Answer

  A credit default swap (CDS) is a financial contract between two parties. The CDS, in this case, is a financial derivative that allows one party, the investor to transfer his credit risk from another investor in the market to another person. CDS are commonly issued to transfer credit risk exposure on fixed assets in the market and are often maintained by regular premiums such as those of an insurance policy. For instance, if a lender has borrowed out his money to another business person in the market, but due to the prevailing circumstances in the market, he/she feels the borrower is likely to default in the loan given to him, the lender can transfer the default risk through CDS to another investor in the market. The investor who accepts to take the risk is liable to make full repayment of the debt should the borrower fail to meet his financial obligation to the lender.  However, the borrower, on the other hand, pays premiums to secure the CDS to the new investor before the credit period of the borrower elapses.

 In real life, CDS works as follows; an investment bank issues a loan of $1,000,000 to a building contractor to be rapid in 5 years.  The investment bank because of the value of the credit decides to secure it with a CDS from a hedge fund in the market at an interest rate of 4% for the duration of the contract. In this arrangement, the investment bank will pay the hedge fund $40,000 yearly until the term of the contract expires.  If the building contractor pays back the money within the five years, the hedge fund company makes profits. However, if the building contractor fails to repay the money, the hedge fund pays the entire debt to the investment banker.  Therefore, in a credit default swap, the party taking over the liability of the loan bears the greatest risk. The value of the interest rate paid varies depending on the level of risk involved in the transaction; the higher the value of debt, the higher the risk and the higher the interest rate.

AIG role in Mortgage securitization

American International Group (AIG) played a crucial role in mortgage securitization in the market.   Mortgage securitization is the process of pooling mortgage loans that have similar characteristics and selling them off in a secondary market (Kruger, 2018). For instance, a lender such as a bank issues a client a mortgage of $400,000 at an interest rate of 5%. In this arrangement, the lender will only receive back his capital plus the interests. However, through mortgage securitization, the lender can sell the loan to another investor and recycle the $400,000 thus making more money. These types of transactions are lucrative but have a risk of default should the property market suffer a hit. AIG’s main role in mortgage securitization was to reimburse the super senior should there be a default in the mortgage securities sold in the secondary market.  AIG was supposed to honor the CDS it had acquired to take the risk of Goldman Sachs. The company had a lot of financial resources and had profited for several years on CDS it had bought in the market. However, the collapse of the housing market made them receive huge invoices from companies such as Goldman Sachs to the tune of $1.8 billion as collateral for the CDS it had with AIG because mortgage owners were defaulting on their loans and the prices of the mortgages had fallen below market to market prices in the contract the two parties signed.

The Risk of BBB Tranches

  In the spectrum of credit quality, BBB tranches are in the middle of the spectrum. They are the second secure credit after the equity tranche. In the first layer of securitization, BBB tranches are risky as they can easily be wiped out. In a collateralized debt obligation (CDO), BBB tranches start to suffer loses after the equity tranches have been wiped outs since they are the first line of protection.  For instance, in a CDO, mortgage-backed security rated BBB can easily be wiped out by just 3-5% of the loss in value of the underlying asset. This, therefore, makes BBB rated tranches extremely risky since a little loss margin in the underlying security makes them extremely worthless.

Risk of super-senior tranches in the second layers

Super senior tranches in the second layer have significantly lower risks in the market. According to Jobst (2016), data gathered over the years on the nature of corporate defaults shows a significantly lower number for super senior MBS. This, therefore, means the loss on super senior is less likely to happen. The stability of this tranche enabled AIG to profit from it for several years.  However, the market is dynamic and keeps changing. Even super senior tranches are not entirely excluded from suffering losses. Even though the losses are unlikely and the tranches are less risky, they can also lead to significant losses as was the case of AIG. These tranches are made of BBB rated bonds which are lower level bonds in term of credit rating. The bonds are risky and their value can easily be wiped out by slight changes in the value of underlying assets. This correlation makes superior senior tranches not excluded from market risks. Therefore, although they are less risky as compared to BBB tranches, super senior tranches are also exclusively shielded from risks as AIG came to realize.

Risk assessment of super-senior tranches

Super senior tranches were viewed to be of low risk in the financial market. This view was created because of the following reasons; first, they are backed by layers of lower level tranches that have to be wiped out before their value is affected. For instance, they are backed by equity tranches and BBB tranches. The value of all these tranches have to be reduced significantly and become worthless before super senior tranche is affected in the market. Secondly, they could easily be insured by a monoline insurer through the use of CDS as a derivative. The insurers liked super senior trenches because they were cheap and were almost a pure source of profits because they never imagined a day when they would have to make the actual payments for the debts insured through the CDS.  These factors made super senior tranches to have a favorable risk assessment in the market.

 AIG’s counterparts were justified to ask for collateral because the risk assessment proved to be wrong in the actual market. The value of all the underlying tranches that were protecting the value of the super senior had been rendered worthless by the reduction in the prices of underlying assets, which were the price of the houses in the market. A small reduction in the price of the underlying assets wiped out the equity tranche and soon after the BBB tranche. This left the super senior exposed to market changes. Its value dropped below the contractual agreement necessitating the counterparts to ask for collateral on the CDS

 Lessons learned

AIG’s CDS experience teaches financial service providers and investors like me to have a cap of the risks they can take.  Financial derivatives traded in the market cannot be without risks. It is imperative for managers and investors to understand the underlying risk in every financial derivative in the market.  AIG assumed the super senior tranches had significantly low risk because of the number of years they had profited from trading in CDS. This assumption bankrupted the company necessitating a bailout. It is therefore imperative for managers and investors to accept risks that their companies can shoulder and reduce reckless uptake of risks as was seen in the case of AIG with its CDS trade.