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Implication of AIG Default: Hedging, Reserve and Capital Requirements

for Credit Default Swaps



Xinyue Fan, Siteng Jin, Xu Cheng, Zeyang Tao, Chiyu Zhang, Hongxiang Tan
University of Illinois at Urbana-Champaign
Master of Science in Financial Engineering


Abstract

The default of AIG and the subsequent government bailout during the 2007-2009 financial crisis
is still frequently mentioned and discussed today. It was the first time people got to know that the
previously cryptic OTC derivatives market, especially credit default swap (CDS), could impose
such an impact on the global economy. Regulators, along with financial institutions are still
trying to take measures to prevent the story from happening again. In this paper we firstly
analyze the impact AIG-FP defaulting on the CDSs it wrote and the moral hazard associated with
the US government making AIGs counterparties whole and elicit implications for the financial
system from such a precedent. Then we develop a method for hedging CDS instruments in
general and adapt several models to determine appropriate reserves for both writers and buyers
of CDS. In computation of the reserves, we attempt to take into account factors which were
neglected in the models devised before the financial crisis but constantly reignited afterwards.
Finally we come up with a method for establishing capital requirements for CDS instruments
from a regulators perspective based on the newly introduced Basel III rule.




Part I. Implications of the Crisis
Over the last five years, one of the most prevailing topics in the global financial world is the
meltdown of AIG and ensuing regulatory reforms concerning OTC derivatives markets. On
September 9, 2008, the Federal Reserve Board (Feb) announced that the NY Fed with the help of
Department of the Treasury, had been authorized to launch a Fed Credit Facility to bail out AIG
by providing a line of credit of up to $85 billion and requiring AIG to issue so-called Series C
Preferred which entitled the government to hold 79.9% of stake of AIG. When clarifying the
reasons of a bailout, the Fed stated that in current circumstances, a disorderly failure of AIG
could add to already significant levels of financial market fragility and lead to substantially
higher borrowing costs, reduced household wealth, and materially weaker economic
performance.
Since the bailout was initialized, skepticisms had been raised about whether the governments
step-in to bailout AIG, whose failure is caused by AIG-FP, one of subsidiaries of AIG, defaulting
on its obligations to post collateral on the credit default swaps (CDS) it wrote to various
counterparties on multi-sector CDOs, is necessary. From our perspectives, however, bailing AIG
out is a considerate decision as the fallout of AIG can be a trigger to not only the collapse of
derivatives market, but also the malfunctioning of entire financial system.
Due to AIGs scale and interconnectedness to plenty of counterparties, the bankruptcy of AIG
could give rise to a cascading set of domino effects. According to Gerry Pasciucco, who was
invited to lead AIG-FP after the bailout with the task of unwinding its business at minimum cost,
Financial Products had $2.7 trillion worth of swap contracts and positions; 50,000 outstanding
trades; 2,000 firms involved on the other side of those trades. In addition, AIG Group, the
guarantor of obligation of AIG-FP, provided insurance to a large number of entities and had
more than 74 million policyholders worldwide. All these facts underscored the pivot role AIG
played in the financial system. Therefore once AIG-FP had gone default on the CDSs, though all
its counterparties would mitigate some of the potential losses by seizing collateral posted by AIG
or gaining from hedges against AIG, it would be costly for them to replace the contracts because
of the widening credit spreads, soaring borrowing cost, falling valuation of associated assets and
the lack in liquidity as so many firms would be seeking CDS sellers simultaneously, while the
European banks using CDS for regulatory capital relieve purpose would have been faced with
tough equity capital requirements from regulators and multiple downgrades, which would further
exacerbate the fragility of many financial institutions.
Furthermore, when analyzing the impact of AIG-FP defaulting, the consumer expectation, or
confidence, which could be the essential powder hose to a widespread catastrophe, is such an
important factor that cannot be neglected. Once the government had stood by in both Lehman
Brothers and AIG cases, U.S. consumers would have been likely to lose faith in governments
ability to stabilize the financial system and expect the imminent bankruptcy of other Wall Street
behemoths. The denting of consumers confidence might lead to their run to withdraw from
insurance policies and even savings account, which would have created an unstoppable turmoil
in U.S. and global markets, making the government not even able to afford the unpredictable
consequences.
Though government bailout was imperative, it would, as many have complained, cause moral
hazard in enormous financial institutions. Knowing that their losses on AIG-FP defaulting would
be paid by government even without a discount and their bankruptcies were beyond the tolerance
of government, the enormous banks would be spurred to advance irresponsible and predatory
lending to borrowers with lower credit records for a higher profit margin, ease off internal
control on loan approvals, and purchase CDS to transform the highly risky assets to somewhat
risk-free assets so as to evade capital requirements. In this case, risky lending, represented by
subprime mortgage loans, bulged to an unprecedented level, making the entire financial system
vulnerable to an unexpected prevailing macroeconomic downturn.
In order to prevent this kind of disaster from happening again, we have to learn from the
implications of the event, and regulatory reform along with improvement on companies internal
risk management system is imminent.
The uppermost implication was that the OTC derivatives market could no longer be opaque and
unregulated. Apparently, many experts and practitioners perceived the enactment of the
Commodity Futures Modernization Act of 2000 (CFMA) which exclude any security-based
swap agreement between eligible contract participants, including CDS, from the definition of
security as the root cause of the crisis. Exempt from both security and insurance regulations,
CDS and even naked CDS boomed in volume while regulator had no information about
contents and terms of the contracts to assess associated risk. It can be seen from the precedent of
AIG that, notwithstanding its effectiveness in hedging credit risk, CDS itself might result in
disruption in financial markets without careful monitoring.
In order to solve the problem, the regulation gap should be patched and sizes of those too big to
fail financial institutions should be trimmed to prevent them from posing systematic risk to the
entire market, which has been accomplished to some extent by the introduction of Dodd-Frank
Act along with the recently completed Volcker Rule and the Basel III Rule, combined with the
establishment of central counterparties for derivatives contracts. Based on these efforts, national
regulators including SEC and CFTC have to take the responsibility of implementing the rules
strictly and imposing recordkeeping and reporting requirements on OTC derivatives participants
for proper intervention when potential risk mounts to a certain level.
Besides, it can be implied from the AIGs failure that financial institutions have to build up
efficient and comprehensive internal risk assessment and management systems as credit ratings
and venerated computer models had been proven to be unreliable. Subjective judgments, in some
cases, have no substitutes. Regarding AIG-FP, since it was initialized in 1987, a culture of
skepticism had been developed with everyone in the company keeping criticizing and double-
checking other peoples positions to make sure that significant risk had been hedged and a
committee examining all transactions daily as managers knew that AIGs AAA rating was the
backbone of their success, until Hank Greenberg was forced to step down in March 2005.
From then on, AIG-FP had sold much more CDS on super-senior tranches of collateralized sub-
prime mortgage obligations (CMO) but the no one in the company conducted full inspections
into the components of the CMOs and the computer model failed to take into account the
possibility of AIGs downgrade as well as the sudden nationwide crash of housing market.
Consequently, there is no doubt that a new model including more risk factors and liquidity
concerns is in urgent need to quantify the enterprise-wide risk, based on which risk officers are
supposed to devise hedging strategies and compute the cash reserves they need to protect the
company from meltdown in an unexpected future turmoil in global markets.
In following parts, we will discuss measures to hedging CDS instruments and models to
determine the amount of reserve buyers and sellers should hold respectively, and the appropriate
capital requirements for regulators to impose on these instruments.

