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Protection
The buyer gets ‘protection’ on credit risk of the issuer. The seller acts as an insurer for the notional value of the CDS. The seller gets the premium and that is the maximum revenue that the seller of the protection gets.
Credit risk
The credit risk forms the subject matter of this insurance contract. ISDA enlists certain events as credit events, the occurrence of which triggers the termination of the contract.
Bilateral contract
The CDS contract has two parties the buyer of protection and the seller of protection. The contract is done over-the-counter (OTC).
Reference entity
The Issuer of the fixed income security on which protection is bought and sold is known as the Reference entity. The Reference entity could be a corporate entity or it could be a ‘Country’.
Reference Obligation
The specific security on which the protection is bought and sold is known as the ‘Reference Obligation’. The terms of the reference obligation are spelt out in the contract – for example, senior, senior-secured, senior-unsecured etc.
Protection buyer
The ‘Protection buyer’ pays a fixed premium on a quarterly basis to the protection seller and the premium is all that has to be paid by the buyer of protection. The protection buyer is the insured.
Protection seller
Effectively the ‘Protection seller’ is the insurer. The protection seller lodges a percentage of the underlying with the protection buyer as collateral for the transaction. This partially ensures that the protection seller is in a position to fulfill his obligation when the credit event occurs.
Credit events
The ISDA agreement specifies the standard credit events and the specific CDS contract will specify which credit events are covered in the particular contract.
Fixed income securities are issued by a company to raise debt financing. These are called corporate bonds and usually these bonds have a fixed coupon rate and a fixed maturity period usually 10 to 30 years. The coupon rates can also be variable and can be linked to any interest rate like LIBOR. An investor can subscribe to these bonds directly from the company at the time of initial issue or these can be bought from the secondary market. When an investor buys the bonds then the investor is subject to several kinds of risks as follows:
Interest rate risk
Fluctuations in the market interest rate will affect the market rate of the security. The interest rate and the market rate of fixed income security are inversely correlated. When the interest rate goes up, market rate of the fixed income security goes down and vice-versa.
Currency rate risk
Securities purchased in foreign currency are exposed to risk of fluctuations in foreign exchange rate. This will affect the effective yield of a security.
Issuer default risk
The issuer may default in the payment of interest and / or principal amount if the issuer faces liquidity crisis or files bankruptcy.
Issuer credit rating risk
The credit rating of the Issuer may undergo change and if it is downgraded the market rate of the security also will suffer to that extent.
An investor can take protection against each type of risk. There are hedging instruments available to cover the interest rate risk as well as currency risk. For the interest default or issuer bankruptcy risk the investor can buy protection and this form of protection is known as ‘Credit Default Swap’.
As per the press release issued by BlackRock, Inc., it confirmed that negotiations are ongoing with U.K.’s third-largest bank, Barclays Bank plc, about the potential purchase of Barclays Global Investors (BGI), including the iShares business. The negotiations are ongoing and there is no certainty that any transaction will be agreed upon or, if agreed upon, completed.
About BlackRock
BlackRock is one of the world’s largest publicly traded investment management firms. At March 31, 2009, BlackRock’s AUM was $1.283 trillion. The firm manages assets on behalf of institutions and individuals worldwide through a variety of equity, fixed income, cash management and alternative investment products. In addition, a growing number of institutional investors use BlackRock Solutions investment system, risk management and financial advisory services. Headquartered in New York City and has employees in 21 countries and a major presence in key global markets, including the U.S., Europe, Asia, Australia and the Middle East.
Foreword by Mr. T. N. Manoharan Former President of The Institute of Chartered Accountants of India
Accounting for Financial Instruments is a complex exercise in view of the varied kind of instruments that are emerging in the market in the recent past. The flow of funds across the borders in the form of financial instruments is ever increasing in the global scenario. Equity, Futures and Options have trade life cycle and accounting treatment on such life cycle from the front office and back office perspectives call for detailed elucidation. Hardly there is any book that provides guidance on these matters. This book is a commendable effort to fill the knowledge gap that exists in the accounting of financial instruments.
International Financial Reporting Standards (IFRS) encompassing IAS 32, IAS 39 and IFRS 7 deals with the principles involved in recognition, measurement, disclosures and presentation of financial instruments. The Institute of Chartered Accountants of India (ICAI) has come out with corresponding Accounting Standards (AS) viz., AS 30 on ‘Financial Instruments – recognition and measurement’; AS 31 on ‘Financial Instruments – Presentation’ and AS 32 on ‘Financial instruments – disclosures”. In sum and substance, the Indian Accounting Standards are the same as that of the relevant IFRS. This book deals with the principles laid down in the IFRS and in relevant places deals with similarities and differences between US GAAP and IFRS. In that sense, one can say without fear of contradiction, that this book is a comprehensive treatise of the title.
