financial crises 2007
TRANSCRIPT
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Running head: Derivative Instruments and the 2007-2008 Financial Crisis 1
What part did derivative instruments play in the financial crisis of 2007-2008?
Richard Lartey, PMP
SMC University
Switzerland
March 04, 2012
The views expressed in this paper are the authors alone. I am extremelygrateful to Dr. John
H. Nugent,Associate Professor, School of Management, Texas Womans University, forconstructively reviewing this paper and providing valuable comments. But of course, the usual
disclaimers apply and any mistake is the authors only and does not engage anyone but the
author!
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Derivative Instruments and the 2007-2008 Financial Crisis 2
Table of Contents
Table of Contents .......................................................................................................................................... 2
Abstract......................................................................................................................................................... 3
1.0 Introduction....................................................................................................................................... 4
2.0 Presentation of the facts .................................................................................................................... 6
2.1 What are Derivatives?................................................................................................................... 6
2.1.1. The use of derivatives ................................................................................................................. 7
2.2 Derivative instruments that were traded during the 2007-2008 financial crisis ........................... 9
2.3 How and why did the 2007-2008 financial crisis happen? ......................................................... 10
3.0 Discussion of the facts .................................................................................................................... 13
3.1 The role of the subprime mortgage market ................................................................................. 14
3.2 Derivative instruments and the financial meltdown.................................................................... 16
3.3 The Role of Credit Rating Agency ............................................................................................. 18
4.0 Analysis of the facts ........................................................................................................................ 19
4.1 How the derivative instruments contributed to the global financial crisis .................................. 19
5.0 Conclusions..................................................................................................................................... 23
6.0 Recommendations........................................................................................................................... 23
7.0
Areas for further research............................................................................................................... 24
References................................................................................................................................................... 25
Appendices.................................................................................................................................................. 28
Appendix I: Overview of credit risk transfer instruments ...................................................................... 28
Appendix II: Mortgage-Backed CDO Issuance Prior to the Financial Crisis ......................................... 29
Appendix III: Subprime Share of Mortgage Market ............................................................................... 29
Appendix IV: Losses and Bailouts for US and European countries during the global financial crisis... 30
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Derivative Instruments and the 2007-2008 Financial Crisis 3
Abstract
Derivative instruments provide means of hedging and speculation for many of the players
to actively participate in the capital market, thereby leading to high volume of transactions and
growth. Several things have led to an imminent failure of the derivative market during the 2007-
2008 global financial crisis. These include lack of close monitoring of the Securities and
Exchange Commission (SEC), inappropriate rating of the derivative instruments by the credit
rating agencies, failure of these instruments to reflect the true market price and lack of effective
risk management. But failure of the financial derivative instruments leading to their worsening of
the global financial crisis is not to suggest that derivatives should not be traded. Derivative
markets should be properly regulated and controlled by the appropriate agencies.
Keywords: Derivative Instruments, Financial Crisis, Risk, Subprime, Financial Market,
Securities and Exchange Commission, Credit Rating Agencies.
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Derivative Instruments and the 2007-2008 Financial Crisis 4
1.0 Introduction
While the development of new financial instruments has created opportunities for
households and companies to improve their management of financial risks and has facilitated the
smoothing of consumption and investment over time and across different states of the world, it
has added much complexity to the global financial system. Contemporary management of
financial instruments is now being focused on several financial assets, ranging from money
market instruments to bonds, stocks and derivatives (both in euro and in foreign exchange). But
there are problems in relations to the complexity of the structure under management. Before the
financial crisis, it became obvious that the risks taken by the largest banks and investment firms
were so excessive and risky that they threatened to bring down the financial system. On the
contrary, this was back when the major investment firms were still assuring investors that all was
well, based on their fantastically complex mathematical models (Nocera, 2009).
Developments in the banking and the near-bank system, which had been lauded as
improving efficiency and financial stability, have rather caused serious harm to the real
economy. Turner (2009) found that at the core of the 2007-2008 crisis was an interplay between
macroeconomic imbalances which have become particularly prevalent over the last 10-15 years,
and financial market developments which have been going on for 30 years but which accelerated
over the last ten under the influence of the macro imbalances. In recent years, fund managers,
insurers and bankers have transformed investment practices by creating financial instruments
known as derivatives, whose value is derived from the price of another underlying asset. The
original idea of derivatives was to help actors in the real economy insure against risk but many
derivatives trades have crossed the line of price stabilization and risk management into
speculation (Wilks, 2008). The 2007-2008 financial crisis was a system-wide bank run on the
trade of complex derivative instruments, in that it did not occur in the traditional-banking system,
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Derivative Instruments and the 2007-2008 Financial Crisis 5
but instead took place in the securitized-banking system (Gorton, 2010). Complex derivative
trades, as contemporary financial practices have fuelled more than a decade of cheap credit and
destabilized financial system.
