 Hey guys, it's MJ and in this video, it's going to be quite interesting because we're going to be talking about Credit derivatives and more importantly the conspiracy around these instruments So yeah, this is going to be the conspiracy of credit derivatives Now remember this is me studying out loud. This is very much my opinion. It's not textbook. This is not a lecture It's me like I said studying out loud So yeah, think for yourself and feel free to disagree with me in the comment section below but we're going to be talking about credit derivatives and Maybe a little conspiracy theory that I have surrounding them Remember, I'm taking a very skeptical approach to finance. It's going to help me Tackle the concepts and help me learn and think about all these things that we need to know for the upcoming exams So credit derivatives We're gonna see they've got these weird names and this is where the conspiracies come around it's coming around their names So they're called stuff like credit default swap and There's also saying known as total return swap or credit spread option and This makes it quite difficult. Okay, this makes it a difficult area of finance because these names are Pretty much done. Okay, so the names are confusing But they're confusing for a reason well according to my conspiracy at least okay, and This is the word that I want to focus upon swap option derivative Okay, the way these things have been named is that they are derivatives all these exotic instruments And I think the reason for them calling them Using the language of derivatives swap option is for them to avoid Regulation not regulation totally but a very specific regulation Because what these things actually are is believe it or not their insurance and Insurance has a much difficult Sorry a much different set of rules and regulations in who can provide it to consulates and all these various things then derivatives I Think anyone can write a derivative or the the license to do derivative trading is Much less stringent than say insurance insurance is a much more heavily regulated financial service So what these guys are doing is they're gonna call their instrument derivatives when they're actually Insurance products and the reason why they're doing that is to get around regulation and allow them to do it But this causes a big problem because not only does it make us Confused as students trying to learn well, what is this whole thing? But it also has some dire consequences in the sense that you know the 2007 2008 credit crunch or world recession and It was pretty much these instruments did play a role in in the fall of the global financial markets and They weren't properly regulated because they were passed off as derivatives and not as insurance and The credit rating agencies like I was telling you guys in the earlier videos were totally fooled by the fancy mathematics that depended on really dumb assumptions like normality and Because empirical evidence shows that you know Financial data is more leptocurtic than normal leptocurtic is something like that Where you have fat tails and peaked whereas normal distribution is something more like that, so I didn't draw that very well anyway so the best way to understand credit derivatives is to realize that they are in Insurance now I don't know how much time we've taken just to talk about this very much introduction But it's important because what a credit derivative is is it's gonna make a payout if someone defaults and That is absolutely crazy. So let's maybe get a different color over here credit derivatives make a payout on A default So the idea is that when you have a bond okay when you have a bond it has credit risk as Well as a whole bunch of other risks The idea is that a credit default swap or something like that Strips this risk out and creates a new package or a new instrument around it. So let me explain let's say I am the bank and I lend money to Mr. Charlie I Lend him 100 grand and mr. Charlie is gonna pay back 10 grand every single day But there's a chance that Charlie might default if Charlie defaults The bank doesn't get this hundred grand and that's bad for the bank What the bank then does is they can buy an instrument from another bank That says well, you know what we will sell you Insurance because that's actually what this is so pay us a five-round premium and If this guy over here ever defaults, we will pay you 100 rent So pay us five-round and we'll pay you back the hundred rent the bank says well that's great because what we're doing is we're stripping the credit risk and So it might be saying five-round every single day or every time there's a payment So now instead of getting 10 round. We're only getting five round, but at a much lower risk and That makes a lot of sense in practice, you know insurance around these things except for the fact that people can now make money if Someone's defaulting because what happens is that? Another guy let's call him Jojo He might say you know what I really I like that their product. Let me also buy Credit default swaps on on Charlie. Okay, so I'm also gonna pay I'll pay you five round and I'll want 100 grand if this guy defaults So now you have two different parties two different parties creating an instrument and trading amongst themselves on another individual who is not connected to them in any other way and This is where that movie the long and the short of it I think it's called the long short or the short long with Steve Correll is You had that one asset manager guy go to a bank and Say I want to take out this position. I want to be the Jojo here. I will pay you guys a premium and If there is a default on the mortgages, I want a Payment a benefit and this is why his investors Got really upset with him because they said you're you're hemorrhaging money You're paying these premiums every single month to the bank for a Product which you have no exposure to are you dumb and in a way he was taking a speculative position because one of the things of Insurance and this is where they've gone around the insurance law is one of the criteria for insurance is that the person buying the insurance must have an Interest in that what's being insured So as to avoid moral hazard to reduce the risk and so forth so forth like that So in a sense this person here the bank who's making that loan to Charlie Doesn't want Charlie to default and that's why you can get the the insurance It's like almost like buying insurance in your own car You don't want to crash your car because it's your car But buying insurance on somebody else's car Then you might go and say hey, bro, you know drink before you drive so that they have an accident because you're gonna get a payout If they have an accident, it's it's kind of crazy. So it's breaking one of the rules of insurance Also insurance has got more regulations and all those type of things, but they're getting around it by calling it Giving it this weird name and I was thinking what why are they calling it a swap? And if you think about it insurance is a swap even