Credit risk management of CDSs, case from AIG Essay

Credit risk management of CDSs, case from AIG - Essay Example In regard to the bailout, AIG was presented with access to a $85 billion credit facility. In exchange, the United States government was presented with warrants for a 79.9% equity stake in AIG and the power to expel dividend payments to shareholders. AIG’s misfortunes started in a unit known as AIG Financial Products, which traded in credit default swap (CDS). A CDS acts as a safeguard against a default on assets that are connected to corporate debt and mortgage securities. The losses to AIG’s portfolio of CDSs were prompted by the disintegration of the subprime mortgage1 market. A groundbreaking amount of defaults by subprime borrowers with adjustable rate mortgages initiated the current catastrophe in the global financial markets in 2008. Most of these began in 2005 and 2006 when lenders remarkably loosened up on underwriting standards. Figure 4.2: Subprime mortgage originations Source: Bradford (2008) ‘The Subprime Mortgage Meltdown, the Global CreditCrisis and the D&O Market.’ Advisen : Productivity&insight for insurance professionals. The assumption was that homeowners would refinance prior to the monthly payments being readjusted, but decreasing real estate prices made it inaccessible for the majority of subprime borrowers who had hardly any or no equity in their houses to refinance. As they were incapable of paying the increased monthly payments, many borrowers had no choice but to default. Defaults in U.S. mortgages rose beyond record levels in the second quarter of 2007, and the fallout rapidly expanded all through the financial markets. The subprime mortgage debacle immediately brought forth the worldwide credit crisis. AIG is one of the financial institutions with credit default swaps business that was also affected during these circumstances. From then on, many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis. As those mortgage-backed securities2 and collateralized debt obligations3 became more or less valueless, abruptly that reputedly low risk event saw an actual bond default occurring on a daily basis. AIG sold CDSs were no longer taking in free cash. It had to pay out a large amount of money. The crisis at AIG is a â€Å"question of liquidity, not of capital†, according to ROB Schimek, EVP and CFO of AIG Property Casualty Group. Despite the fact that there have been a small amount of losses paid under the CDSs, contract provisions demand of AIG to post collateral in cash if the value of the assets underlying a CDS declines. At the parent level, AIG has approximately $80 billion in shareholder equity, though the majority of that is secured in the company’s insurance operations and cannot be converted to meet the collateral calls of the financial products unit. Since it did not have enough cash to meet the collateral demands, the company faced a liquidity crisis and bankruptcy protection. 4.3 What AIG actual did leaded the company go down 4.3.1 The undoing of AIG liquidity crisis AIG reported â€Å"an unrealized market valuation loss of $11.5 billion on [the] super senior credit default swap (CDS) portfolio† held by its subsidiary, AIG Financial Products in the annual report for 2007. The definition of CDSs was discussed in chapter 2.2. This initiated a drastic downfall and ended AIG’