Targeted financial instruments such as derivatives (futures, swaps, or options) or
insurance are alternative to using operations directly to reduce risk. Such instruments are
available for many commodities, currencies, and stock indices, interest rates, and the menu is
continually expanding to reflect a variety of other risks including even the weather (Meulbroek,
2002). But the use of derivative instruments can be disastrous and mess up the capital markets.
Hedge funds, private equity corporations, investment banks and pension funds have all used
derivatives to evade regulations. They have devised elaborate and opaque financial vehicles
through which they have dumped risks onto the state or onto less informed investors including
pension holders (Wilks, 2008). Most derivatives are sold over the counter through private
trades rather than on public stock or commodity exchanges, which gives investment banks
flexibility to propose to their customers whatever deal they want, rather than being bound by the
trades sanctioned by exchange supervisors (Wilks, 2008). What this means is that as the deals are
secret they do not help other investors price risk, and often investors, regulators and other
analysts do not know what liabilities a company has taken on. The crisis and the role played by
some derivative market segments require a deeper discussion on how to reconcile the clear value
played by derivative markets.
This paper explores some of the derivatives available on the capital markets and
discusses the role these derivative instruments played in the 2007-2008 financial crisis. The
paper is divided into three parts. Part one provides a background of the essay and presents some
facts on derivative instruments and the role they played in the 2007-2008 financial crisis. Part
two discusses the findings, with emphasis on relating the relevant issues raised in the
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Derivative Instruments and the 2007-2008 Financial Crisis 6
presentation to existing literature. The final part analyzes the contribution of derivative
instruments in the financial crisis and provides recommendations to obviate future occurrences.
2.0 Presentation of the facts
This section discusses some of the key derivative instruments that were traded during the
2007-2008 financial crisis. Their brief description and how they contributed to the global
financial crisis are also presented.
2.1 What are Derivatives?
Derivatives in general are financial contracts on a pre-determined payoff structure of
securities, indices, commodities or any other assets of varied maturities; which assume economic
gains from both risk shifting and efficient price discovery by providing hedging and low-cost
arbitrage opportunities (Jobst, n.d.).The underlying platform on which a derivative is based can
be an asset, (e.g., commodities, equities (stocks), residential mortgages, commercial real estate,
loans, bonds), an index , (e.g. interest rates, exchange rates, consumer price index (CPI), stock
market indices), or other items e.g., weather conditions, or other derivative instruments) (Qudrat,
2009). Derivatives are like chameleon - they easily can change form and appearance. The
chameleon-like nature of derivatives makes it difficult to determine what constitutes a credit
derivative, and thus what should be required to be registered (Schwarcz, 2009). In mathematical
terms, the first derivative is always positive, the second always negative. Thus derivatives can be
likened to Falkensteins (2010) assertion that We always like more money but a dollar is worth
less the more you have.
There has been rapid growth (frequency of use and complexity of instruments) in the
corporate use of financial derivatives such as forwards, futures, options and swaps. A recent
survey conducted by the Bank for International Settlement (BIS) showed that of the estimated
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Derivative Instruments and the 2007-2008 Financial Crisis 7
US$ 74 trillion (in notional value terms) of over the counter interest rate and foreign exchange
derivatives outstanding in December 1999, approximately 11% (US$ 8 trillion) were held by
non-financial users (Merton, 1996, cited in Barnes, 2001). But there were issues of financial
reporting with respect to the use of these derivatives. In the late 1990s, as the use of derivatives
was exploding, the Securities and Exchange Commission ruled that firms had to include a
quantitative disclosure of market risks in their financial statements for the convenience of
investors (Nocera, 2009). The rapid growth in the use of derivatives by corporate users has not
been matched by the corresponding development in the financial infrastructure i.e. the
institutional interfaces between intermediaries and financial markets, regulatory practices,
organization of trading, clearing, back-office facilities and management information systems
(Merton, 1996, cited in Barnes, 2001).
