Running head: Derivative Instruments and the 2007-2008 Financial Crisis

What part did derivative instruments play in the financial crisis of 2007-2008?

Richard Lartey, PMP SMC University Switzerland

March 04, 2012

The views expressed in this paper are the authors alone. I am extremely grateful to Dr. John H. Nugent, Associate Professor, School of Management, Texas Womans University, for constructively reviewing this paper and providing valuable comments. But of course, the usual disclaimers apply and any mistake is the authors only and does not engage anyone but the author!

Electronic copy available at: http://ssrn.com/abstract=2029073

Derivative Instruments and the 2007-2008 Financial Crisis

Table of Contents

Table of Contents .......................................................................................................................................... 2 Abstract ......................................................................................................................................................... 3 1.0 2.0 2.1 Introduction ....................................................................................................................................... 4 Presentation of the facts .................................................................................................................... 6 What are Derivatives? ................................................................................................................... 6

2.1.1. The use of derivatives ................................................................................................................. 7 2.2 2.3 3.0 3.1 3.2 3.3 4.0 4.1 5.0 6.0 7.0 Derivative instruments that were traded during the 2007-2008 financial crisis ........................... 9 How and why did the 2007-2008 financial crisis happen? ......................................................... 10 Discussion of the facts .................................................................................................................... 13 The role of the subprime mortgage market ................................................................................. 14 Derivative instruments and the financial meltdown.................................................................... 16 The Role of Credit Rating Agency ............................................................................................. 18 Analysis of the facts ........................................................................................................................ 19 How the derivative instruments contributed to the global financial crisis .................................. 19 Conclusions ..................................................................................................................................... 23 Recommendations ........................................................................................................................... 23 Areas for further research ............................................................................................................... 24

References ................................................................................................................................................... 25 Appendices.................................................................................................................................................. 28 Appendix I: Overview of credit risk transfer instruments ...................................................................... 28 Appendix II: Mortgage-Backed CDO Issuance Prior to the Financial Crisis ......................................... 29 Appendix III: Subprime Share of Mortgage Market ............................................................................... 29 Appendix IV: Losses and Bailouts for US and European countries during the global financial crisis ... 30

Electronic copy available at: http://ssrn.com/abstract=2029073

Derivative Instruments and the 2007-2008 Financial Crisis

Abstract Derivative instruments provide means of hedging and speculation for many of the players to actively participate in the capital market, thereby leading to high volume of transactions and growth. Several things have led to an imminent failure of the derivative market during the 20072008 global financial crisis. These include lack of close monitoring of the Securities and Exchange Commission (SEC), inappropriate rating of the derivative instruments by the credit rating agencies, failure of these instruments to reflect the true market price and lack of effective risk management. But failure of the financial derivative instruments leading to their worsening of the global financial crisis is not to suggest that derivatives should not be traded. Derivative markets should be properly regulated and controlled by the appropriate agencies.

Keywords:

Derivative Instruments, Financial Crisis, Risk, Subprime, Financial Market,

Securities and Exchange Commission, Credit Rating Agencies.

Electronic copy available at: http://ssrn.com/abstract=2029073

Derivative Instruments and the 2007-2008 Financial Crisis

1.0

Introduction While the development of new financial instruments has created opportunities for

households and companies to improve their management of financial risks and has facilitated the smoothing of consumption and investment over time and across different states of the world, it has added much complexity to the global financial system. Contemporary management of financial instruments is now being focused on several financial assets, ranging from money market instruments to bonds, stocks and derivatives (both in euro and in foreign exchange). But there are problems in relations to the complexity of the structure under management. Before the financial crisis, it became obvious that the risks taken by the largest banks and investment firms were so excessive and risky that they threatened to bring down the financial system. On the contrary, this was back when the major investment firms were still assuring investors that all was well, based on their fantastically complex mathematical models (Nocera, 2009). Developments in the banking and the near-bank system, which had been lauded as improving efficiency and financial stability, have rather caused serious harm to the real economy. Turner (2009) found that at the core of the 2007-2008 crisis was an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10-15 years, and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances. In recent years, fund managers, insurers and bankers have transformed investment practices by creating financial instruments known as derivatives, whose value is derived from the price of another underlying asset. The original idea of derivatives was to help actors in the real economy insure against risk but many derivatives trades have crossed the line of price stabilization and risk management into speculation (Wilks, 2008). The 2007-2008 financial crisis was a system-wide bank run on the trade of complex derivative instruments, in that it did not occur in the traditional-banking system,

