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Financial Collapse

Financial Collapse. Destruction of Wealth Collapse of Banks Falling Housing Prices Freezing Credit Markets Attributable to Credit Default Swaps?. Credit Default Swaps (CDS). Financial Derivative Protection Buyer and Seller Insurance Contract No exposure needed Not transparent.

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Financial Collapse

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  1. Financial Collapse Destruction of Wealth Collapse of Banks Falling Housing Prices Freezing Credit Markets Attributable to Credit Default Swaps?

  2. Credit Default Swaps (CDS) • Financial Derivative • Protection Buyer and Seller • Insurance Contract • No exposure needed • Not transparent

  3. Benefits and Costs • Credit Risk allocation • Creation of larger market • Revealing of credit risk information • Systemic Risk through large exposure • Credit Boom • Lack of Transparency and manipulation

  4. OTC vs. Exchange • Quotes from dealers vs. brokers • Exchange Clearinghouse • Margin Agreements • Publicly Available prices

  5. CDS Market Size • Originally conceived by JPMorgan Chase when they sold the credit risk of Exxon to the European Bank of Reconstruction and Development • Grew incredibly large over a short period of time • Since 1997 grew to $45 trillion

  6. Subprime Mortgages • Banks made loans to individuals with a high probability of default • Mortgages are pooled, securitized and have notes issued against them so that financial institutions do not have to keep them on their books • This allows banks to make more loans that they may otherwise not be able to

  7. Securitization of Mortgages and Tranches

  8. Banks then hedge • Investors are essentially buying a claim on the cash-flow from these mortgages • Because there is a high probability of default on this cash-flow banks are hesitant to assume all of the risk • They then engage in CDS contracts which shift the risk of default to another company (i.e. AIG) • That company may then hedge against that newly acquired risk with another CDS

  9. Default • Once default occurs the CDS seller is required to pay out the sum of the debt lost • Because CDS can be traded, the holder of the CDS may not be the holder of the debt • This can cause problems because the don’t know whose debt they have assumed responsibility in covering and restructuring is not a possibility • Furthermore, if you don’t hold the debt but hold the CDS, there is no incentive to restructure

  10. CDO • Issuers of CDS would issue CDO (collateralized debt obligation) to offset the CDS • Credit defaults benefited the buyers of the CDS and hurt the investors of the CDO • No net loss only wealth transfer • However, CDO often had higher credit rating than the loans they were collateralizing

  11. Unconsidered Correlations • Law of large numbers did not hold because of unconsidered correlations in the housing market • Mortgages were pooled from the same geographic area • Resulted in insufficient collateral and reserves

  12. Systemic Collapse • The crisis created a situation in which already weak institutions were at risk of losing more money if another institution became insolvent, thus causing their own insolvency. • This could have created a domino effect, in which all major financial institutions crumbled. This would cause a situation in which loans would be near impossible to get, and economic activity of even profitable institutions would be severely curbed.

  13. The Bailout • The first moves were by the Federal Reserve began loaning large sums of money in auctions at high interest rates to improve liquidity in a rigid market. • In 2008 the Federal Reserve began offering bailouts in which it would loan large sums of money to troubled institutions in exchange for large stakes in equity, the most famous example being AIG • Congress, under the advice of the Secretary of the Treasury and the Chairman of the Federal Reserve, allocated $700 billion to purchase troubled assets from institutions, thus massively decreasing the riskiness of each institution and allowing business between institutions without the fear that their partner was insolvent.

  14. Looking Forward • A variety of remedies have been proposed for the problems surrounding the crisis; however, little has come of them so far. They include: • A system to deal with the failure of a currently non-regulated financial institution such as a hedge fund • Various measures to decrease the size of financial institutions, thus removing the possibility that any one institution is “too big to fail.” • Requiring that credit default swaps are only made if one party is actually insuring their own debt, thus making it more like an insurance contract or, at least to make the CDS market public. • Restrict the amount of leverage an institution can assume, and make salaries or bonuses associated with long-term rather than short-term success. • Requiring minimum down payments for mortgages

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