In 2003 Warren Buffett called derivatives financial weapons of mass destruction. It is
in the light of this that Alexandre Lamfalussy cautioned against the use of derivatives that
enhances instability and increases system risks against the backdrop of global markets (ALDE,
2008). Merton (1996, cited in Barnes, 2001) found that accounting and disclosure in relation to
the use of derivatives by non-financial corporations have been internally inconsistent, non-
uniform across various types of derivatives and incomplete.
2.1.1. The use of derivatives
Derivatives can be combined to replicate other financial instruments, thus they can be
used to "connect" markets by eliminating pricing inefficiencies between them (European
Commission, 2009). Derivatives thus play a fundamental role in price discovery. They may also
provide a view on the default risk of a reference entity, on a company or a sovereign borrower, or
of a particular segment of the credit market. Thus, derivatives allow for pricing of risk that might
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Derivative Instruments and the 2007-2008 Financial Crisis 8
otherwise be difficult to price because the underlying assets are not sufficiently traded (European
Commission, 2009). Derivative contracts can either be traded in a public venue, i.e. a derivative
exchange, or privately over-the-counter (OTC), i.e. off-exchange. OTC derivatives markets have
been characterized by flexibility and tailor-made products (European Commission, 2009). This
satisfies the demand for bespoke contracts tailored to the specific risks that a user wants to
hedge. Exchange-traded derivative contracts, on the other hand, are by definition standardized
contracts. Chart 1 depicts the size of derivatives markets (on- and off-exchange)
Chart 1: The size of derivatives markets: on- and off-exchange
Source: European Commission, 2009
While derivatives were initially mostly traded in public venues, today the bulk of
derivatives contracts is traded OTC (roughly 85% of the market in terms of notional amounts
outstanding). The OTC market has expanded quickly in recent years, but decreased in 2008 for
the first time since monitoring started in 1998 (European Commission, 2009). Contrary to equity
markets, where the post-trade aspects (e.g. exchange of cash and transfer of ownership) are
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Derivative Instruments and the 2007-2008 Financial Crisis 9
completed quickly (less than 2/3 days), derivative contracts involve long-term exposure, as
derivative contracts may last for several years (European Commission, 2009). This leads to the
build-up of huge claims between counterparties, with the risk of a counterparty defaulting.
2.2 Derivative instruments that were traded during the 2007-2008 financial crisis
Some derivative instruments were traded on the capital market during the 2007-2008
financial crisis. These include asset-backed securities, mortgaged-backed securities, collaterized
debt obligations, credit default swaps, forward, futures and options. Asset-backed securities are
the most basic forms of financial derivatives which provide the backbone for much of the
complex derivative instruments. An asset-backed security refers to any type of debt security
which is backed by a pool of assets, their cash flow generating ability. A mortgage-backed
security (MBS) is an asset-backed security whose cash flows are backed by the principal and
interest payments of a set of mortgage loans.
Derivatives traders have also developed collateralized debt obligations (CDOs) through
which a financial institution combines assets of various types (for example prime mortgages
with subprime ones). The packaged debt is then sold to a special purpose vehicle, generally
registered offshore in a low tax jurisdiction. The new entity then issues its own equity or bonds
to resell the debt to other investors, carving it up into different tranches with different risk ratings
using complex mathematical models (Wilks, 2008). In a credit default swap deal, the buyer
makes periodic payments to the seller in exchange for the right to a payoff if there is a default or
credit write-down in respect of a mortgage or other debt securities they hold (Wilks, 2008).
CDSs are mainly credit derivatives where the underlying asset is a loan, mortgage or any other
form of credit. Credit derivatives are financial contracts that allow the transfer of credit risk (see
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Derivative Instruments and the 2007-2008 Financial Crisis 10
appendix I) from one market participant to another, potentially facilitating greater efficiency in
the pricing and distribution of credit risk among financial market participants (Bomfim, 2001).
A forward is a contract whereby two parties agree to exchange the underlying asset at a
predetermined point in time in the future at fixed price (European Commission, 2009).
Therefore, the buyer agrees today to buy a certain asset in the future and the seller agrees to
deliver that asset at that point in time. Futures are standardized forwards traded on-exchange. An
option is a contract that gives the buyer the right, but not the obligation, to buy (call) or sell (put)
the underlying asset at or within a certain point in time in the futures at a predetermined price
(strike price) against the payment of a premium, which represent the maximum loss for the buyer
of an option (European Commission, 2009).
