The Role Played by Derivative Investments

Introduction

The sub-prime mortgage crisis that was experienced in the United States of America since 2006 comprised of a series of events that led to the global financial crisis of the year 2007 (Keys, 2009). This event was characterised by an increase in sub-prime mortgage delinquencies leading to a decline in the securities that supported these mortgages. As a result of this phenomenon, major financial institutions in the United States collapsed. This led to a decline in the provision of credit to businesses and individuals as well. Due to the trickledown effect, the impacts of this phenomenon affected other financial sectors hence leading to the great global recession of 2008. This paper will therefore critically analyse the role played by derivative investments and derivative securities in the sub-prime bond credit crunch that led to the greatest financial crisis that the world has ever experienced since the great depression of the 1930s.

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Summary

Since the 1990s and the beginning of the 21st century, the US mortgage industry had been growing at a tremendous rate. However, in 2006, this industry started to face a number of challenges leading to its meltdown. According to Lang (2010), the following factors played a critical role that led to the meltdown of this industry:

  1. Appreciation of the housing industry
  2. Reduction in mortgage underwriting standards
  3. Rapid growth of the residential mortgage-backed securities market

Due to the viability of the housing market in the United States since the 1990s, many people invested in this industry to gain its lucrative profits. Consequently, the growth of house prices was characterised by an increase in the provision of mortgage loans. The high prices of houses increased the borrower’s equity and at the same time, it reduced default rates (Keys, 2009). However, due to the viability of the housing market, there were reductions in the underwriting standards. For instance, there was a change in the sub-prime mortgages between the year 2000 and 2006 where it increased from 2.4% ($150 billion) to 13.5% ($700 billion) (Lang, 2010). Similarly, the combined loan-to-value ratio (CLVT) also increased from under 90% in 2003 to 100% in 2006 (Lang, 2010).

Other than these facts, several models have been advanced to explain the deterioration of the underwriting standards. In their model for instance, Demyanyk and Van Hemert (2009) stated that sub-prime mortgages reduced drastically since 2001 across all mortgage product types. To guarantee the effectiveness, Demyanyk and Van Hemert (2009) ensured that this model focused on the survival rate of mortgages, measures that had been put in place to control the characteristics and activities of borrowers, the characteristics of the loans that had been issued, and most importantly, the effects that macroeconomic factors had on the housing industry.

Finally, the housing market grew drastically between the year 2000 and 2006 due to an increase in the rate of residential mortgage-backed securities (RMBS). During the 20th century, RMBS rate use to be approximately 20%. However, between the year 2000 and 2006, this rate increased to an astonishing 56% (Mayer, 2009). Due to this fact, mortgage lending companies started giving out loans without following the standards and procedures that had been put in place to ensure that this process is effective and efficient. Most of these institutions operated on the notion that the housing industry was too big to fail (TBTF).

However, the collapse of the RMBS in 2006 played a significant role in the collapse of huge financial institutions hence leading to the global financial crisis that commenced in 2007. Prior to this occurrence, the price of houses in the United States started to decline since the 2005 leading to an increase in mortgage loan default rates (Kumar, 2007). However, using the TBTF concept, analysts believed that these defaults and foreclosures would not have a huge financial impact on the housing market since they only accounted for only 13% of the mortgages that had been issued.

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By 2007, the effects of the mortgage defaults started to be experienced in the financial sector. This impact was great on firms that were exclusively involved in the mortgage lending business such as New Century Financial. In June 2007, Bear Stearns spent over $3.2 billion to bail itself from the losses that it was facing (Lang, 2010). In August 2007, BNP stopped funding three major investments in the mortgage industry (Lang, 2010). According to the French bank, the main reason behind this decision was that it was not possible for them to value any asset in the investment scheme since they had ‘disappeared’. This move froze the short-term credit market. To averse this situation, the European Central Bank, the Federal Reserve and the Bank of Japan pumped more money into the market to reduce the effects of the sub-prime credit crunch. Despite these efforts however, the credit worthiness of many mortgage-lending companies was questionable hence the outburst of the global financial crisis.

Critique

From the summary above, it is evident that derivative investments and securitisation played a critical role in the sub-prime credit crunch that was experienced in the United States hence leading to the global financial crisis that commenced in 2007. In the process of giving out mortgages, the mortgage lending institutions took several measures to ensure that these loans were secure. At the same time, they ensured that such commitments would not expose them on the mortgage industry. However, from the studies that have been conducted, it is evident that these firms did not accurately determine the risk that they were exposing themselves to since their decisions and operations were based on the TBTF concept (Lang, 2010). These firms highly concentrated on the incentives that were being offered in the market while disregarding the quantity, nature, and the effects that their decisions had on their operations. Thus, such decisions are evidence of the failure of the risk management strategies that these firms had put in place (Senior Supervisors Group Survey, 2009).