Part II. Hedging CDS Instruments
As indicated in the default of AIG-FP, the enormous notional amount of unhedged CDS
positions can be devastating during financial distress when borrowers tend to default
simultaneously. Therefore hedging against the positions is essential for the writer to survive in an
economic downturn. Mortgage Real Estate Investment Trust (REIT), which is funded like a
stock on the exchanges and invests principally in real estate, has been proven to be an effective
instruments for hedging CDSs on mortgage backed securities (MBS). Chyi Lin Lee and Ming-
Long Lees (2012) empirical results show that REIT futures outperform other hedging
instruments with a greater risk reduction found in stock, interest rate and foreign currency futures
contracts. In addition, S&P 500 index ETF, which is often regarded as representing the
performance of the market can be a general hedging tool for CDS instruments, including CDSs
on MBS. In the rest of this part we attempt to use S&P 500 index EFT to hedge a short position
in the general CDS index.
To begin with we assume that when a CDS (P) is written, of another instrument (Q) should be
sold to hedge risk caused by fluctuations of the spread, which is associated with the market value
of the underlying assets, where is called hedge ratio.
Mathematically, the hedge ratio defines the spread and can be given by the following time series
equation:


Where S
t
is the spread at time t, is the hedge ratio, and q
t
and p
t
are the prices for Q and P
respectively at time t.
As for the computation of hedge ratio, we employ the Total Least Square (TLS) model as the
results from this algorithm is reasonably symmetrical compared to others.
\Here we suppose the regression model is as follows:
Y=
0
+
1
X
Instead of minimizing the sum of vertical distances between the regression line and actual data
points, we attempt to minimize the sum of perpendicular distances R
i
, which we can write as:


