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WHAT IS CREDIT DEFAULT SWAP?A Credit Default Swap (CDS) is A contract Where a buyer pays a payment to a seller to take on the credit risk of a third party. In exchange, the buyer receives the right to a payoff from the seller. If the third party goes into default or on the occurrence of a specific credit event named in the contract (such as bankruptcy or restructuring).

An ExamplePerson B (Borrows Money from A)Person A (lends money to B & enters into a contract with C)Person C (takes on the credit risk of B)Now, imagine two situations Situation A: Person B pays back Rs. 1000 to person A. Since person B has not defaulted, the transaction ends between persons A & B, and also between persons A & C.

Situation B: Person B defaults in his payment to person A. Now, according to the contract between persons A & C, It becomes the obligation of person C to pay back Rs. 1000 to person A.

ThereforeThis contract, which:Transfers the credit risk from one person to anotherIs exercised when one party defaults in its paymentConsists of a swap of a buyer and a seller (in our example, person A is a seller to person B and a buyer to person C)is called a Credit Default Swap.

F A L L E N G I A N TCase Study of American International Group, Inc.O V E R V I E W

American International Group, Inc. (AIG) is a world leader in insurance and financial services.

It is headquartered in New York City, and operates in more than 130 countries and jurisdictions.

Its primary activities include General Insurance and Life Insurance & Retirement Services.

In 2006, AIG had sales of $113 billion and 116,000 employees.

According to the 2008 Forbes Global 2000 list, AIG was once the 18th-largest public company in the world.

It was listed on the Dow Jones Industrial Average from April 8, 2004 to September 22, 2008.

AIG's common stock is listed on the New York Stock Exchange, as well as the stock exchanges in Ireland and Tokyo.

London, England

AIG Building, 70 Pine St., Lower ManhattanAIG faltered in Americas sub-prime mortgage crisis. It had traded heavily in credit default swaps and could not meet its obligations. The United States government came to its rescue with an $85 billion bailout on September 16, 2008.O V E R V I E WH I S T O R Y

Greenberg was fired due to accounting scandal in February 2005, and was succeeded as CEO byMartin J. Sullivan.On June 15, 2008, Sullivan resigned and was replaced byRobert B. Willemstad, Chairman of the AIG Board of Directors.Willemstad was forced by the U.S. government to step down and was replaced by

Edward M. Liddy on September 17, 2008.

SEPTEMBER 2008

AIGs credit ratings were downgraded below "AA" levels, causing the company to suffer a liquidity crisis.

The United States Federal Reserve Bank created an $85 billion credit facility to help AIG meet increased collateral obligations, in exchange for stock warrants worth 79.9% of the companys equity.

H I S T O R YMARCH 2, 2009

AIG reported a fourth quarter 2008 loss of $61.7 billion.

The announcement of the loss had an impact on morning trading in Europe and Asia, with the FTSE100, DAX and Nikkei all suffering steep losses.

In the U.S., the Dow Jones Industrial Average fell to below 7000 points, a twelve-year low.H I S T O R YF I N A N C I A L C O N D I T I O N Sales17.53 Bil Income -97.25 Bil Net Profit Margin -557.83% Return on Equity-155.05% Debt Equity Ratio4.09 Revenue/Share130.87 Earnings/Share-720.86 Book Value/Share340.12 Dividend Rate0.00 Payout RatioN/AAIGCURRENT FINANCIAL HIGHLIGHTSfrom MSN Money, July 20, 2009.

One of the largest (Star) hedge fund at that time: Founded in 1994, go bankrupt in 2000$1.28 trillion off-balance sheet worth of Asset Under Management (AUM)Stellar performance: 21% first year, 43% second year, 41% third yearKey people: John W. Meriwether (founder Famous Wall Street Bond trader) Myron S. Scholes and Robert C. Merton (shared 1997 Nobel Prize in Economic Sciences for discovery of Black-Schole model)David Mullins (later become vice chairman of the Federal Reserve) Due to the reputation of its managers, LTCM was able to raise impressive funds in very short period

About Long Term Capital Management (LTCM)LTCMs Failure Key FactorsTaking highly leveraged positionsDue to LTMCs reputation, most banks waive the margin requirement for LTMC transaction of securities, taking long/short positions. LTMC was able to take a more leveraged trading positionLTCM Investment StrategyRelative value Arbitrage based on Credit spread & Equity VolatilitySeeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securitiesModel Risk, LTMCs Risk & Return AssumptionAssume that risk premium (the difference in yield between risky and risk-free securities) tended to revert to historical level. Assume that volatility of equity options tended to revert to long-term historical level.

Unexpected and Extreme eventsAugust 1998, Russia defaults on it debts, Russia Interest Rate soaring 200%, Crushing Value of Ruble. Increase interest rate, risk premium and market volatility unexpectedly LTCM lost 44% of its capital in 1 month due to Cash flow crisisForce to liquidate position to meet margin calls due to sharp divergence of asset prices.Prices in Relative value arbitrage strategy can diverge and create temporary losses before they ultimately converge. If LTCM have enough funds to withstand the Cash Flow Crisis, The hedge fund will ultimately gain profit in the long-term (when prices converge)

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):$1.6 billion in swaps$1.3 billion in equity volatility$430 million in Russia and other emerging markets$371 million in directional trades in developed countries$286 million in equity pairs (such as VW, Shell)$215 million in yield curve arbitrage$203 million in S&P 500 stocks$100 million in junk bond arbitrage

The Subsequent BailoutWall Street feared that the downfall of LTCM could have spiralling effects in the global financial markets causing catastrophic losses throughout the financial system. Goldman Sachs, AIG and Berkshire Hathaway on September 23, 1998 offered to buy out the funds partners for $250 million and decided to inject $3.75 billion and to operate LTCM within Goldmans own trading division. The final bailout was $3.65 billion.