Financial Derivatives On Sub-Prime Crisis Dissertation

Length: 30 pages Sources: 25 Subject: Economics Type: Dissertation Paper: #96070915 Related Topics: Lehman Brothers, Financial Institution, Crisis Intervention, Deregulation
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...


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…

Sources Used in Documents:


Case Study, 2011, Investopedia. Available from: <> [14 February 2011]

Citi Merger a Mistake, 2008, Huffington Post. Available from: <> [14 February 2011].

Deregulation Redux, 2011, FCIC. Available from: {14 February 2011].

Derivatives, 2011, Financial Dictionary. Available from: <> [12 February 2011].
Forward Contract, 2011, Invest Words. Available from: <> [14 February 2011].
Major Act of Congress,2010, E Notes. Available from: <> [14 February 2011].
Options, 2011, Investopedia. Available from: <> [14 February 2011].
Repeal of the Glass Steagall Act, 2008, Opera. Available from: <> [14 February 2011].
Residental Backed Mortgage Securitzation, 2007, Vinod Kothari Financail Services. Available from: <> [14 February 2011].
SWAP, 2011, Invest Words. Available from: <> [14 February 2011].
Ten Myths About Sub-Prime Crisis, 2009, Economists View. Available from: <> [12 February 2011].
Types of Derivatives, 2009, All Interview. Available from: <> [14 February 2011].
Acrari, Katie, 2011, the History of Backed Mortgage Securities, E How. Available from: [14 February 9011].
Conley, Paul, 2011, Collateralized Debt Obligations, About. Available from: <> [13 February 2011].
Geisst, Roger, 2009, Globalization and the U.S. Financial System, America. Available from: <> [14 February 2011]
Gleason, Patrick, 2011, Sub-Prime Mortgage Effects, E How. Available from: [12 February 2011].
Holmes, Steven, 1999, Fannie Mae Eases Credit, New York Times. Available from: <> [ 14 February 2011].
Katz, Ian, 2010, Volker Panel, Bloomberg. Available from: <> [14 February 2011].
Markowitz, Harry, 199, Portfolio Theory, Risk Glossary. Available from: [14 February 2011].
Morrisey, Janet, 2008, Credit Default Swaps, Time. Available from: <,8599,1723152,00.html> [13 February 2011].
Pritchard, Justin, 2011, Sub-Prime Definition, About. Available from: <> [12 February 2011].
Verengo, Mitias, 2011, Triple Crisis. Available from: <> [14 February 2011]
Ware, Tony, 2005, Financial Derivatives, University of Calgary. Available from: [14 February 2011].
Harvard Format.

Cite this Document:

"Financial Derivatives On Sub-Prime Crisis" (2011, February 14) Retrieved June 30, 2022, from

"Financial Derivatives On Sub-Prime Crisis" 14 February 2011. Web.30 June. 2022. <>

"Financial Derivatives On Sub-Prime Crisis", 14 February 2011, Accessed.30 June. 2022,

Related Documents
Financial Derivatives This Study Emphasized the Importance
Words: 3145 Length: 10 Pages Topic: Economics Paper #: 53617269

Financial Derivatives This study emphasized the importance roles of financial derivatives, which has been known for the last decade and its effects on the Global financial crisis. It further analyzes the impact of financial derivatives and how it can be controlled to prevent corporations from incurring a lot of risks. It also explains the existence of financial derivatives since 1970, to the recent Global Financial Crisis which occurred in the 2006. Risk

Derivatives the Line Between the
Words: 1675 Length: 6 Pages Topic: Economics Paper #: 62699014

Interest rates are set at the national level, and the state of the economy is also national. Additionally, trends in investment flows (particularly into real estate) also proved to be national. As a result, the level of market risk remained high even when the level of asset-specific risk was reduced through the securitization process. It is not inevitable that this had to happen this way. Banks, however, overinvested in the

Financial Crisis of 2007-2009
Words: 2251 Length: 8 Pages Topic: Economics Paper #: 7342025

Financial Crisis and Its Implications: Events Occurring Between 2007 and 2009 A Critical Literature Review The Roots of the Crisis Real Estate Valuation Bubble Sub-Prime Mortgages Low Interest Rates Moral Hazard in Regard to Consumer Spending Packaging Real Estate Loans as a Commodity (Derivatives) Market Interrelatedness Future Implications The financial crisis, which seemed to be elevated to its greatest extent world-wide between the years 2007 and 2009, is difficult to unravel. The causes, interlink-ages, and effects are so intertwined that

Bank of America Financial Analysis
Words: 2682 Length: 7 Pages Topic: Business Paper #: 35332232

Key findings from the analysis are provided here: Income Statement Variance Analysis Bank of America achieved a 37.4% increase in revenue between 12/31/05 and 12/31/06, driven by acquisitions and organic growth in Retail Banking and Card Services. Cost of Revenue increased 53% in the same fiscal period. Net Income increased 28% from $16.4B to $21.2B also driven by the acquisitions completed during the period. As a result Earnings per Share on a

Global Financial Crisis GFC the Present Global
Words: 2500 Length: 8 Pages Topic: Economics Paper #: 46711777

Global financial Crisis (GFC) The present Global Financial Crisis (GFC) has been considered by the financial experts and economists as the worst financial crisis apart from 1930s Great Depression. The GFC led to the collapse of large financial institutions and downturns of the major stock markets globally. The crisis led to the failure of several key businesses and s significant decline in the economic activities. The GFC started on the U.S.

Subprime Crisis Work Plan and Report
Words: 3105 Length: 6 Pages Topic: Careers Paper #: 64288901

real or hypothetical situation? The context of the report is based on the real world implications of the financial crisis on the banking industry and society as a whole. The report details the need for reform within the sector overall. Particular emphasis is placed on Bank of America, as it was a large component of the subprime-lending crisis. Why did you choose this topic, and does it relate to you in