Derivative Instruments and the 2007-2008 Financial Crisis

but instead took place in the securitized-banking system (Gorton, 2010). Complex derivative trades, as contemporary financial practices have fuelled more than a decade of cheap credit and destabilized financial system. Targeted financial instruments such as derivatives (futures, swaps, or options) or insurance are alternative to using operations directly to reduce risk. Such instruments are available for many commodities, currencies, and stock indices, interest rates, and the menu is continually expanding to reflect a variety of other risks including even the weather (Meulbroek, 2002). But the use of derivative instruments can be disastrous and mess up the capital markets. Hedge funds, private equity corporations, investment banks and pension funds have all used derivatives to evade regulations. They have devised elaborate and opaque financial vehicles through which they have dumped risks onto the state or onto less informed investors including pension holders (Wilks, 2008). Most derivatives are sold over the counter through private trades rather than on public stock or commodity exchanges, which gives investment banks flexibility to propose to their customers whatever deal they want, rather than being bound by the trades sanctioned by exchange supervisors (Wilks, 2008). What this means is that as the deals are secret they do not help other investors price risk, and often investors, regulators and other analysts do not know what liabilities a company has taken on. The crisis and the role played by some derivative market segments require a deeper discussion on how to reconcile the clear value played by derivative markets. This paper explores some of the derivatives available on the capital markets and discusses the role these derivative instruments played in the 2007-2008 financial crisis. The paper is divided into three parts. Part one provides a background of the essay and presents some facts on derivative instruments and the role they played in the 2007-2008 financial crisis. Part two discusses the findings, with emphasis on relating the relevant issues raised in the

Derivative Instruments and the 2007-2008 Financial Crisis

presentation to existing literature. The final part analyzes the contribution of derivative instruments in the financial crisis and provides recommendations to obviate future occurrences. 2.0 Presentation of the facts This section discusses some of the key derivative instruments that were traded during the 2007-2008 financial crisis. Their brief description and how they contributed to the global financial crisis are also presented. 2.1 What are Derivatives? Derivatives in general are financial contracts on a pre-determined payoff structure of securities, indices, commodities or any other assets of varied maturities; which assume economic gains from both risk shifting and efficient price discovery by providing hedging and low-cost arbitrage opportunities (Jobst, n.d.). The underlying platform on which a derivative is based can be an asset, (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index , (e.g. interest rates, exchange rates, consumer price index (CPI), stock market indices), or other items e.g., weather conditions, or other derivative instruments) (Qudrat, 2009). Derivatives are like chameleon - they easily can change form and appearance. The chameleon-like nature of derivatives makes it difficult to determine what constitutes a credit derivative, and thus what should be required to be registered (Schwarcz, 2009). In mathematical terms, the first derivative is always positive, the second always negative. Thus derivatives can be likened to Falkensteins (2010) assertion that We always like more money but a dollar is worth less the more you have. There has been rapid growth (frequency of use and complexity of instruments) in the corporate use of financial derivatives such as forwards, futures, options and swaps. A recent survey conducted by the Bank for International Settlement (BIS) showed that of the estimated

