The role derivatives in the financial crises of 2008

1. Credit Default Swaps
Presentation by-
Faiz Mohammad

2. Key points
● Definition
● Features
● Role in Financial Crises
● Growth in diversity of CDS contracts
● Securitization

3. Definition
● Credit Default Swaps represent bilateral insurance
contracts between a protection buyer and a
protection seller, covering a corporation's or
sovereign's specific bond or loan.
● They are subject to counter-party risk - the risk that a
protection seller will not be able to pay a claim.

4. Features
● Unlike options and futures, swaps are not
standardized instruments and have been generally
traded on OTC markets - that is, directly between
buyers and sellers rather than through a regulated
exchange.
● An important aspect of CDS is that investor can
purchase CDS protection without actually having
ownership of the insured security.

5. Role in the financial crises
● In the period leading up to the financial crises the
advantageous leverage and convenience of CDS
fueled a speculative frenzy.
● Dealers on both the buy and sell sides rushed to
issue and purchase CDSs written on debt they did
not even own.

6. Role in the financial crises
● While there are relatively safe CDSs written on
interest rate and corporate bonds, some financial
institutions wrote CDS on low quality sub-prime
mortgage-backed securities (MBSs).
● The MBS are bonds that combined into large pools
the mortgages issued to borrowers with below
average credit history by loan originators.

7. Role in the financial crises
● The rise in the amount of CDS outstanding was swift;
it rose from $920 bn in 2001 to $62 tn in 2007, which
was more than 4 times the U.S GDP for that year.

8. Growth in diversity of CDS contracts
● The surge in trading volume led to innovation and
differentiation among CDSs.
● For instance, a single name CDS protects the buyer
against the default risk of a single company.
● While a multiple-name CDS hedges the risk of
default of several firm or forms of debt, such as pool
of sub-prime residential MBSs.

9. Growth in diversity of CDS contracts
● At the same time dealers also hedged their exposure
with equivalent protection purchased from another
dealer or insurance company.
● American International Group (AIG), for example,
sold an enormous amount of these contracts.

10. Securitization
● It is necessary to clarify that MBS and CDO, which
are often mentioned in discussions of the financial
crises, are not derivatives.
● They are securitization.
● The process of securitization involves creating a new
financial instrument by combining other financial
assets and then marketing other financial tiers of
repackaged instruments to investors.

11. Summary
● Credit Default Swaps are customized derivative
contracts between protection buyer and protection
seller.
● In the period preceding the financial crises, CDS
written on MBS became very popular.
● Securitization is a process of creating a financial
instrument or security from an underlying financial
asset e.g.mortgages.

12. Steps in Financial Crises
Key Points
● Excess Liquidity
● Growth in Housing Market
● Credit Crises
● Collapse of Banking System
● Bankruptcy, Mergers & Bailouts

13. Excess Liquidity
● In 2001, following a massive stock market and capital
spending bubble Federal Reserve worried about
recession.
● It kept interest rates down to 1% till 2004, raising
them slowly only 0.25% at a time.
● During low interest rate regime, the financial services
industry became bullish on real estate.

14. Growth in Housing Market
● Meanwhile, the American retail investors too were
anticipating a bubble burst.
● But they soon realized that money lost in the stock
market was more than offset by rising housing prices.
● They too started investing in real estate. As
americans spent freely, the U.S went further into debt
with the rest of the world.

15. Credit Crises
● In 2006 the sub-prime borrowers - started to default,
when prices ran out of their range of affordability.
● In february 2007, HSBC wrote down billions of dollars
in losses from their acquisition of U.S sub-prime
lender Household International.
● In June 2007, two Bear Sterns hedge funds with
exposure to U.S housing market blew up.

16. Credit Crises
● In August 2007, BNP Paribas froze withdrawals in
three investment funds.
● This marked the official beginning of credit crises.
● If a bank with zero exposure to U.S mortgage sector
could have this difficulty, anyone could be hiding
untold losses.

17. Credit Crises
● The result was mutual distrust amongst large banks
operating in the global market for inter-bank loans
which lead to credit crises in the banking system.
● By september, liquidity in the inter-bank market was
so bad Northern Rock - an aggressive British
mortgage lender - had to be bailed out by the Bank
of England.

18. Collapse of Banking System
● Meanwhile, the U.S. housing prices continued to
decline. The first wave of mortgage-related losses
were reported from derivative instruments - MBS,
CDS and CDOs.
● In October 2007, Merill Lynch was first to report
losses of $5.5 bn. Within three weeks its losses rose
to $8 bn.

19. Collapse of Banking System
● Eventually, the losses reached $500 bn a year into
the crises for all global institutions.
● In March 2008, hedge funds - Carliyle Capital and
Peloton went down.
● Then Bear Sterns - fifth largest investment bank -
collapsed. The fed mediated its takeover by JP
Morgan Chase that was a catastrophic 90% loss for
BS's shareholders.

20. Collapse of Housing Finance
● In June 2008, Lehmann Brothers declared a $3 bn
loss. And by August 2008, Merill Lynch losses were
followed by losses at most of the financial institutions.
● IndyMac, a mortgage lender was taken over by FDIC.
● The result led to the questioning the viability of
Fannie Mae and Freddie Mac, the two largest
mortgage lenders in the U.S.

21. Bankruptcy, Mergers & Bailouts
● In september, Lehmann brothers was unable to close
a merger in around-the-clock negotiations. The
company filed for bankruptcy as the U.S. government
didn't come to the rescue.
● Merrill Lynch- another investment bank- sensed
trouble. But it sought and also received cover in a
takeover by Bank of America that very same
weekend.

22. Bankruptcy, Mergers & Bailouts
● After the collapse of Lehmann Brothers, no company
appeared too big to fail. AIG - largest insurance
company in America- was bailed out by the Federal
Reserve.
● By this time, the Fed had enough. The time for ad-
hoc management was over. The Treasury Secretary
moved decisively and put forward his $700 bn bailout
plan.

23. Overview
● The recessionary conditions meant that the Fed had
to keep interest rates low.
● Low interest rate economy made the housing market
attractive.
● But the housing prices couldn't keep pace with the
returns expected by Mortgage industry.
● Sub-prime borrowers were the first to default. But
they triggered the collapse of the whole banking
system.