Lecture Notes on the 2008 Financial Crisis and Credit Default Swaps

Current Market Indicators and Federal Reserve Activity

• Crude Oil Trends

  • Crude oil prices have dropped below the key support level of $80$.

  • Previously, there was a significant support level at $80$ for a duration of time; however, that support has been broken and prices are now well below it.

  • As a direct consequence of lower oil prices, overall inflation expectations have decreased.

• Interest Rates and the Yield Curve

  • Interest rates are down across virtually the entire yield curve.

  • This decline is linked to the dropping inflation expectations.

• The Federal Reserve and Kevin Walsh

  • Kevin Walsh is presiding over his first meeting as Chair of the Federal Reserve.

  • The meeting commenced today and is scheduled to conclude tomorrow at $1:00$ PM Central time.

  • A policy statement will be released at $1:00$ PM Central tomorrow.

  • Projections for the Fed Funds Target: No change is expected in the Fed funds target rate.

  • Policy Bias:

    • Loosening: Not expected; that possibility disappeared months ago.

    • Tightening: Likely would have been the bias if oil prices were still in the range of $90$ to $100$.

    • Neutral: Current oil price decreases provide "cover" for a neutral bias (no bias toward tightening or loosening).

  • Press Conference: Walsh is expected to give a statement and participate in a Q&A session at $1:30$ PM Central.

  • Historical Leadership Comparisons:

    • Jerome Powell: Known for talking about future expectations, which can lead to looking "stupid" when predictions do not materialize.

    • Alan Greenspan: Served from $1987$ to approximately $2006$. He was known for being more secretive and not over-explaining, based on the philosophy that the future is unknown.

    • Leadership Sequence Mentioned: Alan Greenspan, Ben Bernanke, Janet Yellen, Jerome Powell, and now Kevin Walsh.

Financial Institutions and Pre-Crisis Structures

• Monoline Insurance Companies

  • These companies specialized in insuring the top tranches of Collateralized Debt Obligations (CDOs), promising to cover any losses.

  • Most monoline insurers went out of business because they lacked sufficient capital to cover the catastrophic losses of the Great Financial Crisis (GFC).

  • The few that remain today primary insure municipal bonds rather than complex derivatives.

  • These entities are notably absent from the narrative in the movie The Big Short.

• Special Purpose Vehicles (SPVs)

  • Investment banks used these to keep liabilities off their main balance sheets.

  • Banks would keep the "equity portion" (the riskiest, first-loss layer) of CDOs in these SPVs because they were unable to sell them, wrongly assuming the market would not collapse.

Credit Default Swaps (CDS): The "Wild West" of Finance

• Definition and Function

  • Despite the name, a Credit Default Swap is not a traditional "swap" (like an interest rate swap where cash flows are exchanged).

  • It is essentially insurance on a bond.

  • Regulatory Loophole: By avoiding the label of "insurance," these instruments were unregulated and highly illiquid prior to the GFC.

  • Naked Credit Default Swaps: This refers to speculators buying insurance on a bond they do not actually own. It is compared to buying fire insurance on a neighbor's house in hopes that it burns down.

• Mechanics of the "Big Short"

  • Speculators like Michael Burry (played by Christian Bale) bought CDSs on private-label CDOs.

  • They were technically "long" the insurance product, but they were "shorting" the mortgage market because the CDS would only pay out or increase in value if the mortgages defaulted.

  • As the underlying bonds/CDOs lost value, the premium (price) for the insurance (CDS) skyrocketed. Speculators could then sell the CDS back to the issuer or other buyers for a massive profit.

• Pricing and Mathematics of CDS

  • Notional Value: Typically, these contracts involve a multiplier, often at a minimum of $10,000,000$. This excludes individual retail investors from the market.

  • Premium Calculation (Example: Greece Debt):

    • The price is quoted in basis points ($bps$). Recall that $100\,bps = 1\%$.

    • Current quote provided: $27.6\,bps$.

    • Decimal conversion: $0.00276\,0$.

    • On a notional value of $10,000,000$: $10,000,000 \times 0.00276 = 27,600$ per year.

    • Quarterly payment: $27,600 / 4 = 6,900$.

  • Historical Context (Oct 2022): Greece CDS was $128.25\,bps$, costing over $32,000$ per quarter for the same coverage.

  • Investment banks often mispriced these swaps intentionally or to cover their own positions before allowing the market price to rise.

The Great Financial Crisis: Collapse and Bailouts

• Lehman Brothers and Systemic Risk

  • Leverage: Lehman Brothers had a market capitalization of approximately $60,000,000,000$ but had issued debt totaling nearly $600,000,000,000$—a $10:1$ leverage ratio.

  • CDS Exposure: About $400,000,000,000$ of Lehman's debt was covered by Credit Default Swaps.

  • When Lehman Brothers collapsed on Sept 15, 2008, all those CDS payments became due simultaneously.

• Timeline of Events in 2008

  • March 2008: Bear Stearns fails. It is saved via a bailout brokered by the Federal Reserve, where JPMorgan Chase buys the firm.

  • September 6, 2008: The government bails out Fannie Mae and Freddie Mac (not mentioned in the movie).

  • September 15, 2008: Lehman Brothers collapses without a bailout.

  • Post-Lehman: The government realizes the entire system is at risk due to counterparty failure.

• AIG: The Systemic Linchpin

  • American International Group (AIG) was one of the largest companies/insurers in the world, often rivaling General Electric in market cap.

  • AIG was the number one seller of Credit Default Swaps.

  • When Lehman failed, AIG owed billions to banks like Goldman Sachs and JPMorgan that had bought protection from them. AIG did not have the cash to pay.

  • The Bailout: The US Government bailed out AIG (the largest bailout ever at the time, similar in size to Fannie/Freddie) to ensure they could pay off the CDS contracts. This prevented other banks from failing due to AIG’s inability to pay.

• The Role of Hank Paulson

  • Hank Paulson was the Secretary of the Treasury (former Goldman Sachs CEO).

  • Ben Bernanke was the Fed Chair.

  • Speculation on Lehman: The lecturer posits that letting Lehman fail was personal. Paulson and Dick Fold (Lehman CEO) were rivals for over a decade. Paulson chose to let Lehman die while brokering deals for others and indirectly saving Goldman Sachs via the AIG bailout.

Movie Context: The Big Short

• Characters and Real-Life Counterparts

  • Michael Burry: Played by Christian Bale. He is the only character who uses his real name in the film.

  • Jared Vennett: Played by Ryan Gosling. Based on real-life Deutsche Bank trader Greg Littman.

  • Mark Baum: Played by Steve Carell. Based on Steve Eisman of Frontpoint/Brownfield.

  • Jared Vennett's Role: Though he worked for Deutsche Bank, he was a trader who made a $40,000,000$ bonus by selling the very CDS products that bet against the market. He acted as a middleman, profiting from commissions and the eventual liquidity of the swaps.

• The Exit Strategy

  • The hedge funds in the movie (Frontpoint, Brownfield, Burry) sold their CDS positions before the actual entities they were betting against went under.

  • They did this because if the entire financial system collapsed without a bailout, the CDS contracts would have been worthless due to the bankruptcy of the issuers (like AIG).