The world financial market faced a huge crisis that led to a recession in the year 2007 and it lasted till 2009. Major investment banks like Goldman & Sachs, and Lehman Brothers went bankrupt. Crawford and Young (2008) explained the financial crisis that occurred recently in the financial markets as an effect of the subprime mortgage rates. Sub-prime Mortgage is a type of mortgage that is normally made out to borrowers with lower credit ratings usually for the purpose of home-buyers. This means the mortgage is given to those borrowers who are usually known to default their loans or does not have enough income to be able to pay back the monthly installments of the loans that they borrow. Sometimes making late bill payments or declaring personal bankruptcy could also very well land borrowers in a situation where they can only qualify for a sub-prime mortgage. The borrowers are given a credit score and based on that score it is decided whether they are good borrowers or bad ones. Usually a score of less than 620 is considered a bad debtor according to website bankrate.com. As a result of the borrower's lowered credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on sub-prime mortgages at a rate that is higher than a conventional mortgage in order to compensate for carrying more risk. Thus in a sub-prime mortgage the risk is for both the lender as well as the borrower.
Financial Institutions like banks are the biggest lenders of mortgages at sub-prime rate. Due to the high risk involved, banks and other lenders have repackaged the rights to these mortgage payments into a variety of complex investment securities, generally categorized as mortgage-backed securities or collateralized debt obligations (CDO). They sell these securities to other investors with a promise of high return like the sub-prime rate. In exchange for purchasing the CDO, third-party investors, like investment banks, also receive a claim on the mortgage assets, which become collateral in the event of default. Further, the CDO investor has the right to cash flows related to the mortgage payments. These CDO or likewise securities are tradable in the secondary market. During those times such credit derivatives became a very popular financial instrument for investors to invest in. If we take a look at the chart given below we can see how the popularity of credit derivatives increased in the past decade. The maximum volume of derivatives was traded during the years 2005 to 2007 of which 2006 was the highest at $2000bn. Then when the financial crisis occurred at the end of 2007 the trading decreased rapidly the following two years to as low as $100bn in 2009.
The financial crisis that occurred recently in the financial markets as an effect of the subprime mortgage rates was actually because of the housing bubble that started in 2001. From the year 2001 the prices of housing and other real estate properties started to increase rapidly in the real estate market. Seeing this phenomenon, people speculated that real estate investment will give increasing returns in the near future and so everyone started to buy houses. The action of the speculators was the main reason for the housing bubble. People purchased houses not to live in them but to make capital gains by selling them at higher prices later. Among the investors there were many people who could not afford to purchase a house on their own and so took mortgage loans for the purchase keeping the new house as the collateral. But due to most of their credit history these investors had to take sub-prime mortgage at a higher rate than usual. They still took the risk as they believed that their new home’s price will increase and they’ll get enough return to be able to afford high monthly installments of the sub-prime mortgage. This increase in taking sub-prime mortgages also shot up the volume of trade of the CDOs and other mortgage-backed securities in the secondary market. More and more people sold off their previous securities and bought the CDOs as they also hoped of getting higher return from the increasing price of housings.
But like any other investments, the real estates’ prices also reached its peak and the housing bubble started facing its demise in 2006. All of a sudden, in 2007 the price of all the housing and real estate properties started to go down due to excessive sellers and limited buyers. Now the sub-prime mortgage borrowers faced problems. They still had to payback huge portion of their loan at the high rate and they were also incurring loss from the house that they bought. So, they defaulted their loans. On the other hand, the financial institutions that provided the mortgage loans could not make use of the collateral as its price had gone down and so, they also defaulted in paying the CDO investors. Panic started among the CDO holders as they no longer wanted to hold their securities and wanted to sell them off. Thus there were no buyers for those securities in the secondary markets and the whole financial market faced the possibility of a crash. Several mortgage lenders have filed bankruptcy recently because of this sub-prime mortgage crisis. Alan Greenspan, former chairman of the board of directors of the Federal Reserve, has remarked that there is a one-in-three chance of recession in USA from this crisis, and they were very close to a depression.
From the simple description of what happened during the financial crisis as mentioned above, it is clear that the use or rather the overuse of credit derivatives was the major cause of the collapse of the financial market. The creatively designed derivatives helped to hedge the risks off parties involved and eventually the party held accountable for the risk would get lost in all the complexity of each tranche. In May 2010, the Financial Times quoted Warren Buffett with the following: “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal to the financial system”. This quote nicely reflects the fear of some market participants and observers that credit derivatives may threaten the stability of the financial system. The transactions of credit derivatives are not required to be disclosed by the market participants and this opaqueness in the system can easily lead to yet another collapse in the financial markets. Furthermore, there is no common method of documentation and thus control measures are only self-regulatory. Sometimes foreign government heavily subsidizes the derivative markets making it easier for anyone to get credit derivatives cheaply. The reason the financial crisis did not have a huge impact in the Bangladesh market is because our government still does not allow the use of credit derivatives.