2.3 How and why did the 2007-2008 financial crisis happen?
Understanding what happened, how and why the financial crisis came about is essential
for ascertaining what role derivative instruments played in the crisis. Since 1974, 18 bank crises
had occurred around the world and each shared something in common: a period of great financial
liberalization and prosperity that preceded the crisis (Reavis, 2009). With this in mind, Reavis
(2009) asserts that financial crises may be an unavoidable aspect of modern capitalism, a
consequence of the interactions between hardwired human behavior and the unfettered ability to
innovate, compete and evolve. The financial system became so crowded in terms of the
bizarre amounts of capital deployed in every corner of every investable market that the overall
liquidity of those markets declined drastically. The financial crisis resulted from a cascade of
failures, initially triggered by the historically unanticipated depth of the fall in housing prices.
Many argue that the financial crisis that began in August 2007 was a systemic event, in which
the banking sector became insolvent, in the sense that it could not pay off its debt (Gorton &
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Derivative Instruments and the 2007-2008 Financial Crisis 11
Metrick, 2010). Some economist believed that the 2007-2008 financial crisis was caused by
powerful elites ( banking oligarchy) who overreached in good times and took too many risks
by making ever-larger gambles, with the implicit backing of the government, until the inevitable
collapse (Reavis, 2009).
From a macro-economic perspective, the collapse of the U.S. housing market was what
triggered the financial crisis that began in 2008, thus the erosion of the housing market led to an
erosion of wealth (Reavis, 2009). It all started when former president of the United States, Bill
Clinton, passed a law in 1995 whereby common people could get easy access to bank credit for
housing purposes, without any regards as to whether the loans can be repaid or not in the future
(Qudrat, 2009). Commercial banks thus provided loans at sub-prime rate (rate well above the
reference interest rate charged by the banks) to the common people for housing purposes. These
loans were backed up against the houses - subprime mortgage loans. Subprime mortgages are
mortgage loans issued to individuals who do not meet the standard requirements for conventional
mortgages. This may be due to poor credit history, unstable income history, or any other factor
affecting the cash flow generating ability of the individual (Qudrat, 2009). Prior to the financial
crisis, lenders made mortgage loans available to even risky borrowers and charged high interest
rates to offset losses. However, when home prices stopped appreciating, these borrowers could
not refinance; in many cases, they defaulted (Schwarcz, 2009).
In 2006 the average home cost nearly four times what the average family made. Even
though household incomes remained flat during that time (Chart 2) more and more people were
able to afford houses due to an easing of lending requirements (Reavis, 2009).
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Derivative Instruments and the 2007-2008 Financial Crisis 12
Chart 2: Growth of U.S. Housing Prices versus Household Income
Source: Reavis (2009)
By 2007 it became evident that the housing bubble was starting to burst and people began
defaulting on their mortgages, sending a ripple effect through the financial system (Reavis,
2009). Schwarcz (2009) found that these defaults have caused substantial amounts of low
investment-grade mortgage-backed securities to default and AAA-rated securities to be
downgraded.
As more people defaulted and went into foreclosure, more houses came on the market
pushing housing prices down precipitously (Chart 3). This collapse in market prices meant that
banks and other financial institutions holding mortgage-backed securities had to write down the
values of the securities that caused these institutions to appear more financially risky, in turn
triggering concern over counterparty risk; afraid these institutions might default on their
contractual obligations, many parties stopped dealing with them (Schwarcz, 2009). Suddenly,
banks started defaulting on their loans as well, triggering the downward spiral that by late 2008
gripped the entire world economy. Many banks were facing insolvency, thus their assets were
too small to cover their liabilities, which was to say they owed more money than they had. Credit
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Derivative Instruments and the 2007-2008 Financial Crisis 13
markets started to freeze up and individuals and businesses alike could not get loans (Glass et al.,
2009, cited in Reavis, 2009).
Chart 3: U.S. Housing Prices, 1990-2008 (adjusted for inflation)
Source: Reavis (2009)
There was also the human element of greed and fear that contributed to the crisis (Reavis,
2009); in which banks were not willing to mark-to-market which meant they did not want to
enter the actual market price of their assets on their books, for by doing so many would be
declaring bankruptcy. Instead, many banks chose to hold on to them, thinking either that they
were worth more than the market thought they were or that they would come back (Glass et al.,
2009, cited in Reavis, 2009).
