Cdo_and_Cds

What started off as a bursting of the U.S. housing market bubble and a rise in foreclosures finally resulted in global financial crisis. Some of the largest and most esteemed banks, investment houses, and insurance companies either declared bankruptcy or had to be rescued financially. By 2008, credit flows froze, lender confidence dropped, and one after another countries around the world faced recession. The crisis uncovered fundamental and regulatory weaknesses in the financial systems worldwide, and it still continues despite coordinated easing of monetary policy by governments, trillions of dollars in intrusion by the governments, and several support policies and regulations by the International Monetary Fund. (Nanto, 2009) This paper considers the role of credit derivatives in the financial crisis mainly CDO’s and CDS and aims at providing evidence that is a need of a strict control on these derivatives. After the dot-com bubble which caused the sharp stock market correction in 2000 and the subsequent recession in 2001, The Federal Reserve reacted by cutting interest rates substantially. As a result, more “hot investment capital” began to flow into housing markets—not only in the United States but in other parts of the world as well. At the same time, China and other countries invested a large amount of their accumulations of foreign exchange into U.S. Treasury and other securities. While this helped to keep U.S. interest rates low, it also helped in keeping mortgage interest rates at lower and attractive levels for prospective home buyers. (Nanto, 2009) Home prices in the United States had risen rapidly for several years. Based on history, people were optimistic that house prices in US will boom. in the frenzy of cheap loans and rising prices, lenders lowered their requirements and started issuing mortgages to sub-prime borrowers. (Weaver, 2008) As a result, demand for homes began to rise thus sending the prices up. From the fourth quarter of 2002 to the fourth quarter of 2006, house prices rose by an annual rate of 7.1 percent. This resulted in even more construction. (Baker, 2008) In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down. Eventually the number of houses exceeded the number of people willing to buy them. (http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/index.html) As supply exceeded the demand, housing prices fell. Subprime mortgages rose from only 8 percent in 2003 to 20 percent in 2005 and 2006, while the interest-only and payment-option went up from just 2 percent in 2003 to 20 percent in 2005. As a result, borrowers with adjustable rate mortgages who were planning to sell or refinance their houses before rates increased were unable to do so. People now began to default even before their interest rates reset. With prices falling, many owners could not sell their homes to avoid foreclosure or delinquencies (Harvard Kennedy School, 2008) This housing boom coincided with greater popularity of the securitization of assets, particularly mortgage debt (including subprime mortgages), into collateralized debt obligations (CDOs). The basic principle behind a CDO involves the re-packaging of fixed income securities and the division of their cash flows according to a strict waterfall structure. A CDO is constructed by creating a special purpose entity (SPE) or structured investment vehicle (SIV), which buys assets and issues bonds backed by the assets’ cash flows. The bonds are divided into a number of tranches with different claims on the principal and interest generated by the CDO’s assets. (Barnett-Hart, 2009) Subprime CDOs were aggressively sold to investors and were considered money making machine on Wall Street. They were viewed as one of the most important financial innovations of the past decade. According to the Securities Industry and Financial Markets Association, the total U.S. issuance of asset-backed securities during the 2005-2007 period was $3.289 trillion, and the total U.S. issuance of CDOs during the same period was $965 billion. (Longstaff, 2008) In order to cover the risk of defaults on mortgages, particularly subprime mortgages, the holders of CDOs purchased credit default swaps (CDSs). These are a type of insurance contract (a financial derivative) that lenders purchase against the possibility of credit event (a default on a debt obligation, bankruptcy, restructuring, or credit rating downgrade) associated with debt, a borrowing institution, or other referenced entity. The purchaser of the CDS did not have to have a financial interest in the referenced entity, so CDSs quickly became more of a speculative asset than an insurance policy. (Nanto,2009) In December 2007, the value of credit default swaps hit $62 trillion even more than the combined gross domestic product of the entire world ($54 trillion), while the maximum value of debt that might possibly be insured through these derivatives was $5 trillion; it means that massive speculation by banks and others was taking place. (Crotty, 2009) When problems in the housing market led to increase in subprime defaults, the value and demand of MBSs, CDOs and CDS collapsed. As a result, banks were left holding huge amounts of mortgages and mortgage-backed securities they could not sell. These securities had become so unreliable for investors that they were neither being sold nor bought. Global CDO issuance fell from $177 billion in the first quarter of 2007 to less than $20 billion one year later, a drop of 84%. The collapse in the price of these products was the main reason for the massive losses suffered by large investment