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Taxation of Credit DerivativesThe text below is an excerpt from the complete document. Read the full report in PDF format. AbstractOne arguably good thing about the current financial crisis is that it has broadened public understanding of the global financial system. Few people had heard of credit default swaps two years ago, but these instruments have, since then, forced themselves on the attention the most casual reader of financial news. Credit default swaps brought insurance giant AIG to its knees, and precipitated a $100 billion U.S. government bailout of the company. More recently, it has been reported that hedge fund manager John Paulson made more than $3 billion during 2008 using credit default swaps to bet against subprime mortgages. IntroductionUntil the U.S. government's rescue of American International Group, Inc. (AIG) in September of 2008, few people outside the world of finance had heard about credit derivatives or their most common form, credit default swaps. Credit derivatives are bilateral contracts that shift credit risk from one contracting party to the other. Under a credit default swap, the two parties are known as credit protection buyer and credit protection seller. The buyer pays a periodic fee to the seller, and the seller usually agrees to make a payment to the buyer in the event of a default by a third person (reference entity) on debt that it has issued (reference obligation). For example, B and S might make a swap contract with reference to bonds issued by IBM Corp., under which B must make quarterly payments to S throughout the contract term, and S must, in the event of IBM's default on the bonds during the contract's term, pay to B an amount equal to the excess of $10 million over the post-default value of $10 million of IBM bonds. AIG made a large business selling credit protection. Its credibility as a protection seller depended importantly on its own credit rating, which, among other things, measured its ability to perform its obligations under swap contracts. The contracts required AIG to post additional collateral if the credit rating on its debt fell below AAA. When the major rating agencies lowered this rating, AIG was contractually obligated to supply approximately $100 billion of additional collateral, which it did not have. U.S. officials concluded that because AIG had made these contracts with financial institutions and investors throughout the world, the possibility of default by AIG under these contracts posed an unacceptable risk to the global financial system, The U.S. government therefore supplied the needed collateral in exchange for a major equity stake in AIG. (End of excerpt. The entire report is available in PDF format.) |
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