Aig Bailout

Can We Expect A Regulated CDS Market?

Derivatives Project

Xilin Yang (Celine)

Introduction

The article introduces credit default swaps and explores the problems of the credit derivatives. By analyzing the AIG’s bailout, the article describes the regulation gap in the CDS market and states the regulation reform after the crisis. Part I is background, generally introduces the Wall Street crisis. How it happened? What consequence it has? Part II is mainly about AIG’s CDS business: how AIG got involved in the crisis and why the biggest world insurance company suddenly collapsed. Part III is about credit default swaps: definition, construction, and problems. Part IV is concerned on the regulation reform after AIG’s failure.

Wall Street Crisis

Speaking of the Wall Street crisis, people all know it proceed from subprime crisis. The relatively low interest rate prompts banks to issue large amount of housing loans. To transfer default risk embedded in those loans, investment banks package those loans and mortgages into student loans, car loans and credit card debt, which form the so-called collateralized debt obligation (CDOs). All these derivatives depend on the housing loans. In the era of low interest rates, house prices rise rapidly and promote the rapid development of the housing loans business. With steady stream of housing loans into financial derivatives products, different ranks of products are packaged to sale out. The good view of economy makes those potentially risky CDOs popular with retirement funds. Lenders didn’t care anymore about whether a borrower could repay; the investment banks earned more money on selling more CDOs; the rating agencies had no liability if their ratings of CDOs prove wrong. Everyone in this securitization food chain made money. Ever one was happy until the market for CDOs collapsed.

By 2008, home foreclosures were skyrocketing, and the securitization food chain imploded. In March 2008, the investment bank Bear Stearns ran...