Where we have identified the slop
1
=tan
So we need to solve the equation
Minimize: R(
1
,
0
)=


For the TLS solution:


Where

]
Initially, the returns on the unhedged and the hedged portfolios are calculated as:
R
u
=S
t
-S
t-1
And R
h
= (S
t
-S
t-1
) h*(F
t
F
t-1
)
Where R
u
and R
h
are returns on the unhedged portfolio and the hedged portfolio, respectively. F
t

and S
t
are logged price of CDS and hedge instruments at time period t, and h*is the optimal
hedge ratio.
Besides, the variances of the unhedged and hedged portfolios are calculated as:
Var(U)=


And Var(H) =


Where Var(U) and Var(H) represent variance of unhedged and hedged portfolios,
s
and
f
are
standard deviations of the CDS and hedge instruments, respectively. s,f represents the
covariance of the two serials. The effectiveness of hedging can be measured by the percentage of
decrease in variance of the hedged portfolio relative to the unhedged portfolio. The decrease of
variance can be computed as:
(Var(U) Var(H))/Var(U)
Thus we can check the hedge effectiveness by looking at the returns and variance over in-sample
and out-of-sample hedge period of 5, 10, 20 days.
We use the price data of Markit CDX North American Investment Grade Index and iShares Core
S&P 500 ETF (IVV) from 3/20/2009 to 28/10/2013 to calculate the hedge ratio.
Through our regression, we get the hedge ratio -0.1779, which means 0.1779 shares of IVV
should be sold for every CDS written.
To judge the hedge effectiveness, firstly we use next 5 days out-of-sample data to calculate the
returns of hedged portfolio and unhedged portfolio respectively.
From the table above, we can see that the return of the hedged portfolio is higher than the
unhedged portfolio.
We also check the variance reduction of the hedged portfolio and found that the hedge ration
from TLS provides approximately 90.87345% variance reduction, which indicates that the hedge
provided by the S&P 500 ETF is effective.

Part III. Reserve for writers and buyers
In our model, we attempt to account in factors that were revealed to be devastating if ignored
during the financial crisis, including the significant disruption in the market and the credit
downgrade of the CDS writer. What we consider here is the reserves for a CDS written on non-
truncated RMBS, and we abandon any external rating-based approach due to the failure of credit
rating agencies to precipitate the collapse of housing market in the financial crisis as well as
regulatory concern.
Once a CDS contract is set, we are able to extrapolate the default probability of the underlying
assets from the credit spread with a no arbitrage approach. Suppose the probability of a default
happening at maturity T is p, risk free rate is r, credit premium provisioned in the contract is s
and the premium is paid every T/K period of time, recovery rate given default is R.
The premium leg is


The protection leg is


By setting Premium leg = Protection leg, we can get


which is the average default rate of a single loan in the underlying pool.
According to the Gaussian Copula Model (Vasicek. 1987) we can simply assume that correlation
between any pair mortgage loans in the MBS is . We then set the confidence level as X, which
is usually 99% or 99.9%, and the percentage of loss as , then
(


)
For the seller of CDS, it should also hold reserves cover the potential collateral call from its
counterparty once it is downgraded. As credit rating is abandoned in our model, we assume that
in the CDS contract, the seller is required to post a certain amount of collateral (C) if its leverage
ratio increases to a certain level, that is, the total asset of the seller falls below its total liability
multiplied by a constant, a. We can derive this probability using Mertons model proposed in
1973. According to Merton,


and the probability of asset falling below a certain percentage of liability can be represented as

, where

is


In the formula, A is the assets of the seller, L is the liability, and is the maturity of the contract.
Thus, the reserve of the seller, assuming no initial margin posted, can be computed as follows:


Where N is the notional amount of the contract and

is the probability of a collateral call,


which equals

.
On the other hand, the buyer of CDS should also hold some reserves to protect itself from the
sellers default. Here we assume that the seller establishes a special purpose vehicle (SPV) which
specializes in transacting in CDS. We also assume that the SPV takes all of the available liquid
assets of the seller, which is the proportion of liquid assets that is still left after all liquid
liabilities are paid off, and the liability side of the SPV is the credit VaR computed above. Since
the seller is regarded as default if it cannot liquidate its assets to post additional collateral, we can
use Merton Model here for the SPV, and the default probability of the SPV, also the seller, is
represented as

