Innovation-Fueled Crisis and Innovative Bailout in Global Financial Market, 2008

1. Int’l Business Yee-Tien Fu NCCU Disappearing Act Las Vegas home prices peaked in 2006, so do home prices in general in the States. Get Money’s Worth from Distressed Assets. Only to See their Own “Tickers” The time when investment firms selling CDS of other companies see their own CDS market value (insurance premiums) surge, i.e., approach default or bankruptcy. Of course, if the insurer bankrupts, all the CDS issued by them loses all the value. Innovation-Fueled Crisis and Innovative Bailout in Global Financial Market, 2008 Figure 3: The Fed was proposing new curbs on sub-prime lending, but the market was dwindling. Source: WSJ. Credit Default Swap: An Innovation The investor owns the reference asset [mortgage-backed security], which was issued by XYZ. The investor buys a credit default swap and pays 40 basis points per year in exchange for the swap writer’s payment in the event of a default by XYZ. [i.e., investors bet on the potential failure of XYZ for claims, if insurer survives to pay.] In theory, no limit on the amount of default swaps that can be created. Figure 6: Only to see their own “tickers”. Source: IHT. How Does a Synthetic CDO Work? Managers created so-called “synthetic” CDOs, in which the portfolios consisted of credit-default swaps (CDS). Figure 12: Reverse Auction scheme. Source: WAJ & IHT. Shorten Recovery Time With Liquidity Now International coordination and orchestrating, known as mushrooming or bambooing, are observed for the first time in the global bailout effort. In 2008, the CDS market ballooned to 54.6 trillions, when world GDP was at 54.3 trillions. Figure 88: Fed Weighs Its Options as Europe Cuts Rates. Source: WSJ. Figure 7: Synthetic CDO (an insurance) Source: McDonald and Economist. Figure 5: Depiction of the cash flows in a credit default swap. Source: McDonald, Derivatives, 2008. 1212 2008 Taipei, Taiwan, ROC