Credit Derivatives Contribution towards the Global Financial Crisis
The 2008 global financial crisis was sparked by the dot-com bubble, or stock as well as the erosion of confidence brought about by the attacks on the World Trade Center on 9/11, 2001 and the housing bubble. Just before the occurrence of the financial crisis, the Federal Reserve chairman, Alan Greenspan had lowered the funds target by the federal government drastically. The federal funds rates refers to the interest rate at which institutions offering depository services can lend overnight to other depository institutions based on the balance with the Federal Reserve. The lending environment was therefore loose and further worsened by easier leverage and low interest rates making investors seek for new class of asset by venturing into the housing market and securitization.
In his reaction about derivatives, Warren Buffet views them as financial weapons of mass destruction. Indeed, he calls them time bombs to the economic system and the parties dealing in them. The fact that derivatives call for exchange of money in at a future date based on some variables like interest rates, currency values or stock prices means that either of the parties will lose or gain. Warren Buffet argues that derivatives need to be based on guarantee or collateral as if not, their final value will depend on the counterparties’ creditworthiness. Before the settling of a derivative contract, there is often a record of huge profits or losses by the counterparties in the current statements of earnings although no money changes hands in reality. Warren Buffet’s response on the danger of derivatives is based on the fact that counterparties can often report wildly overstated earnings based on the transactions. After all, some of the contracts run for over 20 years therefore taking so long to detect the overstatement of earnings. Clearly, the 2008 global financial crisis was an outcome of interplay of wrong financial derivative contracts and housing bubble in the United States.
The Causes of the 2008 Global Financial Crisis
The global financial crisis of 2008 is regarded as the worst ever since the Great Depression of 1930s. There are numerous factors associated with the 2008 global financial crisis ranging from the innovation of complex financial instruments, lax or poor practices of risk management by financial institutions and banks, inappropriate supervision and regulation of financial markets, predatory lending, speculation in financial markets, increase in the complexity of financial systems and an interplay of structural and cyclical factors (Daianu & Lungu, 2008). Financial literature describes risk management as the identification and management of financial risk exposures to firms. Firms should be committed towards ensuring that variability of cash flows due to unpredictability of the market is minimized or prevented (Kaen, 2005).
Since the 1990s, financial risk management has become a very important industry. This has mainly been due to the increase in volatility of financial markets, emergence of financial innovations through financial derivatives, serious financial losses on companies in the absence of systems of risk management such as WorldCom and Enron and the increasing importance of financial intermediation process. The recent years have seen certain practices in risk management driven by the requirements of various initiatives such as KonTrag in Germany, Sarbanes-Oxley in the U.S. and BASEL II. Through complex financial instruments such as futures, swaps, and forwards alongside other derivatives have made it possible for firms to roll over financial risks to able and willing economic agents (Shenn, 2008). This has thus led to risk transfers in the financial markets.
The 2008 global financial crisis had so much to do with mortgage-backed securities (MBS). For instance, economic agents were engaged into the transfer of MBS assets such as collateralized mortgage obligations (CMOs) either principal-only or interest-only STRIPs. These asset-backed securities derive value from the pool of assets underlying them. Cash flows from the assets are normally distributed in order to render maturity profiles and prepayments (Jaeger, 2008). The sale of home mortgages started after the chartering of Fannie Mae in 1938. It was mandated to provide financing on mortgages by selling long-term debentures and short-term notes of its own. Until 2008, Fannie Mae’s short-term notes and debentures obtained the sole backing of reputation and creditworthiness from Fannie Mae. Nevertheless, the desire by Congress to expand on opportunities for housing especially to the low income earners/families, subprime mortgages were originated by Fannie Mae and other enterprises sponsored by the government (Mitchell, 2008). They also issued large securities on the basis of subprime mortgage backing. Soon this activity was mirrored by other institutions and started issuing similar subprime mortgage debts and securitizing large pools of mortgages.
The issue of numerous mortgage-backed mortgage securities by Fannie Mae and other agencies sponsored by the government created an enormous market to trade MBS both in secondary and primary markets. Foreign banks and investment banks readily provided a market for the mortgage-backed securities. In particular, investment banks undertook an underwriting on the securities and offloaded them to the secondary markets to be bought by foreign institutions as well as hedgers. The secondary market continued to be highly liquid until the level of default rate increased thus decreasing the value of the securities. The role of MBS securities in the market cannot be overemphasized (Kaen, 2005). For instance, MBS is useful in diversifying idiosyncratic risk associated with mortgages. Most importantly, MBS allow managers of hedge funds to strategically allocate earnings on the basis of diversification across risk premia and economic functions. Capital markets are important channels through which financial intermediaries like insurance firms and banks can transfer risks.
