Role Of Financial Derivatives In The Financial Crisis

Published Date: 02 Nov 2017

Xu Siyuan

Student number: 1105656

-EC372 essay-

Introduction

It has been conventional wisdom that a series of credit derivatives like asset backed securities (ABC), credit debt obligations (CDOs) and credit default swaps (CDS), play a significant role in the financial crisis in period between 2007 to 2008 in United State, and the impact of financial innovations has affected both the financial and real economy seriously. It is worth to understand the role of ABS, CDS and CDOs in the economy before understanding their role in the credit crisis. According to Jarrow (2011), there were two incentive problems that facilitate the financial innovations and creation of this kind of credit derivatives. The first problem was the agency problem in the management of various financial institutions and investments funds. The desire to increase home ownership for low-income families led to the lax supervision of lending by the mortgage originators, the low lending standards of the mortgage originators and low interest rates led the excess demand for real estate markets, which also led to the housing price boom later. However, in order to eliminate the risk of default of payment by borrower, the creation of financial derivatives in mortgage origination and government policies seem like necessary. The second problem was that the credit rating agencies use poor models led to the wrong ratings of corporate and structured debt, addition to the government’s authorization use of the wrong rating and financial derivatives like ABS and CDOs made them used widely. From 2007, the subprime mortgage holders, who holding adjustable rate mortgages with teaser rates started to default on their loans due to the increasing of interest rate and oil prices rose Jarrow (2011). However, never the less, these mortgage defaults also led to a significant losses to credit derivatives, while the financial institutions which investing the financial derivatives like ABS, CDS and CDOs experienced a massive loss of their capital. This serious loss of financial institutions impacted the financial markets and real economy, while causing unemployment and a deep recession eventually.

The excess supply of derivatives of subprime mortgage

In order to understand the cause of the credit crisis, we need to understand the residential housing price boom and crash of housing prices. The root of causes of credit crisis was low interest rate, lax mortgage lending standards and easy credit. Recently, in market of mortgage loans, there is asymmetric information between the borrowers and the mortgage lenders. Because the borrowers know their financial situation which lend money to them, but the mortgage lenders know their borrowers incomplete, so mortgage lenders are facing huge default risk of their loans. Due to the cost of performing loans and risk of default of loans, the financial institutions which performed loan origination have to seek for the resources and expertise. Because of that, the financial institutions often sell their loans issue with debt and equity to third parties, like government-sponsored enterprises, the entities that issue credit derivatives, and this kind of indirect lending is called securitisation (Jarrow, 2011). According to Bailey (2013), securitisation is a process that marketable securities like bonds are created from non-marketable instruments like mortgages, corporate loans. After securitisation, these kind of non-marketable instruments are more liquid, easily bought and sold. However, the problem is that if the loans default, the costs are not undertaken by the mortgage originators but by the third parties. Thus, under lax lending standards, borrowers who may unable to pay back the loans can able to borrow the money. As we all know, mortgage loans should only lend to the borrowers who have good credit, stable income and require large down payments. However, from early 2000, under lax lending standards and wrong rating by credit agencies, mortgage loans were started lent to the borrowers with high credit risk, and it is well known as ‘subprime borrowers’ recently. Literally, subprime borrowers are the borrowers who with bad credit and have not stable income, addition with high probability of default. From 2000, the unusually large excess supply of funds for subprime mortgage loans were generated by two aspects, the first one was government policies, and the other one is the subprime mortgage credit derivatives (Jarrow, 2011). In order to encourage home ownership for low-income families, the government of United States adopted some policies, for example, on December 6, 2003, aimed to help about 40000 families a year with their down payment and closing costs, and strengthen America’s housing market, the American Dream Downpayment Initiative was signed into law by President of United State, George W. Bush. In addition, the excess demand of subprime mortgage credit derivatives, like ABS, CDO and CDS held by financial institutions and investment funds also led to the excess supply of funds of subprime mortgages. In the period before credit crash, with wrong rating by rating agencies, some risky financial derivatives were mis-rating; AAA-rated ABS, CDOs and CDS bonds were paying significant high yields, so this kind of derivatives were unusually high demand by investors. In the same time, because the structures of CDOs, ABS and CDS are complicate and it is difficult to understand its model, so most of the performance of investment funds depended on the rating agencies. According to U.S. Senate Report (2011), because of the misratings in corporate debt, there were lots of large investment and commercial banks failed after the breakout of credit crash, like Lehman Brothers, Merrill Lynch, Citigroup, AIG etc. Nevertheless, during credit crash, lots of financial derivatives like AAA-rated ABS, CDOs and CDS downgraded to junk. As mentioned above, these financial derivatives are created by financial institutions used to offload risk. CDOs are bonds which underlying assets are illiquid and it provides collateral for the bonds and income from which generates the funds to fulfil the bond agreement (Bailey, 2013).

