Industrial Average
from April 8, 2004 to
September 22, 2008.
AIG's common stock is
listed on the New York
Stock Exchange, as well as
the stock exchanges in
Ireland and Tokyo.
London, England

OVERVIEW

AIG faltered in Americas subprime mortgage crisis. It had

traded heavily in credit default
swaps and could not meet its
obligations. The United States
government came to its rescue
with an $85 billion bailout on
September 16, 2008.

AIG Building, 70 Pine St., Lower Manhattan

HISTORY

Greenberg was
fired due to
accounting scandal
in February 2005,
and was succeeded
as CEO by

Martin J. Sullivan.
On June 15, 2008,
Sullivan resigned
and was replaced
by

Robert B.
Willemstad,
Chairman of the
AIG Board of
Directors.
Willemstad was
forced by the U.S.
government to
step down and
was replaced by

Edward M. Liddy
on September 17,
2008.

SEPTEMBER 2008
AIGs credit ratings
were downgraded
below "AA" levels,
causing the company
to suffer a liquidity
crisis.
The United States
Federal Reserve Bank
created an $85 billion
credit facility to help
AIG meet increased
collateral obligations,
in exchange for stock
warrants worth 79.9%
of the companys
equity.

HISTORY

MARCH 2, 2009
AIG reported a fourth quarter 2008 loss of $61.7
billion.
The announcement of the loss had an impact on
morning trading in Europe and Asia, with the
FTSE100, DAX and Nikkei all suffering steep
losses.
In the U.S., the Dow Jones Industrial Average fell
to below 7000 points, a twelve-year low.

FINANCIAL CONDITION

AIG
CURRENT FINANCIAL HIGHLIGHTS
from MSN Money, July 20, 2009.

Sales

17.53 Bil

Income

-97.25 Bil

Net Profit Margin

-557.83%

Return on Equity

-155.05%

Debt Equity Ratio

4.09

Revenue/Share

130.87

Earnings/Share

-720.86

Book Value/Share
Dividend Rate
Payout Ratio

340.12
0.00
N/A

About Long Term Capital Management (LTCM)

One of the largest (Star) hedge fund at that time:

Founded in 1994, go bankrupt in 2000
$1.28 trillion off-balance sheet worth of Asset Under Management
(AUM)
Stellar performance: 21% first year, 43% second year, 41% third year
Key people:

John W. Meriwether (founder Famous Wall Street Bond trader)

Myron S. Scholes and Robert C. Merton (shared 1997 Nobel Prize in

Economic Sciences for discovery of Black-Schole model)
David Mullins (later become vice chairman of the Federal Reserve)
Due to the reputation of its managers, LTCM was able to raise
impressive funds in very short period

LTCMs Failure Key Factors

Taking highly leveraged positions

Due to LTMCs reputation, most banks waive the margin requirement
for LTMC transaction of securities, taking long/short positions.
LTMC was able to take a more leveraged trading position
LTCM Investment Strategy
Relative value Arbitrage based on Credit spread & Equity Volatility
Seeks to take advantage of price differentials between related financial instruments,
such as stocks and bonds, by simultaneously buying and selling the different
securities

Model Risk, LTMCs Risk & Return Assumption

Assume that risk premium (the difference in yield between risky and
risk-free securities) tended to revert to historical level.

Assume that volatility of equity options tended to revert to long-term

historical level.

Unexpected and Extreme events

August 1998, Russia defaults on it debts, Russia Interest Rate
soaring
200%, Crushing Value of Ruble.
Increase interest rate, risk premium and market volatility
unexpectedly

LTCM lost 44% of its capital in 1 month due to Cash flow crisis
Force to liquidate position to meet margin calls due to sharp
divergence of asset prices.

Prices in Relative value arbitrage strategy can diverge and create

temporary losses before they ultimately converge.
If LTCM have enough funds to withstand the Cash Flow Crisis,
The hedge fund will ultimately gain profit in the long-term (when prices
converge)

The total losses were found to be $4.6 billion. The losses in

the major investment categories were (ordered by
magnitude):
$1.6 billion in swaps
$1.3 billion in equity volatility
$430 million in Russia and other emerging markets
$371 million in directional trades in developed countries
$286 million in equity pairs (such as VW, Shell)
$215 million in yield curve arbitrage
$203 million in S&P 500 stocks
$100 million in junk bond arbitrage

The Subsequent Bailout

Wall Street feared that the downfall of LTCM could have

spiralling effects in the global financial markets causing
catastrophic losses throughout the financial system.
Goldman Sachs, AIG and Berkshire Hathaway on
September 23, 1998 offered to buy out the funds partners
for $250 million and decided to inject $3.75 billion and to
operate LTCM within Goldmans own trading division.
The final bailout was $3.65 billion.