The global financial crisis of 2008 can be associated with three major causes. To begin with, the United States was embroiled in the worst recession in real-estate history. Indeed, the modern financial instruments crisis formed an economic background in reality (Krugman, 2009). Subsequent to the 2008 financial crisis, the United States has registered a massive growth of the real estate sector whereby prices doubled during the period 2000 to 2006. Suddenly, there was a significant decline in housing prices to more than 15% in comparison to the previous year. The prices continued to decline further without any indication of possible stability. The situation was worsened by the fact that the vast majority of the debtors owning house mortgages were unable to service their debts (Katz, 2008). The outcome of the situation was a negative impact on subprime mortgages and Alt-A mortgages amounting to over $2 billion.
It is also evident that the past two decades have witnessed a myriad of financial innovations that have facilitated transfer of risks on mortgage credits. Indeed, large portion of mortgage risks have been transferred through securitization and in turn sold to investors globally. The principle of securitization is the pursuit of broad spread of risks in an attempt to stabilize the financial system. This is facilitated by fact that banks have learnt from past experiences and thus unwilling to bear possible risks alone (Jo et al., 2009). When risks are spread on a broader perspective, there is a change in the market dynamics. In just a few years ago, only a few experts were involved in the evaluation of the financial markets. However, the past few years have seen an enormous increase in the number of market analysts.
In the summer of 2007, there were widespread doubts pertaining to the quality of rating and the formation price led to abrupt investor exits, falls of prices massively as well as sudden erosion of liquidity (Whitehouse, 2005). The ensuing crisis gripped on other important sectors of the market including finance acquisitions credit as well as commercial buildings. The fact that positions of transactions are recorded in terms of net recovery value or fair value, numerous banks recorded massive losses (Harrington, 2008). The intervention of the central bank came in handy to salvage the rapidly intensification of losses by financial institutions. There was no way risk management development could evolve alongside financial innovation. Indeed, the banking and finance sectors had strived to implement BASEL II Agreement for several years. Surprisingly, the BASEL II Agreement refers to assets in investment portfolio and not financial derivatives.
The innovative financial products were actually affected by the crisis were meant for the formation of transaction portfolio as their sole purpose was resale. The decreasing demand for the innovative financial products alongside the massive erosion in prices caught many banks and financial institutions unawares in terms of risk management. The outcome was that financial institutions and banks without credit derivatives as part of their transaction portfolio were suddenly confronted with the need to correct the balance sheet. The widespread turmoil in the financial markets was mainly brought about by the absence of appropriate risk management by brokering societies and large banks (Hutchinson & Gallagher, 2005). Additionally, there are firms that chose to sell credits or invest in assets to investment vehicles regarded special despite the fact that the contracts did not bind them to do so. The situation was so bad to the banks especially based on the prior knowledge that many banks had never imagined their liquidity declining to the balance sheet level. At the same time, the collateralized debt obligations backed by securitized instruments of finance such as ABS and CDO (Sainsbury, 2008).
The use of complicated innovative financial instruments greatly associated with the intensification of global financial crisis. Therefore, dealers in the products experienced numerous difficulties in the valuation and ultimate price to be applied. The problem of valuation was particularly pronounced during periods of decline in market liquidity. Therefore, there was an increase in correlation risk particularly on the market for collateralized debt obligations (Greenberger, 2008). One other cause of the financial crisis was convertible arbitrage on hedge funds. The hedge fund industry has always use derivatives based on speculation and hedging. For instance, various hedge funds normally utilize strategies of convertible arbitrage by taking advantage of inefficiencies in convertible securities pricing. These are equivalent of assuming a position of bond and option on the backed assets (Hutchinson & Gallagher, 2005).
Hedge funds often make use of quantitative models in executing strategies of ‘gamma trading’. This involves taking long exposure to volatility. Other risks also require to be hedged apart from equity risk. Such risks include interest rate risk and credit risks. This is made successful through credit derivatives namely swaps on credit default. Thus managers of convertible arbitrage widely use substantial leverage ratios. The 2008 financial turbulence was characterized with massive use of convertible arbitrage strategies. This had particularly started in 2007. Unfortunately, a negative correlation exists between returns of convertible arbitrage and returns from equity markets. Indeed, the 2008 financial crisis was characterized by elongated volatility of convertible bond arbitrage.
Numerous lessons were learnt from the 2008 global financial crisis. The crisis had multiple implications on the global financial markets (Voinea & Anton, 2009). The 2008 global financial crisis was mainly caused by widespread misuse of derivative securities popularly used by large financial institutions and investors owing to the speculative and hedging properties of the derivatives. Similarly, shadow banks were able to utilize derivatives in assuming more risks through unethical means and eventually transferring the risk to other institutions with an aim of circumventing requirements of capital (Krugman, 2009). Many financial institutions and banks ended up suffering massive losses when eventually the financial market declined extensively. True to Warren Buffet’s warnings on the use ‘financial weapons of mass destruction’, the use of complex derivatives alongside housing bubble in the use led to the 2008 global financial crisis. The crisis was a proof that investors’ psychology about uncertainty on the use of unethical derivative securities in the financial market could have serious implications on the market.
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