Financial Derivatives on Sub-Prime Crisis Dissertation
- Length: 30 pages
- Sources: 25
- Subject: Economics
- Type: Dissertation
- Paper: #96070915
Excerpt from Dissertation :
The article that was written by Conley (2011) discusses the impact that collateralized debt obligations (CDO's) would have upon the subprime loans. These were created in 1987, by the Wall Street firm Drexel Burnham. In this product, the investment bankers would take a number of different articles and combine them together as one investment. The various assets that were used included: junk bonds, mortgages and other high yielding investments from the debt. The idea with these different products is that the investment bank could offer customers a stated return on their investment. The way it worked is the brokerage firm would distribute each investor, the stated amount of returns that they would make off of the tranche (the CDO investment). This was derived using a complex mathematical formula that would divide the total amount of interest that was received, from the various high yielding products that were inside the CDO. At the same time, these products were promoted as way that will provide investors with a guaranteed return on their investment. Part of the reason for this, is because it was believed that by being diversified in various classes of high yield bonds would reduce the overall amounts of risk. This is from the belief that if one of the investment articles was in default, the other areas could address the shortfall that is being experienced. The problems with these kinds of investments began in 2007, when interest rates were rising on many different subprime mortgages. This would have a ripple effect upon, CDO's as many homeowner could no longer afford their mortgage payments and began to default on their loans. At which point, a whole host of assets classes inside the tranche would reduce the overall return that investors were receiving. While simultaneously, being unable to sell these investment in the open market, because they did not trade on public exchange (which made valuing them more challenging). Then, many of the different investment articles were not regulated under existing securities laws. The reason why, is because these investments did not qualify for registration under the existing legal framework. These various elements are important, because they are showing the overall way that CDO's contributed directly to the financial crisis. As they were: marketed as safe investments (providing a stated return), there was no way to sell them and they were unregulated. Over the course of time, these factors would lead directly to the subprime crisis and liquidity challenges facing these institutions. Where, they were unable to fully understand the overall risks of holding these investments and the impact that this would have on the business model. As a result, the information from this source is useful in, identifying how specifically the subprime crisis would contribute to host of economic issues.
The article that was written by Morriesy (2008) talks about how credit default swaps (CDS's) were a major contributor to the financial crisis. A CDS is an insurance contract that backs mortgage investments. The way it works, is if there is a default on the mortgage by the homeowner, the insurance company will protect the investor against any kind of losses. They were structured in a similar fashion as CDO mortgages, by utilizing a tranche and then distributing to each investor a stated amount of interest. During the height of the financial crisis, this asset class became so popular that they were valued at $44 trillion. This is twice the value of the U.S. stock market at its peak in 2007. What this shows, is how this asset class would have an impact upon a number of different financial institutions. Where, homeowners would default on their mortgages and then they would go to the insurance company to receive compensation for the losses. This proved to be problematic, as the value of the investments were significantly higher (while home prices were declining). At the same time, the inability to sell or revalue these investments meant, that the total losses would be unknown to: investors and executives at a host of different financial institutions. This is important, because it shows how CDS's would make the problem of subprime borrowers, by giving everyone the belief that they were guaranteed in the event of a default. However, due to the fact that so many were out there in 2007, this would cause the liquidity position for some of the largest banks to be placed in jeopardy. The information from this source is useful; because it shows how CDS's were one the primary causes of why the subprime crisis would affect so many financial institutions. As the investment article was interconnected to the financial system in numerous ways. Once a wave of defaults began to occur, is the point that the entire financial system would be placed at risk.
When you step back and analyze the different financial products, it is clear that both CDO's and CDS's would have an impact upon the economy. As these two different types of derivatives, were sold to investors under the belief that they were considered to be safe investment articles. Part of the reason for this, is because many investment professionals felt that they were diversified, in a host of high yielding investments that would protect everyone against sudden defaults. At the same time, the insurance protection offered on CDS' would give everyone the impression that these different products were safe. This is because they felt that in the event of a default, the insurance companies would protect them against any undue amounts of risk. As a result, the majority of investors believed that the subprime derivative-based products were safe and that the overall amounts of risk had been reduced substantially. However, beneath the surface: the sheer size of this market, the lack of transparency and the inability to sell these investments would make the economic situation worse. As there was no way to accurately determine their value when home prices are falling and defaults are rising. At the same time, the inability to sell them would mean that investors and financial institutions had no way of raising additional capital or cutting their losses in these particular investments.
1.3: Lessons for the Literature
The lessons from the literature that were examined above reveal that a number of different factors are playing an interconnected role in contributing to the financial crisis. What happened was a simple idea was started in the 1980's of: offering investors another way to receive a larger return and diversify their overall amounts of risk. This would have an impact upon how these products were sold in the future. Where, financial institutions would market them as safe way for investors to receive a stated amount of interest and reduce their overall risk. As a result, two of the most common subprime-based derivatives were CDO's and CDS's. These two investment articles were organized in tranche and would offer investors some form of protection (through diversification or default insurance). On the surface these kinds of assets appeared to be safe investments with relatively little amounts of risk. However, underneath it all, the strategies that were being used for these financial products were becoming more risky as time by. Where, investment bankers began to focus exclusively on the higher returns in subprime mortgage derivatives and the perceived levels of protection. Yet, when you look these asset classes, there should have been warning signs about the underlying amounts of risk (especially when you consider: the inability to trade these investments, understand what specific products they are using to achieve the stated return and the lack of oversight). These different elements are important, because they would set the stage for increasing amounts of risk that everyone was experiencing (without realizing what was taking place).
What made the situation worse is: globalization and improvements in technology. These two factors helped to spread these toxic assets across the globe to a host of: investors, financial institutions and governments. This is problematic, because the reduction in trade barriers and the lack of oversight of these products caused most investors to believe what they were being told. Where, they did not understand the products that they were investing in, because they were using a complex formula to show the potential returns and risks. Instead of asking questions, most assumed that this information was accurate. At the same time, these investors failed to follow up on how these kinds of assets are regulated and if they are publically traded. When you put these different elements together, this would set the stage for the financial crisis, as no one understood these investments or how they were affecting the housing market.
As a result, one could argue that the current financial crisis is the direct impact of the lack of understanding these assets and supervision on all levels. Where, these elements contributed to the spreading of these assets around the world (as their…