, where

is:


The default rate associates the default probability of the protection seller to the extent of loss of
the underlying assets of the CDS. Thus the reserve for the buyer is



Part IV. Capital Requirements
When AIG-FPs positions in CDS contracts were made public, it shocked the world with the
leverage it had built up, as this relatively little subsidiary of AIG, entered into $562 billion of
CDS contracts, which in notional amount was more than half of total assets of AIG. That
prompted regulators to realize the fact that off-balance-sheet transactions, especially credit
derivatives had soared to an unprecedented and even uncontrollable level, and the importance of
enforcing tougher regulations on these transactions cannot be stressed more. Moreover, among
all the CDS written by AIG-FP, more than 70%, or $379 billion was written for European
financial institutions for the purpose of regulatory capital relieve other than risk mitigation,
adding to the volume, and also volatility of CDS market, hence nudged regulators to establish
stricter capital requirement for these instruments to rein in such kind of activities.
In response to the shortcomings of previous regulatory framework, the Basel Committee for
Banking Supervision (BCBS) revised Basel II Rules and released a new framework, known as
Basel III, in order to strengthen the resilience of banking system by increasing the amount,
quality and coverage of capital in 2010. Basel III establishes a set of firm-wide capital
requirements including 4.5% of Common Equity Tier 1, 6% of Tier 1 Capital, 8% of Total
Capital, 2.5% of capital conservation buffer and a countercyclical buffer ranging from 0 to 2.5%,
relative to risk-weighted assets.
As for CDS, determining the credit capital charge is much more complex. Under an internal
ratings-based approach (IRB), the critical part of this process is to determine a stressed
counterparty credit exposure simulated with data in significantly stressed scenarios, which entails
a downgrade of the credit rating of the institution, partial loss of the access to unsecured funding,
significant increase in the secured funding haircuts, and increases in collateral calls concerning
the derivatives contracts. No that a precedent exists, data during the 07-09 financial crisis can
also be employed. After simulation, the value corresponding to a tail event, say a confidence
level of 99.9% is selected to represent the credit exposure for the computation of capital charge.
In addition to the capital charges for counterparty credit risk, Basel III also a capital charge to
cover the risk of mark-to-market losses on the expected counterparty risk, known as credit value
adjustments (CVA) to OTC derivatives which would provide institutions with some liquidity
relieve during financial distress, while the transactions with a central counterparty (CCP) are
exempted from this provision.
Hence, according to arguments above and pursuant to real world rules completed by Basel
Committee, we can derive the following formula for the computation of capital requirements:


Where

is the credit risk charge for ith CDS contract, 10.5% is the minimum capital level
plus conservation buffer, 2.5% represents the maximum countercyclical buffer.

is a unit
variable ranging from 0 to 1 which equals 1 in periods of excessive credit growth and equals 0 in
periods of credit crunch.

is the stressed credit exposure and

is the risk weight assigned


to exposure, which is determined by the institutions internal model based on the riskiness of
underlying assets and the credibility of counterparty.

is the mark-to-market capital


valuation charge, and

is also a dummy variable which equals 1 if the counterparty is a CCP


and vice versa. This formula can be employed to determine credit capital charges for both the
writer and buyer of CDS who can select different risk weights as the writer is more exposed to
the default of underlying assets while the buyer is more exposed to the default of the writer in
this case.
Part V. Conclusion
The 2007-2009 financial crisis, especially the case of AIG default is an important lesson for all
of us. The volume of the OTC derivatives market and the interconnectedness of the Wall Street
behemoths are both beyond everyones expectation. Notwithstanding its damage to the global
economy, the crisis provided us with some important implications for building up a more healthy
and mature financial system, which is characterized with more transparency, comprehensive
regulations and effective risk management. The recent regulatory progress, including the
completion of Volcker rule, reflects that we are heading toward a right direction.
In this paper, we devise a general hedging method of short selling S&P 500 EFT for the writer of
CDS instruments, which is manifested to be effective with our data sets. In addition, the risk
control can also be accomplished by holding reserves computed through Merton Model and
Gaussian Copula Model. Our computation of reserve also factor in both the economic downturn
and the credit downgrade of seller, which AIG-FP failed to consider in its internal risk
assessment model. In real world, the party in the transaction can balance between hedging and
reserve, based on factors such as transaction costs, liquidity conditions, interest rate level, to
minimize its cost incurred for the risk management.
Finally, we also propose a method of establishing capital requirements for the CDS instruments
from a regulators perspective, which underscores the importance of stress tests.
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