The borrower would feel that the lender had less at

This preview shows page 5 - 6 out of 6 pages.

The borrower would feel that the lender had less at stake in the loan’s success and may be more likely to push for bankruptcy even for minor problems. - This is more of a problem for equity contracts because the lender has no set amount of repayment so aims to maximize the return. - Arm’s-length loans would seem more questionable since their purpose is to secure the lender against default. iii. What is the difference between selling a CDS and giving a guarantee? Selling a CDS is different because it is a transaction with the loaner, not the borrower. - CDS embodies risk in an instrument that can be traded. - Both involve taking on the risk without having the loan on the balance sheet. In a CDS, the risk-seller pays annual premiums based on the amount of the loan(s) to the risk-buyer. - If a credit event occurs, the risk buyer makes a stipulated payment to compensate for the loss on the loan - credit event is failure to pay, bankruptcy, credit default, restructuring, merger, and downgrading. In a guarantee, a third-party with better credit than the borrower promises to repay a debt if the borrower defaults. - The third party takes on the assessment of the borrower’s credit and monitors the borrower - each party has an advantage in performing one of the functions and so can perform it more cheaply. iv. What is the difference between selling a CDS and making a loan? Selling a CDS avoids having the loan on your balance sheet and doesn’t involve monitoring or assessment of the borrower.
Image of page 5

Subscribe to view the full document.

2. Read “Goldman Sachs-AIG: It's Likely Worse Than You Think” (Item 18.5) and answer the following: i. What exactly was Goldman’s position? Goldman had $20 billion in trades on with AIG, where it had bought protection on toxic assets from AIG. - Goldman believed this translated to $10 billion in risk to AIG, meaning its mortgage assets may only be worth 50%; against the $10 billion Goldman had $7.5 billion in collateral from AIG and $2.5 billion in CDS hedges at well-respected banks. - This meant that a crisis at AIG would mean a crisis at any bank that Goldman had used to hedge its exposure, making its risk from AIG into systematic risk. Goldman calling on collateral made people wonder if they were trying to drive the market down to benefit from the short position it had taken against the mortgage market - New York Times ii. What did Geithner do? Geithner paid off AIG’s counterparties at 100 cents on the dollar and kept the payments secret. This was done to avoid an AIG default that forced the CDSs to be triggered. iii. How does the author suggest that Goldman profited from this? Why is this wrong? Could Goldman have done even better? The author suggests that a government bailout to liquidate a company is akin to a credit event that would cause the CDSs to be triggered. - Thus, Goldman would receive returns on those as well as be paid from the bailout at 100 cents/dollar. After the bailout was announced, the price of protecting AIG risk skyrocketed, and rose to 40% of the amount hedged - this meant that Goldman profited $1 billion from its $2.5 billion in hedges. Goldman had bought protection on the AIG risk, so had effectively reduced its risk on the company to zero - it would neither profit nor lose if the company failed. - Since the government bailed the company out, it is likely that Goldman didn’t collect on its hedges, so bought and paid for them without gaining. - It could have sold them when it looked like the company was going down, then taken the bailout money and profited from the hedges.
Image of page 6
  • Fall '19
  • Derivative, Nick Leeson, Credit default swap, Tokyo Stock Exchange

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern

Ask Expert Tutors You can ask 0 bonus questions You can ask 0 questions (0 expire soon) You can ask 0 questions (will expire )
Answers in as fast as 15 minutes