Mr. R. Venkata Subramani is a learned person, having immense knowledge and expertise on the matters dealt with in this book. The benefit of his hands on experience and in depth practical exposure is reflected in the illustrations given in the various chapters of this book. With the tremendous growth witnessed in the Investment Banking Institutions, Hedge funds and several other financial institutions, this book will become handy for understanding and capturing the entire trading process of the financial instruments. The author, Mr.R.Venkata Subramani, is also known as a ‘Technology wizard’. Consequently, the lucid exposition that he has adopted would help automating the system of proper accounting of the entire trade cycle of each of the financial instruments.
Investment bankers, financial institutions, dealers, brokers, professionals and other investors would find this book immensely useful in the day-to-day operations, as various concepts unique to the financial instruments are explained in this book besides laying down the accounting treatment in a detailed manner. This book will be a useful addition to any library, which serves as a source of knowledge and information with reference to various financial products dealt with in the market. Mr.R.Venkata Subramani has done a splendid job in authoring this book in order to share wealth of information and knowledge on the subject.
T.N. MANOHARAN
It is an innovative fund raising process which came into existence in the late 1970’s and has multiplied phenomenally over the years. The crux of the concept on which this process is based is the grouping or pooling of assets with predictable and pre-defined cash flows structure or rights on future expected cash streams and the re-engineering or re-packaging of such cash flows into financial instruments or securities that are then sold to investors. Such cash flows can accrue out of loans, trade receivables, mortgages, royalties etc.
The term “securitization”, itself is derived from the fact that securities are the final mode of financial instruments which are issued to investors to obtain funds.
As any asset with an associated stream of cash flows can be securitized the securities which result from a securitization transaction are termed as Asset Backed Securities and the transaction itself is termed an Asset Backed Securitization (ABS). With more such issuances being based on underlying mortgage based loans, Mortgage Based Securitization (MBS) became widely popular.
Once mortgage backed securities started flooding the markets, the banks and financial institutions also resorted to securitization of the pool of assets to shift the risk to investors in these securities as well as to obtain funds well ahead of the scheduled tenor of these assets. This implied that originators/issuers could repeatedly re-lend a given sum, greatly increasing their fee income and providing a multiplier effect of the underlying notional. Securitization resulted in a secondary market for mortgages, and the lenders were no longer required to hold them to maturity. With increasing securitization deals being struck, and the resultant transfer of default risk, the issuers lowered their underwriting practices to increase their loan disbursements.
The flair for securitization i.e. mortgage backed securities accelerated in the 1990s and total amount of mortgage-backed securities issued tripled between 1996 and 2007, to $7.3 trillion. Alan Greenspan has commented that credit crisis cannot be blamed on sub-prime mortgages alone, but rather on the securitization of such mortgages which created a notional far exceeding the actual value of the underlying assets actually available. The credit risk in sub-prime mortgages got passed on to other investors through the securitization mechanism and with a wide arena of investors globally, the impact of the credit crisis is felt on a global level.
During 2004 to 2007, further to the drop in interest rates, many investment banks opted to leverage on the situation as they found it beneficial to raise large amounts of debt at cheaper rates and invest in mortgage backed securities on the impression that housing boom will continue.
During the boom the traders in Wall Street were eying on the bonuses available end of year and not the long term impact on the firm or the market. According to the New York State Comptroller’s office, Wall Street executives have bagged in bonuses totaling @23.9 billion in 2006.
Though profitable during boom, it had adverse impact on such institutions during drop in housing rates and increase in mortgage delinquencies and foreclosures.
After an SEC ruling in 2004 which relaxed the amount that can be raised as debt by investment banks, debt issuances multiplied. Leveraging by top five US investment banks rose phenomenally to over $4.1 trillion for fiscal year 2007, which is about 30% of US nominal GDP of 2007. These were the 5 banks which crumble under the weight of the crisis. One of them viz. Lehman Brothers went bankrupt. Two of them viz., Bear Stearns and Merrill Lynch were sold of at dead low prices.
Two more viz. Morgan Stanley and Goldman Sachs converted themselves into Commercial Banks to avail financial support from the Federal Reserve succumbing to stringent regulation.
Lowering of interest rates in the early 2000s was taken up by the Federal Reserve to negate the effect of the Information Technology bubble earlier based on the premises that the rate could be lowered as long as the inflationary pressure was being kept low.
The low interest rates contributed to the housing bubble.
US government got more inclined towards the mortgage industry to make home purchases more favorable and ended up fanning the boom by relaxing lending standards of Fannie Mae and Freddie Mac.
This has increased the ownership in residential mortgages of the government sponsored enterprises viz. Fannie Mae and Freddie Mac to a staggering $5.1 trillion.
This assumes importance when looked at in relation to net-worth of GSE’s as of 30th June 2008 which was a mere $114 million which raises serious doubts on their ability to service their guarantees.