It can be easily said that if these factors keep on prevailing then another bubble and crash can easily happen in future. Does this mean that credit derivatives should be completely stopped from trading in the global financial markets? It cannot be denied credit derivatives are an excellent and useful tool for risk management. Myron Scholes, a Nobel prize-winner, says a ban would be a “Luddite response that takes financial markets back decades”. Beverly Hirtle in 2008 conducted a research for the Federal Reserve, and found out that banks use the derivatives only as a basis for risk protection and not for increasing credit supply beyond their capability. Currently 95% of the world’s 500 biggest companies trade derivatives. Bank of International Settlements (BIS) published a figure of $604.6 trillion of “notional” value of derivatives in 2011 in the global financial market. It will neither be beneficial for the market nor will it be easy task to ban credit derivatives. Rather the best possible way is to introduce some control measures in the trading rules to avoid it being misused and cause yet another market collapse.
Financial Institutions like banks are the biggest lenders of mortgages at sub-prime rate. Due to the high risk involved, banks and other lenders have repackaged the rights to these mortgage payments into a variety of complex investment securities, generally categorized as mortgage-backed securities or collateralized debt obligations (CDO). They sell these securities to other investors with a promise of high return like the sub-prime rate. In exchange for purchasing the CDO, third-party investors, like investment banks, also receive a claim on the mortgage assets, which become collateral in the event of default. Further, the CDO investor has the right to cash flows related to the mortgage payments. These CDO or likewise securities are tradable in the secondary market. During those times such credit derivatives became a very popular financial instrument for investors to invest in. If we take a look at the chart given below we can see how the popularity of credit derivatives increased in the past decade. The maximum volume of derivatives was traded during the years 2005 to 2007 of which 2006 was the highest at $2000bn. Then when the financial crisis occurred at the end of 2007 the trading decreased rapidly the following two years to as low as $100bn in 2009.
The financial crisis that occurred recently in the financial markets as an effect of the subprime mortgage rates was actually because of the housing bubble that started in 2001. From the year 2001 the prices of housing and other real estate properties started to increase rapidly in the real estate market. Seeing this phenomenon, people speculated that real estate investment will give increasing returns in the near future and so everyone started to buy houses. The action of the speculators was the main reason for the housing bubble. People purchased houses not to live in them but to make capital gains by selling them at higher prices later. Among the investors there were many people who could not afford to purchase a house on their own and so took mortgage loans for the purchase keeping the new house as the collateral. But due to most of their credit history these investors had to take sub-prime mortgage at a higher rate than usual. They still took the risk as they believed that their new home’s price will increase and they’ll get enough return to be able to afford high monthly installments of the sub-prime mortgage. This increase in taking sub-prime mortgages also shot up the volume of trade of the CDOs and other mortgage-backed securities in the secondary market. More and more people sold off their previous securities and bought the CDOs as they also hoped of getting higher return from the increasing price of housings.
But like any other investments, the real estates’ prices also reached its peak and the housing bubble started facing its demise in 2006. All of a sudden, in 2007 the price of all the housing and real estate properties started to go down due to excessive sellers and limited buyers. Now the sub-prime mortgage borrowers faced problems. They still had to payback huge portion of their loan at the high rate and they were also incurring loss from the house that they bought. So, they defaulted their loans. On the other hand, the financial institutions that provided the mortgage loans could not make use of the collateral as its price had gone down and so, they also defaulted in paying the CDO investors. Panic started among the CDO holders as they no longer wanted to hold their securities and wanted to sell them off. Thus there were no buyers for those securities in the secondary markets and the whole financial market faced the possibility of a crash. Several mortgage lenders have filed bankruptcy recently because of this sub-prime mortgage crisis. Alan Greenspan, former chairman of the board of directors of the Federal Reserve, has remarked that there is a one-in-three chance of recession in USA from this crisis, and they were very close to a depression.
From the simple description of what happened during the financial crisis as mentioned above, it is clear that the use or rather the overuse of credit derivatives was the major cause of the collapse of the financial market. The creatively designed derivatives helped to hedge the risks off parties involved and eventually the party held accountable for the risk would get lost in all the complexity of each tranche. In May 2010, the Financial Times quoted Warren Buffett with the following: “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal to the financial system”. This quote nicely reflects the fear of some market participants and observers that credit derivatives may threaten the stability of the financial system. The transactions of credit derivatives are not required to be disclosed by the market participants and this opaqueness in the system can easily lead to yet another collapse in the financial markets. Furthermore, there is no common method of documentation and thus control measures are only self-regulatory. Sometimes foreign government heavily subsidizes the derivative markets making it easier for anyone to get credit derivatives cheaply. The reason the financial crisis did not have a huge impact in the Bangladesh market is because our government still does not allow the use of credit derivatives.
It can be easily said that if these factors keep on prevailing then another bubble and crash can easily happen in future. Does this mean that credit derivatives should be completely stopped from trading in the global financial markets? It cannot be denied credit derivatives are an excellent and useful tool for risk management. Myron Scholes, a Nobel prize-winner, says a ban would be a “Luddite response that takes financial markets back decades”. Beverly Hirtle in 2008 conducted a research for the Federal Reserve, and found out that banks use the derivatives only as a basis for risk protection and not for increasing credit supply beyond their capability. Currently 95% of the world’s 500 biggest companies trade derivatives. Bank of International Settlements (BIS) published a figure of $604.6 trillion of “notional” value of derivatives in 2011 in the global financial market. It will neither be beneficial for the market nor will it be easy task to ban credit derivatives. Rather the best possible way is to introduce some control measures in the trading rules to avoid it being misused and cause yet another market collapse.