Case Study on First American Bank: Credit Default Swaps

When the debt instrument and the option to acquire common stock are inseparable, as in the case of convertible bonds, the entire proceeds of the bond issue are allocated to the debt and the related premium or discount accounts.

the stock is a put option on the firm's assets, and risky projects increase the exercise price of the option.

7. If a convertible bond has a conversion price that is set in reference to the fair market value of shares on the conversion date, then the bond is classified entirely as debt. No (price) risk or reward is transferred to the investor and therefore there is no equity element.

If it did not take the gamble the shareholders value would be zero. So shareholders would take the gamble. If the value of the firm rises to 500, and it does not take the gamble, the value of the shareholders would be 500 − 250 · (1.456) − .4 · (200 − 250 · .456) = 101.6. If they took the gamble, then because they will be able to pay back the debt whether they win or lose the gamble. Therefore, their value with the gamble would be 101.6 - 14.9 = 86.7, so they would not take the gamble. The key intuition is simply that now they get both the gain and the loss from the gamble, while when the initial value was 200, the shareholders only got the gain from the gamble. The value of the firm is now Value of Firm = 1 [.5 · [.995 · 160 + .005 · (1200 − .4 · (900 − 250 · .456))] + .5 · (500 − .4 · (200 − 250 · .456))] 1.05

Both conditions must be met for the modification of the original debt to be considered a troubled debt Restructuring. According to ASC 40-60-55-7, if the debtor is currently in default of any of its debt than the debtor is experiencing financial difficulty. Private Getaways Co. defaulted on its debt instrument with Bank C that resulted in a cross default on the Original Debt held by Bank A and Bank B. Thus, the first condition is met. However, the second condition is not met due to ASC 40-60-55-10 stating, “A creditor is

In 2008 the United States economy faced it most serious economic downturn since the great depression. This crisis began in 2006 when the subprime mortgage market showed an increase in mortgage defaults. This would lead to the decline of the U.S. housing market after a decade of high growth. The problems in the mortgage market where able to spread to other sectors of the economy especially in financial markets because of Collateralized Mortgage Obligations or CMOs. CMOs where mortgage backed securities that where given out by investment banks and where not regulated by the government. These securities fell as did mortgages due to increasing default rates. Because of CMOs companies bought Credit Default swaps or CDSs. These CDSs where nominally

737) (FASB 825-10-20). Entities can decide to use the fair value option in many different situations, one of which is in the recognition of a financial liability (FASB 825-10-15-4a). Outstanding bonds are financial liabilities because they impose an obligation to Target to deliver cash or another financial instrument to a second entity through a contract (FASB 825-10-20). Since, the bond does not fall under any of The Codification’s exceptions to the fair value option, Target can therefore, choose to apply it (FASB

CDSs are used as an insurance against the possibility that the borrower could not repay his or her loan. In such case the issuer has to pay a specified sum to the buyer. Of course they are sold for a premium and if no credit events occur, the issuer makes profit. After the subprime mortgage crisis began, and many borrowers started defaulting on their loans, the pressure on the companies that had issued CDSs was rising. There were companies that simply did not have enough money to repay everything they owed. A famous example is AIG. The subprime mortgage crisis and the bankruptcy of big financial companies, like Lehman Brothers, meant that AIG had to pay much more money that it expected and made the company insolvent. The company itself had AAA rating shortly before this. This made the investors confident that even their high-rating investments failed, the insurer would certainly be able to repay them. A bailout from the US government followed. Generally, the issuers of these instruments can be held accountable for issuing them, without the ability to pay what they had to, when the credit events occurred. Of course many of them were mislead by the credit rating agencies and the overall conviction in the market that it was not as risky as it actually was. Many people argue that such instruments need to be regulated much better. They can create clear conflict of interests. For example, a

Derivatives allow brokers to gamble on virtually anything, such as the rise and fall of oil prices. By the late 1990 deviates was a 50 trillion dollar unregulated market. Now, lenders are no longer at risk if there is a failure to repay. In the new system, lenders issue loans. These loans are then sold to investment banks. The investment banks compile thousands of different loans together, such as student loans, mortgages and credit payments together to form complex derivatives called CDO’s (Collateralized debt obligations). Investment banks then sell these CDO’s to investors. These CDO’s are classified by ratings company on the risk of investing into them. The highest rating is AAA (lowest risk, highly securitized). Investment companies were rating extremely risky investments as AAA but held no responsibility if the CDO failed, because they claimed that their classification and rating system was just opinions.

Collateralized debt obligations (CDOs) refers to a kind of innovative derivative securities product which simply bundling mortgage debt, bonds, loans and other assets together and then rearranging these assets into different tranches with different credit ratings, interest rate payments, risks, and priority of repayment to meet the needs of different investors. As borrowers began to default, investors in the inferior tranche of the CDOs took the first hit, so the owner of this tranche of CDOs may be riskier. In order to compensate for the higher risk, the subordinate tranche receives higher rate of return while the superior tranche receives lower rate but still nice return. To make the top even safer, the banks ensured it small fee called the credit default swap (CDS). The banks do all of the works so that creating rating agencies will stamp the top tranche since as a safe, triple A rated

It was showed in the exhibit 8a, 8b, 8c and 8d, there would be an increase in net income if Cox purchased Gannett by issuing equity of the combination of debt and equity but not only by issuing debt. So we can calculate the cash flow for Cox if it purchases Gannett by issuing equity.

Enclosed is a copy of “Group Assignment” about the understanding of CDOs. This report is aim to critically examined how CDOs may help banks to avoid liquidity risk and create more assets, and also problems in term of the purpose of CDOs, the role of three mechanisms in CDOs and problems faced in CDOs. After that, it discusses how CDOs created problem for Lehman Brothers by analysis subprime mortgage crisis. Finally, this report provides some recommendations for making the CDOs as effective liquidity risk

The American Express company also known as Amex, it is an American multinational corporation. The company was eventually started as an express mail business in Buffalo, New York. It was formed as a joint stock corporation through the merger of express companies owned by Henry Wells( Wells Company), William G. Fargo (Livingston, Fargo and company)and John Warren Butterfield (Wells, Butterfield and company).

The CDS does not require buyers to actually hold underlying assets. That means a third party can “insure” against default risk that it would not bear the consequence at the first place. A financial institution can act like an insurance company by selling CDSs. American International Group (AIG) was the largest CDS underwriter during the crisis. AIG issued tons of CDSs because historical default rate on bonds were so low that issuing CDS became a cash generator. They simply collected the premium and never though of paying out anything until the crisis hit.

If external financing is required, the “safest” securities, namely debt, are issued first. Although investors fear mispricing of both debt and equity, the fear is much greater for equity. Corporate debt still relatively little risk compared to equity because, if financial distress is avoided, investors receive a fixed return.. Thus, the pecking order theory implies that, if outside financing required, debt should be issued before equity. Only when the firm’s debt capacity is reached should the firm consider equity.