3.0 Discussion of the facts
This section discusses some facts in relations to the 2007-2008 financial crises. It focuses
on the parts played by the subprime mortgage market, derivative instruments and credit rating
agencies in the financial crisis.
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Derivative Instruments and the 2007-2008 Financial Crisis 14
3.1 The role of the subprime mortgage market
In the subprime financial crisis, for example, one of the reasons market participants have
had difficulty learning the financial condition of their counterparties is that so many firms
entered into over-the-counter credit derivatives such as credit default swaps under which credit
risk is bought and sold. These swaps reduced transparency, thereby increasing the appearance, if
not the actuality, of counterparty risk by dispersing credit risk contractually without a central
place to ascertain how the risk was ultimately allocated (Schwarcz, 2009). At the time of the
housing market collapse, stocks were sold at prices 50% less than what they were worth and
houses had fallen substantially in value. The point is that people were banking on these assets
having a certain value and that had implications for how much they were willing to consume and
how much they were willing to invest if they were firms (Gross, 2009, cited in Reavis, 2009).
Even though a very high percentage loss in the mortgage market seemed manageable, given the
overall size of U.S. and the world debt markets, the subprime mortgage market was about $1.3
trillion. Moreover, the world financial markets had undergone numerous shocks of seemingly
similar magnitude, such as September 11, the default of Enron and the subsequent accounting
scandal, and the collapse of the tech bubble (Lang & Jagtiani, 2010).
Many experts have given numerous explanations for the mortgage crisis. According to
Lang & Jagtiani (2010), some explanations emphasized the role of irrational exuberance in the
housing market, which led to a bubble that unexpectedly burst. Others cited the originate-to-
distribute model as distorting incentives for risk taking, since lenders no longer had skin in the
game. Other explanations emphasized market participants overconfidence in sophisticated but
untested statistical models of risk which led firms to under-price risk and to engage in excessive
risk taking (Lang & Jagtiani, 2010). Inflated credit ratings of securities issued by the major credit
rating agencies were the explanations given by others as a principal factor in the financial crisis.
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Derivative Instruments and the 2007-2008 Financial Crisis 15
But Lang & Jagtiani (2010) argued that taken individually or in combination, these reasons are
ultimately unsatisfactory explanations for the failure of these large institutions to mitigate the
effects of a large shock to the housing market. With this in mind, Lang & Jagtiani (2010) suggest
that based on information available at the time, the application of fundamental principles of
modern risk management would have protected large and complex financial firms from being as
vulnerable as they proved to be to shocks in the mortgage market.
According to Lang & Jagtiani (2010), most of the initial losses in securities markets came
from collateralized debt obligations (CDOs) and other structured securities that were tied to the
residential mortgage market. Thus, relative to their capital position, large financial institutions
had highly concentrated exposures to this structured but complex securities market. Fitch (2006,
cited in Lang & Jagtiani, 2010) found that the number of subprime downgrades during July-
October 2006 was the largest in its history (see Chart 4 and appendix III). Despite a large number
of defaults and downgrades in subprime securities, according to Calomiris (2008, cited in Lang
& Jagtiani, 2010), both subprime and AAA-rated securities originations continued to rise in 2006
and early 2007 (see appendix II).
The housing loans were being sold off by the commercial banks to many of the
investment banks through securitization. Securitization is the process of issuing securities
collateralized by a pool of assets like loans, mortgages, etc. In this case, the securities were
collateralized by the subprime mortgage loans. This brought about many new forms of financial
derivatives. Most of the investment banks which invested on these derivative securities, issued
by the commercial banks, issued further new derivative instruments based on the values of the
securities. Thus there was an effect of chain reaction. When the housing market collapsed, all
these securities lost values thereby leaving many of the financial institutions bankrupt (Qudrat,
2009).
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Derivative Instruments and the 2007-2008 Financial Crisis 16
Chart 4: Growth of Subprime Mortgages (1994-2006)
Source: Lang & Jagtiani, 2010
3.2 Derivative instruments and the financial meltdown
Derivatives didnt cause the financial meltdown but they did accelerate it once the
subprime mortgage collapsed, because of the interlinked investments (Global Issues, 2008).