Consequently, the failures of mortgage companies also affected financial institutions due to the presence of complex financial products that were used in the mortgage lending process. Between 2007 and 2008, most of the losses that were experienced in the housing industry originated from the financial structured products as compared to the normal operations (as reflected in their balance sheets) of mortgage lending firms (Lang, 2010). As Mayer (2009) reports, a high percentage of securities that were placed on mortgages were based on lowly rated RMBS since most financial institutions retained super senior collateralised debt obligations (CDOs) despite the fact that these instruments exceeded their capacity to handle them within their internal limits. At this time therefore, it would have been wise for the financial institutions to determine the impacts that CDOs would have had on their operations given the status of RMBS and underlying mortgages at that time. With this knowledge, it would have been easier for these firms to effectively implement their risk management procedures with regards to mortgage securities hence avoiding the resultant outcomes.

Consequently, credit rating agencies (CRAs) played a significant role in the collapse of the mortgage industry and the subsequent global financial crisis. From the studies that have been conducted and my personal analysis, it is evident that CRAs failed to exhibit high levels of integrity in following the due process of rating securitised assets (Lang, 2010). There were instances where CRAs highly rated securitised assets as a marketing strategy. Thus, from the models that have been developed, it has been revealed that CRAs actions were driven by the motive of maximizing their profits. At the same time, CRAs had put in place poor monitoring strategies that failed in determining the long-term effects of the housing industry. Between the year 2000 and 2006, it was common for CRAs to base their decisions on the prevailing market trends. Therefore, thay assumed that the past performance of the housing market was an effective indicator of the future trends in the industry. As a result, mortgage lending firms became reluctant to put in place stringent securitisation measures that would ensure that their operations are sustainable, especially in an event of a crisis, like the financial crisis of 2008.

To some extent, it is believed that regulating and law enforcement agencies, investors, and policy makers played a significant role in this outcome of this phenomenon. Alam (2010) argues that people and firms made huge investments in the housing market without undertaking sufficient market analysis. For most of these investors, their main goal was to gain high returns within the shortest time possible. At the same time, regulators and policy makers did not take effective measures to ensure that effective laws and policies have been put in place to control the growing securitised market since most of their decisions were based on results that were released by CRAs. Due to poor policies and regulations, it was difficult for financial institutions and mortgage lending agencies to fully understand the effects that the securitised financial products would have on their operations in an event where the financial market would collapse. Thus, due to poor policies and frameworks, it was virtually impossible for financial institutions and mortgage lending businesses to keep up with the advancements that were being experienced in the financial market. These advancements played a significant role in the growth of securitised products. At the same time, it supported sub-prime lending hence leading to a financial crisis that crumbled the global economy in 2008.

Conclusion

After analysing the housing industry in the United States between the year 2000 and 2008, it is evident that derivative investments and securitisation were the main factors that led to the sub-prime credit crunch in 2007 hence leading to the global financial crisis. Investors, policy makers, law enforcement agencies, CRAs, mortgage lending firms, and financial institutions were reluctant to implement risk management strategies that would have prevented the overreliance of securitised products without proper market analysis. To averse the occurrence of this scenario in the future, I would recommend that tougher regulations should be put in place to control the operations of CRAs to ensure that securities are rated appropriately. Consequently, an international body should be put in place to ensure that CRAs operate as per the set rules and standards. Most importantly, investors, mortgage lending firms, and financial institutions should put in place effective risk management strategies that would ensure that critical analysis and sound decisions are made with regards to derivative investments and securities. This will ensure that a proper valuation of assets is conducted, market viability is considered. Mortgage firms and financial institutions should also be transparent and operate with integrity.

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References

Alam, Q, 2010, ‘Securitisation and Subprime Financial Crisis’, Journal of Economics, vol. 2 no. 1, pp. 1152-1171.

Demyanyk, Y and Van Hemert, O 2009, ‘Understanding the subprime mortgage crisis’ Review of Financial Studies, vol. 3 no. 2, pp. 41-67.

Keys, B 2009, ‘Did securitization lead to lax screening: Evidence from subprime loans’, Journal of Monetary Economics, vol. 56 no. 2, pp. 700-720.

Kumar, R 2007, ‘Bankruptcy prediction in banks and firms via statistical and intelligent techniques: A review’, European Journal of Operational Research, vol. 180 no. 1, pp, 1-28.

Lang, W 2010, ‘The mortgage and financial crises: the role of credit risk management and corporate governance’, Atlantic Economic Journal, vol. 3 no. 1, pp. 32-61.

Mayer, C 2009, ‘The rise in mortgage defaults’, Journal of Economic Perspectives, vol. 23 no. 1, pp. 27-50.

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Senior Supervisors Group Survey 2009, ‘Risk management lessons from the global banking crisis of 2008’, Journal of Consumer Science, vol. 14 no. 1, pp. 11-30.

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