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Case Summary

Alan Frost, the executive vice president of AIG Financial Products had received a disturbing email from Andrew Davilman at Goldman Sachs in the evening of July 26, 2007. The next day, the company served AIGFP with an invoice for the collateral, which was worth a value of $ 1.8 billion on the notional value of the credit default swaps of $ 20 billion that were related to the housing market. All the securities that were underlying the CDS were plummeted because of the decline in the market as the homeowners defaulted. Until this point, the management of AIGFP had thought that the prospect of every having to pay up for the CDS had been virtually nonexistent. Therefore, we need to perform the detailed analysis to determine that whether AIGFP had underestimated the risk and whether Goldman was right in asking AIG for more collateral for their super senior tranches.

Analysis

First, we begin with a description of the credit default swaps and its features.

Credit Default Swap and its Features (Q1)

A Credit Default Swap (CDS) is a financial agreement between two different counter parties where the protection seller of the CDS compensates the protection buyer of the CDS if in case the issuer of the bond is unable to make the regular scheduled premium or fee and defaults on these payments. A CDS acts as an agent. The whole CDS contracts is defined on the basis of range of different factors such as list of credit events, a reference entity, notional amount, reference obligation and the terms of maturity.

The protection seller’s payment is triggered by the list of the credit events that are agreed in advance when the CDS agreement is made between the counter parties. Some of the most common credit events that can trigger the seller’s payments are restructuring, moratorium, repudiation, obligation acceleration, failure to pay and bankruptcy. When the credit event occurs then there are two different types of the settlement, which are cash, and physical settlement.

When the protection buyer delivers the bonds to the protections seller in exchange for the full face value in cash then it is called as physical settlement. When the parties hold an auction to determine the bond prices then it is called as the cash settlement. It would be then obliged on the protection seller to deliver the complete cash with its face value less the current value as determined by the auction to the protection buyer. In this way, the protection buyer would be able to deliver the bond and get the full face value of the investment once the bankruptcy proceedings have been held.

Numerical Example of Replication Strategy & Cost of CDS (Q2+Q3)

In order to illustrate the given numerical example of a CDS, let us assume that a CD has been bought by firm A from firm C on firm B. This CDS would provide an insurance cover to firm A and firm A will have to pay a periodic fee to C in return for this cover, until the maturity of the CDS when it would be expired. However, if firm B defaults in between this time, then firm A will get the right to sell all the bonds that have been issued by B to C at a par value.

At this point, the contract would be terminated. The buying of the CDS can also be considered as a hedge against the credit risk of B if all the bonds are actually owned by A that B has issued. According to the above numerical example, the loss in case 1 if the company B defaults before maturity would be $ 1.25 for the 3-month period. The mapping of the cash flows is shown in exhibit 1 in the appendices. The cost of the credit default swap to the buyer would be 0.499% as shown in exhibit 1 and computed in the excel spreadsheet.

FROM FREE LUNCH TO BLACK HOLE Harvard Case Solution & Analysis

Tranching process & role of super-senior counter party (Q4)

a).The Bistro deal the bank would originate a portfolio of loans and buy credit protections for this portfolio from J.P. Morgan via a CDS. On the other hand, credit protection was bought by JP Morgan on the other hand bought credit protection on this portfolio of the loans from a special purpose vehicle, which was a shell company that had been set up by JP Morgan only for the purpose of this BISTRO transaction.....................

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