banks, including Bear Stearns, Merrill Lynch and Lehman Brothers. Lehman Brothers was the biggest marketer of CDOs and for bankruptcy in 2008. Merrill Lynch, sold itself to the Bank of America to avoid a similar fate. CDOs have been responsible for $542 billion loss of the nearly trillion dollars in losses suffered by financial institutions since 2007. (Crotty, 2009) As for the CDS market, the notional value of CDSs in July 2008 was $54.6 trillion, a $25 trillion reduction and by October 2008 it was estimated to be $46.95 trillion. (Nanto,2009) Companies who issued CDS contracts, such as American Insurance Group (AIG), found themselves short on the funds required to pay investors back. As of February 2009 AIG alone had suffered losses of over $60 billion on CDS contracts and the government invested $180 billion to save AIG. (Jo, Lee, Munguia, Nguyen) In my opinion, the CDS, subprime mortgage, and mortgage-backed security markets exist in a state of complete non-regulation. The problems in the CDO, CDS market were caused by a number of factors like combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures. Most of the securities were initially given a rating of AAA by one or more of the three nationally recognized credit rating agencies, [Moody’s, Fitch, and Standard and Poor’s (S&P)]essentially marking them as “safe” investments. The original credit ratings assigned to CDOs failed to capture the true risks of these securities. Investors relied almost exclusively on the ratings to access CDO investments instead of their due diligence. It was difficult for investors to analyze whether the AAA ratings given to the securities were justified or not, since lack of regulation resulted in inadequate disclosure. Also, Credit-rating agencies have had great difficulty in determining the value of mortgage-backed securities. Ratings companies had less information regarding securities than loan originators. (Murphy, 2008) Therefore, there is a need of an increase in information sharing between loan originators, security raters, and security purchasers. Also, in order to prevent raters from “guessing” when they rate securities, new, comprehensive rating standards must be developed that allow for improved transparency, and new ratings models should be developed that include data from the 2008 housing market crash and is updated frequently with current housing market data. Also, an external body should be formed that evaluate any and all incentives being provided to ratings agencies by the financial companies relating to the rating of their securities so that there is always a fair rating system. (Murphy, 2008) Credit derivatives, mainly CDS and CDOs, are traded in bilateral transactions over‐the‐counter (OTC), unlike other major financial derivatives that are traded on exchanges. As a result, they suffer from greater counterparty and operational risks. The terms for these contracts are not standardized and no account is taken of the risk externality by which credit enhancement for one deal affects the risk exposures of other market participants. (Acharya, Engle, Figlewski, Lynch, Subrahmanyam, 2008 ) Hence, a firm trading in OTC credit derivative contracts should be required to provide information to a central Registry on each deal they enter into. Information gathered in this way should be available to regulators and to the public so that the counterparties can evaluate each other's risk exposures. Lastly, for investors there is a need for increased due diligence rather than blind reliance on the judgments of the rating agencies. Ratings must be taken as a complement for risk assessment and not a substitute for due diligence. Hence, I agree that there should be a strict control on CDOs and CDS otherwise what happened in 2008 may happen again. REFERENCES: * Acharya V, Engle R, Figlewsk S, Lynch A and Subrahmanyam M (2008), Centralized Clearing for Credit Derivatives, New York University Stern School of Business, pg. 1-2. * Barnett-Hart A (2009), The Story of the CDO Market Meltdown: An Empirical Analysis, Department of Economics, Harvard College, Cambridge, Massachusetts, accessible at www.hks.harvard.edu/mrcbg/students/.../2009-CDOmeltdown.pdf * Baker D (2008), The housing bubble and the financial crisis, real-world economics review, Issue no. 46, pg. 73-81. * Crotty C (2009), Structural causes of the global financial crisis: a critical assessment of the new financial architecture, Cambridge Journal of Economics, Volume 33, pg. 563–580. * Jo H, Lee C, Munguia A and Nguyen C, Unethical misuse of derivatives and market volatility around the global financial crisis, Journal of Academic and Business Ethics, pg. 1-11. * Longstaff F (2008), The subprime credit crisis and contagion in financial markets, Journal of Financial Economins, Volume 97 Issue 3, pg. 436-450. * Murphy A (2008), An Analysis of the Financial Crisis of 2008: Causes and Solutions, School of Business Administration, Oakland University, pg. 1-28, accessible at http://ssrn.com/abstract=1295344. * Nanto D (2009), The U.S. financial crisis: The global dimension with implication for U.S. policy, Congressional research service, Report for Congress, pg. 1-88, accessible at http://www.whitehouse.gov/news/releases/2008/11/20081115-1.html. * The state of the nation’s housing (2008), Joint Center for Housing Studies of Harvard University, Graduate School of Design, Harvard Kennedy School, pg. 1-40 * Weaver K (2008), The sub-prime mortgage crisis: a synopsis, Global Securitisation and Structured Finance 2008, pg. 22-31. * (http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/index.html)