Adopted Derivative and Function in the Financial Markets
Derivatives are important tools in the financial markets because they help reduce investment losses resulting from the fluctuating interest rates. For example, Societe Generale lost about $7 billion following the 2008 property market crisis, which could have been much higher if the company did not hedge its funds. Credited default swaps (CDS) or credit derivative contracts on mortgage-backed securities played a major role in the development of the housing bubble in the American property markets. The swipes were widely used to insure debts using subprime housing securities in the property markets. Swap derivatives can be defined as a series of exchanges of cash flow determined by different exchange rates, interest rates, and prices that are calculated in reference to a principle notional amount, which is usually an asset. In this case, the notional amount was the subprime mortgage securities. CDS can be described as insurance contracts that protect an owner of security against a possible default of a firm. CDSs are backed by assets such as the real estate where the premiums are subject to change interest rates in the financial markets.
CDSs serve to redistribute wealth in the financial market, but do not create or destroy wealth. This means that one party (investor or issuer) stands to make a profit at the expense of another’s losses (Stulz 67). Unfortunately, the resulting effect of this operation may affect the economy at a greater level because of the direct connections it has with the market and the population at large. If a financial institution has an operating capital of $1 billion and happens to lose $1.4 billion in derivative contract with another entity, its $1 billion capital will be wiped out in the process of paying off its $1.4 billion liabilities, and may be forced to sell some of its assets. This was the resulting effect that led to the downfall of numerous financial institutions during the 2008/2009 financial crisis.
Role of Derivatives in the Financial Crisis
The trading of the unstandardized credit default swaps in over-the-counter markets is largely to blame for the development of the crisis. In seven years, the national value of credit default swaps (CDS) rose from $0.91 trillion (2001) to more than $62.2 trillion (2007) before the markets collapsed. Between 2006 and 2007 alone, the value of CDS increased by two folds from $34 trillion to $62.2 trillion (Colon 3). This was a noticeable problem because the value of CDS in 2007 was four times larger than the country’s real domestic product, which is highly unreflective of a sustainable market. The value of the unregulated over-the-counter derivative market was in an excess of about $600 trillion (Greenberger 14). Using the conservative risk figure of 3% provided by the Federal Reserve, in the case of a default, about $52 trillion were at risk, which was close to the world’s GDP at the time.
CDSs were convenient for many investors that they fueled a speculative frenzy in the sale and purchase of securities. As a result, financial institutions were prompted to write CDSs on low-rated subprime mortgage-backed securities to satisfy the increasing demand. Therefore, CDS facilitated pulling together of the mortgage-backed securities (MBS) into a complex collateralized debt obligation (CDOs) (Greenberger 17). CDS was not categorized as insurance products by the underwriters, which means that the swaps went on unsupervised as provided by the CFMA’s exclusion and deregulation of swaps. Because CDSs were not insurance products or other defined financial products regulated by the government, issuers did not care to set aside substantial capital to back them.
Conversely, there was no reporting, which means that the regulators and the fraud department were left guessing on the actual reality of the systemic risk. Most importantly, it provided an avenue for the mortgage service providers to make new agreements with homeowners in place of foreclosure (Kimball-Stanley 254). The financial institutions sold the illusion that CDSs were risk-free and as such, offered CDSs guaranteed against an investor who had no risk in any mortgage-backed instruments .The lack of transparency meant that the MDS CDO frenzy sparked by the insurance assurance was not adequately capitalized. It was this loophole that the Goldman bank defrauded major institutions by convincing them to bet on the synthetic CDSs, which were most likely to lose value (Holmes 5). They could not see that the issuers were now offering naked CDSs that were deemed illegal under the insurance law.
Previous Regulations on Derivatives
The Commodity Future Modernization Act (CFMA) of 2000 de-regularized swaps, removing over-the –counter derivative transactions and clearance requirements for counterparties that qualified as eligible contract participants (Greenberger 12). Previously, there was no regulated exchange in over-the-counter trade of derivatives. Assignment of derivatives over the phone to parties that were originally not a party to the original deal created a huge backlog of un-cleared credit derivatives. In retrospect, this concern was expressed by Timothy Geithner (New York Federal President) in 2005 who demanded that the largest banks should reduce the backlog within a year (Greenberger 16). Conversely, one could buy a CDS without having the ownership of the insured security.
An eligible party had to have $10 million and above in assets and limited liability for risk management purposes. Energy and metal swaps were exempted from this exchange requirement and as such were subject to regulation and fraud prohibitions. This explains why the surge in market activities was concentrated in the property market because it was the single largest area where insurance and resources were invested in the United States. The exclusion of the energy and iron industry in the deregulation of swaps was based on the sensitive nature that the two areas play in the production of functional products and infrastructural development. Without the close control of the CDSs, the federal government lost track of the status and activities of the over-the-counter trade of securities backed by subprime mortgages.
New Regulations
Commodity Futures Trading Commission repackaged over-the-counter derivatives into exchange-traded derivatives by introducing closer regulation and new requirements. They included the trade reporting stipulations, margin rubrics for uncleared derivatives, and clearance requirements for OTC derivatives (Colon 4). Another important reform in the trading of derivatives is the requirement that contracts must be purchased and sold at the swap execution centers facilitated by companies such as Tradeweb and Bloomberg. In February 2016, Europe and the U.S. agreed to create common clearinghouse where traders post collateral before a transaction is made (Moyer 4). The advantage of this system is that traders are now able to get a closer look at the quality of the offers and the bids in the CDS markets. As a result, the single-name CDS market has shrunk with the interest rate swaps and government and corporate bonds CDSs performing better (Colon 1). In the future, the trade of derivatives is expected to stabilize as a result of closer control of innovations in the financial markets.
Works Cited
Colon, Hector. "The Role of Derivative in the Financial Crisis." National Center for Policy Analysis (2016): Issue Brief No. 187.
Greenberger, Michael. Financial Crisis Inquiry Commission Hearing: The Role of Derivatives in the Financial Crisis. Washington, DC: University of Maryland School of Law, 2010.
Holmes, David. AIG eyes action vs Goldman over CDOs: report. 19 April 2010. web <http://www.reuters.com/article/us-goldman-aig-idUSTRE63J13E20100420>. 26 July 2016.
Kimball-Stanley, Arthur. "Insurance and Credit Default Swaps: Should Like Things Be Treated Alike?" Connecticut Insurance Law Journal (2008): 241-267.
Moyer, Liz. U.S. and Europe Reach Agreement on Derivatives Regulation. 10 February 2016. Web <http://www.nytimes.com/2016/02/11/business/dealbook/us-and-europe-reach-agreement-on-derivatives-regulation.html?_r=0>. 26 July 2016.
Stulz, René M. "Financial Derivatives: Lessons From the Subprime Crisis." The Milken Institute Review (2009): 58-71.