Asset Backed Securities

Jarrow (2011) has present a brief overview about asset-backed securities (ABS) in his paper. ABS are beneficial providing previously unavailable investment opportunities to market participants which facilitates the access to debt capital while increasing economic growth. An asset backed securities is a liability issued by a firm or corporation. Commonly, firm or corporation’s balance sheet consists of assets and liabilities, while liabilities are divided into debt and equity. Debt are loans which paid interest and equity is the ownership of the firm’s residual cash flows, after all debt obligations are paid. As mentioned in Bailey (2013), ABS created by banks are separate legal entities which is different from a typical corporation, it is a special purpose vehicle (SPV). The assets purchased by an SPV are called the collateral pool, and this collateral underlying the SPV’S liabilities. There are a collection of loans like auto loans, student loans, credit card loans, real estate loans, mortgages etc. consist in the collateral pool. There are three tranches of ABS, the first one is ‘Senior tranche’, which investors can get the payoffs first, so it is the least risky. The second one is ‘Mezzanine tranche’, which payoffs depend on the senior tranche, so it is riskier than the senior tranche. The last one is ‘Equity tranche’, which claims the payoffs after fulfilling obligations to the senior tranche and the mezzanine tranche, so it is the most risky one. According to credit crash in 2007, the ABS of greatest interest are those with residential mortgage loan collateral pools (Jarrow, 2011). The ABS decrease the cost of borrowing, thus facilitating real economic activity related to the purpose of the loans. The growth of the ABS market facilitated the growth of the residential housing market, increasing the demand for house while increasing the housing prices. So it can be seem that the wildly use of ABS led to the large increasing in subprime mortgage loans, and it also led to the lax lending standards and easy credit which generated the demand for the mortgage loans by homeowners. Never the less, the demand for the ABS bonds was generated by the excess demand of debt obligations (CDOs) and credit default swaps (CDS) by financial institutions and investment funds, because the creation of CDO and CDS rely on the ABS bonds.

Collateralized Debt Obligations

According to Brunnermeier (2009), the creation of collateralized debt obligations (CDOs) follow the following steps. The first step is to form diversified portfolios of mortgages, loans, corporate bonds, and assets like credit card receivables, obviously, these portfolios are illiquid. Secondly, slicing these portfolios into different tranches which are then sold to investors groups with different preferences for risk. ‘Super senior tranche’ which is known as the safest tranche is sell to the investors with low preferences of risk, offers a low interest rate, but it is the first to be paid out of the cash flows of the portfolio. Different from super senior tranche, ‘Equity tranche’ paid only after all other tranches have been paid, so it is the most risky tranche in CDOs. There are two types of CDOs, the first one is ‘Cash flow’ CDO and the other one is ‘Synthetic’ CDO. Cash flow CDO is a type of ABS, but different in their structure of the collateral pool. A subprime ABS has subprime mortgage loans which is non-traded in its collateral pool while a subprime CDO has mezzanine ABS bonds, which has mentioned above, tradable debt but more risky, in its collateral pool. When housing prices crashed and mortgages defaulted, theses CDOs bonds lost significant value.

Credit default swap

Credit default swap (CDS) is just as any OTC contract, it is insurance contracts written between two counterparties that in order to insure the face value of a particular corporation, sovereign or structured debt issue for a fixed period of time pools (Jarrow, 2011). According to Bailey (2005), in a typical CDS, one party makes regular payments to the another party but receives nothing in return unless default occurs on the asset specified in the contract. So if the default happened, the first party will receive the amount of compensation from the counterparty, so CDS contract can be seem as some kind of insurance. CDS also play an important role in the housing price boom and the financial crisis. With the CDS contract, the buyer can short the credit risks effectively in the underlying debt instrument, and the financial institution with a highly rated can sell a CDS at zero value without posting any collateral, thus, the credit risk of in a bond can be assumed without posting any additional equity capital to guarantee execution (Jarrow, 2011). However, because highly rate financial institutions do not need to post collateral to trade in CDS, so the misrating of the credit risk of these financial institutions would caused serious problem. With respect to the housing price boom and the financial crisis, because of the ABS with residential mortgage loans collateral pools were highly interested, so it also increased the using of credit default swaps. Buyers who bought tranches from ABS also purchased CDS to protect themselves against the risk of default of ABS, that made the amount of credit default swaps increased a lot from 45 trillion dollar to 62 trillion dollar in 2007, before the subprime mortgage crisis happened. The combination of the misestimate of risk in the CDS and lax requirements in collateral to the highly rate financial institutions led to the excess supply of CDS, thus, when housing prices crashed in 2007, and mortgages defaulted, there were unusually large position in CDS in financial institutions and the most serious problem is that there was not sufficient equity capital in these financial institutions to cover their losses (Brunnermeier, 2009).

Regulatory Reforms

As mentioned above, even thought those credit derivatives like ABS, CDS, and CDO made the financial institutions which invested in losses a lot of their capital after housing price boom burst and mortgage defaults occurred, but credit derivatives still have useful economic functions in financial markets. ABS provide more opportunities of available investment for the investors, facilitating the access to debt capital, increasing financing for the underlying collateral pool, CDS make it more easily to short sell debt, and indirectly increase the efficiency of debt markets’ information, CDOs can minimized the transaction cost in investing in ABS and enhance the efficient allocation of debt capital. Thus, the main problem that need to be corrected is the structural problems in those financial derivatives. As pointed out by Jarrow (2011), where regulatory reforms need to be implemented was the credit agencies’ rating systems which facilitated the misuse of credit derivatives before and during subprime mortgage crisis. If the credit agencies’ rating system had been corrected, there would less misused. The first reform to fix the problem is change of the payment structure of the credit rating agencies. Recently, the payment structure of credit rating agencies are paid by the corporations or financial institutions which are rated, that will cause incentive problem like over-seeking profit as mentioned previously.