Turner (2009) points out two roles that derivative instruments played in the financial crisis. The
first is mutual funds (which are not banks), taking consumer investments which are liquid in
nature (immediate or very short redemption) and investing in long-term securities. The second is
hedge funds, whose asset managers are present in the UK, and who are regulated as asset
managers, though the actual legal fund is usually registered offshore and not subject to prudent
regulation.
Derivatives allowed money to flow more freely from those who had it to those who
needed it. In addition to offering protection against the risk of financial loss, they offered fair
returns to high-dollar investors willing to take calculated risks (Jordan, 2008, cited in Reavis,
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Derivative Instruments and the 2007-2008 Financial Crisis 17
2009). For banks that loaned out tens of billions of dollars, derivatives, theoretically, helped
mitigate risk by protecting them in case loans were defaulted. The global derivatives market
expanded almost 50% during 2007, with CDS market and options markets growing
exponentially (see Chart 5). The outstanding value of CDS contracts surged to more than five
times the outstanding principal of global corporate bonds by the end of 2007 whilst the
outstanding value of commodity derivatives rose from around US$400 billion in 1998 to US$9
trillion at the end of 2007 (Jenkinson, et al., 2008). Options markets have also grown very
strongly. For example, the outstanding principal of interest rate options had increased from US$8
trillion in 1998 to US$57 trillion in 2007 (Jenkinson, et al., 2008).
Chart 5: Outstanding notional amounts of derivatives
Source: Jenkinson, et al., 2008
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Derivative Instruments and the 2007-2008 Financial Crisis 18
The risks inherent in Credit Default Swaps (CDS) and other types of over-the-counter
(OTC) derivatives played crucial role in the financial crisis (European Commission, 2009). OTC
markets are markets (with fairly light regulatory treatment) for professional investors, which are
not directly accessible to the general public. These characteristics proved to be the bedrock of the
OTC market during the financial crisis and might have, absent prompt and forceful intervention
from governments, wrecked havoc to the financial system. For example, the near-collapse of
Bear Sterns in March 2008, the default of Lehman Brothers on 15 September 2008 and the bail-
out of AIG on 16 September highlighted the fact that OTC derivatives in general and credit
derivatives in particular carry systemic implications for the financial market (European
Commission, 2009). EU governments have turned to derivatives and securitization as a means of
removing debt from the public accounts and of raising capital without increasing their official
debt burden (Wilks, 2008). Pension payments for former state employees, Export Credit Agency
debts, and government real estate have all been put out to the market. The claims that are
transferred through securitization are often disposed off without informing or obtaining
agreement from the debtor country; and once ownership of the debt is dispersed it becomes
difficult for the originating government to restructure or cancel claims (Wilks, 2008).
3.3 The Role of Credit Rating Agency
Ratings of securities by the major rating agencies also played a major role in the
derivative market. The market relied on the accuracy of ratings by the major rating agencies,
which were greatly overstated, perhaps because of conflicts of interest in the rating process and
the reliability of complex structured financial securities backed by low-quality mortgage loans
(Lang & Jagtiani, 2010). Reliance on agency ratings of CDOs was a direct outcome of the
difficulty in evaluating such complex financial products such as CDOs. Lang & Jagtiani (2010)
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Derivative Instruments and the 2007-2008 Financial Crisis 19
points out that in many cases, even sophisticated financial firms will do little independent
analysis of the credit risk of a security if it has an AAA rating. Thus, firms may believe that it is
an inefficient use of resources to independently analyze these AAA-rated securities.
While it is clear that inflated ratings played a major role in promoting mortgage-related
structured financial products, Lang & Jagtiani (2010) suggest that there are several problems
with relying on this as an explanation for why large firms were so vulnerable to severe negative
shocks to the mortgage market. Some investors in debt securities look only at the credit ratings
provided by a few rating agencies such as Moodys and Standard & Poors (S&P), which
themselves evaluate credit largely using only mathematical models. But these models can ignore
very important factors and possibilities (Murphy, n.d.).
4.0 Analysis of the facts
Understanding the premise of how the derivative instruments played their roles in
bringing about the 2007-2008 global financial crisis cannot be over-emphasized. Therefore it is
important to scrutinize the relevant information surrounding the various parts played by these
derivative instruments. This section provides an analysis of the major facts.