with say core insurance Okay, what we're doing is we're swapping premium for benefit Okay, so they get on getting away with the semantics of these terms and they have You know sidestepped the regulations, which is dangerous because it has these catastrophic Effects, but anyway coming back to credit default swaps one thing I saw in the movie which I really enjoyed was This guy comes and he tells the bank. He says he wants them To create this contract. So this was not something that he could buy Over the I mean buy on the the exchange because it didn't exist at that time He said to them he said this is the product that I want It was very much tailor-made customized over the counter and he went to all the banks and he kind of did this Took as much as he could The banks they thought Man this guy's being an idiot because we have done our copulas and we've done our own little risk models Which shows that the credit risk is very small. Okay, so they thought that the credit risk was very small Problem is this model here was flawed on the assumptions, you know to assume normality Remember I was talking about that we don't want to get too technical But basically they made a model that had a various mathematical assumptions which are flawed This guy realized that and thought you know what I'm gonna take advantage of this Interesting part of the movie was is how long it took for the entire financial market to crumble It took years and years or Sorry months and months and this guy was paying this premium. And that's why you see in the movie, you know His performance keeps going down, you know minus 10 percent minus 20 percent minus 30 percent Until there's finally the payoff and it's plus 500 percent So if you ever got confused by the video This does explain it a little bit But this is my conspiracy around credit derivatives is that they're not derivatives they're not swaps they're not options. They are actually in fact in insurance and therefore that you should be Pricing them and thinking about them like insurance. You should they should have the same regulation as insurance and Maybe if that was the case we would not have had The credit crunch look the credit crunch was no, no, no, maybe I like the credit crunch was for other reasons I mean like the securitization and all these other things What the credit derivatives did is they added on more risk. So let me sum off this video Quickly here. Let me explain how these things amplified the problem. So The bank sells houses, okay, and they have this credit risk Exposure, okay, and this is where it gets really crazy So a bank has credit risk exposure in the sense that if the person who owns the house Okay Defaults then the bank loses money or has to collateralize the house and resell the house And there's all that administrative burden but what these banks would then do is They would then sell a credit Derivative on their own asset. So let's say their credit risk was 10% instead of buying a credit derivative or taking the position to hedge that out They speculated on it with this other guy and what they did is they amped it up to say 20% I'm just making these numbers up. But so instead of credit risk being say 10% that the person defaults Sorry, they didn't increase the percentage. They increased their exposure So let's say there's a 10% that the guy defaults on repaying his home loan Then that causes say 100,000 Rand lost to the bank after they've done collateral and sold off the house and all that sort of stuff So that is their risk their credit risk is 100,000 Rand by then selling these credit derivatives They then increased their exposure so that if a risk did happen, it was actually 200,000 Rand. I'm also getting just making up these numbers for illustrative purposes Now what we're also going to be talking about later on the course is this whole agent and principal Problems that or dilemmas that happen in business But the people in the bank they were excited to sell these instruments because they would earn a commission on it So they were happy to increase the banks risk exposure in order to get their commission Because if the bank tanked they didn't mind they just wanted to get their commission And so this was a massive breakdown in risk management And it's actually it's it was it was basically a beautiful disaster How how all they built this house of cards and then they blew they basically got a fan They set up a fan right next to it and they pumped it up to its maximum level and they basically wiped themselves out it was a massive systemic risk and I mean it was so clear that that's why these guys were going to the banks and buying these instruments But that is my conspiracy Remember I basically haven't really spoken a lot about the notes go a lot into the Formulas use and how to price these things, but I just find this Fascinating how I was always confused in varsity, you know why these things called swaps And when you stop learning about regulation, you stop picking it all together It does actually make for quite a nice conspiracy Around this but job. These are credit derivatives, but like I said, I don't think they're derivatives They are more likely insurance their insurance in the sense that you're getting a payout on the default And so you should be buying the insurance If you have that exposure not selling it because this is basically what it was Maybe let me explain it one last time so that you guys actually get how crazy this is It's like having a car Instead of buying insurance So if your car crashes instead of buying insurance on your car you sell insurance on your own car So if you crash you pay the hundred thousand rent to rebuild your car And you pay another hundred thousand rent to some random person Who you then took the risk out on so you're doubling your exposure and the reason why you're doing this Well, if you're a very good driver You might want to do this in the sense that the person is paying you a premium every day Say 20 Rand or 200 Rand a month or whatever it is And maybe this could be quite a fun model or a product to make in the world is maybe call it car derivative where you You basically sell a derivative or you're selling insurance on your own car So if you crash not only do you have to pay out your car, but you actually have to pay out even more to another party I think people will drive very very carefully on the road there. So it might actually have some good knock-on effects, but this just shows you how crazy and how messed up the financial world was getting pre 2007 and it's no wonder why we actually had this credit crunch. But anyway, this has been quite a fun video Tomorrow will be more serious We'll be looking at asset liability modeling and how Actories have actually created this practical technique that has assisted investors in setting their objectives and reaching their goals But with this time I'm going to leave you guys with this conspiracy Let me know your thoughts in the comment section below hit subscribe Because like I said video is coming out every single day. Cheers