Financial Crises 2007

7/28/2019 Financial Crises 2007

1/30Electronic copy available at: http://ssrn.com/abstract=2029073

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!



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

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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




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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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


Appendix III: Subprime Share of Mortgage Market



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Appendix IV: Losses and Bailouts for US and European countries during the global

financial crisis

Source: Global Issues, 2008