4.1 How the derivative instruments contributed to the global financial crisis
The 2007-2008 financial crisis has illustrated that professional investors not always
understand the risks they face and the impact of the outcome. The bilateral nature of this market,
coupled with the high level of concentration in the market in terms of participants makes it
obscure to parties outside a particular transaction. Moreover, as the price determined in the
derivatives markets may be used to calculate the price of other instruments, its obscure nature
may affect other market segments (European Commission, 2009). During a recent evaluation of
certain trading positions, a lot of irregularities in derivatives instruments were discovered. For
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Derivative Instruments and the 2007-2008 Financial Crisis 20
example, there was a case of an "irregular" trading where a currency trader has reportedly lost 84
million pounds ($118.4 million) in FX bets (Laurent, 2009). The subprime crisis came about in
large part because of financial instruments such as securitization where banks would pool their
various loans into sellable assets, thus off-loading risky loans onto others (Global Issues, 2008).
For example, some investment banks like Lehman Brothers got into mortgages, buying them in
order to securitize them and then sell them on. Rating agencies were paid to rate these products
(risking a conflict of interest) and invariably got good ratings, encouraging people to take them
up.
For all the derivatives that contributed to the global financial crisis, the underlying assets,
indirectly or directly, were the real-estate houses. These financial instruments provided investors
with leverage- high risk and high return. When the housing bubble burst, much of these
derivative instruments lost values (since their values were dependent on houses) leaving the
financial institutions in huge losses (Qudrat, 2009). Many banks were taking on huge risks
increasing their exposure to problems; and investment banks, not content with buying, selling
and trading risk, got into home loans, mortgages, etc without the right controls and management
(Global Issues, 2008).
While many blame defaulting mortgages for the 2007-2008 financial crisis, it is only a
component and symptom of the deeper problem. Morris (2008, cited in Murphy, n.d.) attributes
the root cause of the crisis to mispricing in the massive Credit Default Swaps market. With this
in mind, Simon (2008, cited in Murphy, n.d.) points out that the pricing of credit default swaps,
whose principal amount has been estimated to be $55 trillion by the Securities and Exchange
Commission (SEC) and may actually exceed $60 trillion (or over 4 times the publicly traded
corporate and mortgage U.S. debt they are supposed to insure), are totally unregulated, and have
often been contracted over the phone without documentation.
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Derivative Instruments and the 2007-2008 Financial Crisis 21
While exchange-traded derivatives leave a transparent trail in terms of positions, prices
and exposures, information available to OTC market participants and supervisors is limited
(European Commission, 2009). Many analysts have therefore blamed the role derivatives
instruments have played in the 2007-2008 financial crisis on the lack of transparency. But Wilks
(2008) asserts that the problem is not a lack of transparency of such instruments but their
complexity and the lack of controls employed by buyers and sellers. With this in mind, Wilks
(2008) recommends treating derivatives like other financial instruments, increasing prosecutions
of financial frauds, improving disclosure by moving from a rules-based to a standards-based
reporting framework, and ensuring that regulations do not confer oligopoly power on
gatekeepers such as ratings agencies or auditors.
Some argue that subjective human judgment opens up for the possibility of undesirable
human biases and manipulation, and can lead to crisis. Failing to charge a systematic risk
premium on the credit default swaps compounded the problem of underestimating average
default losses that were applied without human judgment or business common sense (Murphy,
n.d.). Such under-pricing of credit default swaps resulted in a credit bubble, as investors were
able to hedge their investments in bonds and loans with the insurance of the credit default swaps
to reduce their risk at abnormally low costs. But according to the (Global Issues, 2008), by
summer 2008, the market for credit default swaps was enormous, exceeding the entire world
economic output of $50 trillion. The worlds largest insurance and financial services company,
AIG alone had credit default swaps of around $400 billion at that time, which had a lot of
exposure with little regulation. Furthermore, many of AIGs credit default swaps were on
mortgages, which of course went downhill, and so did AIG (Global Issues, 2008).
In the minds of many, one of the scariest things about the financial meltdown is how
evaluating risk has changed dramatically. Federal regulators allowed banks to greatly increase
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Derivative Instruments and the 2007-2008 Financial Crisis 22
their loan to asset ratios whilst all sorts of higher mathematical equations popped up that seemed
to justify trading in murky derivatives in ways not considered before (Galuszka, 2009). Pykhtin
& Zhu (2007) found that for years, the standard practice in the financial industry was to mark
derivatives portfolios to market without taking the counterparty credit quality into account. This
practice is risky, especially if exposure tends to increase when counterparty credit quality
worsens. There have been a number of attempts to mitigate risk (using securitization), or insure
against problems.
While these are legitimate things to do, the instruments that allowed this to happen
helped aggravated the financial crisis. In an attempt to take on risk and make money more
effectively, many hedge fund managers and bankers fooled themselves into thinking they were
safe and on high ground (Global Issues, 2008). Thus the whole system was heavily grounded in
bad theories, bad statistics, misunderstanding of probability and greed. As people became
successful quickly, they used derivatives not to reduce their risk, but to take on more risk to
make more money; thus they were making more bets speculating or gambling. Hedge funds
have received a lot of criticism for betting on things going badly. In the 2007-2008 crisis, they
were criticized for shorting on banks, driving down their prices. In some regards, hedge funds
may have been signaling an underlying weakness with banks, which were encouraging
borrowing beyond peoples means. On the other hand the more it continued the more they could
profit (Global Issues, 2008).
The extent of the financial crisis has been so severe that some of the worlds largest
financial institutions have collapsed. Others have been bought out by their competitors at low
prices and in other cases, the governments of the wealthiest nations in the world have resorted to
extensive bail-out (see appendix IV) and rescue packages for the remaining large banks and
financial institutions (Global Issues, 2008). According to Laurent (2009), the 2007-2008
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Derivative Instruments and the 2007-2008 Financial Crisis 23
financial crisis have landed several traders of derivative instruments into trouble, such as the
infamous rogue trader, Jerome Kerviel who lost billions at French bank Societe Generale. That
notwithstanding, volatile financial markets are still luring ambitious traders into dangerous
territory.
5.0 Conclusions
Derivatives instruments are the key mechanism in todays shadow banking system. While
derivatives provide the market's view on future developments in market variables, they can cause
havoc to the entire financial market if not properly regulated. Many financial analysts and
economists have underscored the role that excessive risk-taking through the use of derivative has
played in the 20072008 financial crisis. The high risks taken by the various financial
institutions through issue of various derivative instruments were the prime reason for such crisis
starting with the collapse of the housing market. Most of these instruments were traded via the
OTC markets which were poorly regulated.
Several experts in the industry have blamed the role derivatives instruments have played
in the 2007-2008 financial crisis on subjective human judgment, lack of transparency of the
instruments, complexity and the lack of controls employed by buyers and sellers. While all these
factors are critical, the financial crisis could have been avoided if the financial institutions
adopted effective risk management practices in their derivative trading. It is worth noting that
derivatives have revolutionized the financial markets and will likely be here to stay because there
is such a demand for insurance and risk mitigation.
6.0 Recommendations
Financial derivatives are the underlying reasons for the growth of the capital market.
However, much of these instruments must be transparent and must reflect their true market
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Derivative Instruments and the 2007-2008 Financial Crisis 24
prices. They must be closely monitored by the SEC in order to ensure that investors are not
taking uncalculated risk-return positions in the market. Also credit rating agencies should
appropriately rate the derivative instruments in order for the investors to know the extent of risks
of their investments. The obvious regulatory solution is to require that parties to these types of
derivatives transactions, or intermediaries for those parties, keep a registry of the transactions
from which market participants can ascertain risk allocation.
7.0 Areas for further research
This paper analyzes the part derivative instruments played in the 2007-2008 global
financial crisis. It is not surprising to know how evolving industry structures and institutional
roles are changing the nature of risk in the derivative market. At present most discussions
emphasize transparency reforms such as ensuring that any derivatives or similar trades are only
done via exchanges. A further research should focus on the role of the regulating agencies in
promoting transparency in the derivative market.
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Derivative Instruments and the 2007-2008 Financial Crisis 25
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Appendices
Appendix I: Overview of credit risk transfer instruments
Source: Jobst, n.d.
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Appendix II: Mortgage-Backed CDO Issuance Prior to the Financial Crisis
Source: Lang & Jagtiani, 2010
Appendix III: Subprime Share of Mortgage Market
Source: Lang & Jagtiani, 2010
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Appendix IV: Losses and Bailouts for US and European countries during the global
financial crisis
Source: Global Issues, 2008