Derivative Instruments and the 2007-2008 Financial Crisis

US$ 74 trillion (in notional value terms) of over the counter interest rate and foreign exchange derivatives outstanding in December 1999, approximately 11% (US$ 8 trillion) were held by non-financial users (Merton, 1996, cited in Barnes, 2001). But there were issues of financial reporting with respect to the use of these derivatives. In the late 1990s, as the use of derivatives was exploding, the Securities and Exchange Commission ruled that firms had to include a quantitative disclosure of market risks in their financial statements for the convenience of investors (Nocera, 2009). The rapid growth in the use of derivatives by corporate users has not been matched by the corresponding development in the financial infrastructure i.e. the institutional interfaces between intermediaries and financial markets, regulatory practices, organization of trading, clearing, back-office facilities and management information systems (Merton, 1996, cited in Barnes, 2001). In 2003 Warren Buffett called derivatives financial weapons of mass destruction. It is in the light of this that Alexandre Lamfalussy cautioned against the use of derivatives that enhances instability and increases system risks against the backdrop of global markets (ALDE, 2008). Merton (1996, cited in Barnes, 2001) found that accounting and disclosure in relation to the use of derivatives by non-financial corporations have been internally inconsistent, nonuniform across various types of derivatives and incomplete. 2.1.1. The use of derivatives Derivatives can be combined to replicate other financial instruments, thus they can be used to "connect" markets by eliminating pricing inefficiencies between them (European Commission, 2009). Derivatives thus play a fundamental role in price discovery. They may also provide a view on the default risk of a reference entity, on a company or a sovereign borrower, or of a particular segment of the credit market. Thus, derivatives allow for pricing of risk that might

Derivative Instruments and the 2007-2008 Financial Crisis

otherwise be difficult to price because the underlying assets are not sufficiently traded (European Commission, 2009). Derivative contracts can either be traded in a public venue, i.e. a derivative exchange, or privately over-the-counter (OTC), i.e. off-exchange. OTC derivatives markets have been characterized by flexibility and tailor-made products (European Commission, 2009). This satisfies the demand for bespoke contracts tailored to the specific risks that a user wants to hedge. Exchange-traded derivative contracts, on the other hand, are by definition standardized contracts. Chart 1 depicts the size of derivatives markets (on- and off-exchange) Chart 1: The size of derivatives markets: on- and off-exchange

Source: European Commission, 2009 While derivatives were initially mostly traded in public venues, today the bulk of derivatives contracts is traded OTC (roughly 85% of the market in terms of notional amounts outstanding). The OTC market has expanded quickly in recent years, but decreased in 2008 for the first time since monitoring started in 1998 (European Commission, 2009). Contrary to equity markets, where the post-trade aspects (e.g. exchange of cash and transfer of ownership) are

Derivative Instruments and the 2007-2008 Financial Crisis

completed quickly (less than 2/3 days), derivative contracts involve long-term exposure, as derivative contracts may last for several years (European Commission, 2009). This leads to the build-up of huge claims between counterparties, with the risk of a counterparty defaulting. 2.2 Derivative instruments that were traded during the 2007-2008 financial crisis Some derivative instruments were traded on the capital market during the 2007-2008 financial crisis. These include asset-backed securities, mortgaged-backed securities, collaterized debt obligations, credit default swaps, forward, futures and options. Asset-backed securities are the most basic forms of financial derivatives which provide the backbone for much of the complex derivative instruments. An asset-backed security refers to any type of debt security which is backed by a pool of assets, their cash flow generating ability. A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Derivatives traders have also developed collateralized debt obligations (CDOs) through which a financial institution combines assets of various types (for example prime mortgages with subprime ones). The packaged debt is then sold to a special purpose vehicle, generally registered offshore in a low tax jurisdiction. The new entity then issues its own equity or bonds to resell the debt to other investors, carving it up into different tranches with different risk ratings using complex mathematical models (Wilks, 2008). In a credit default swap deal, the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or credit write-down in respect of a mortgage or other debt securities they hold (Wilks, 2008). CDSs are mainly credit derivatives where the underlying asset is a loan, mortgage or any other form of credit. Credit derivatives are financial contracts that allow the transfer of credit risk (see

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appendix I) from one market participant to another, potentially facilitating greater efficiency in the pricing and distribution of credit risk among financial market participants (Bomfim, 2001). A forward is a contract whereby two parties agree to exchange the underlying asset at a predetermined point in time in the future at fixed price (European Commission, 2009). Therefore, the buyer agrees today to buy a certain asset in the future and the seller agrees to deliver that asset at that point in time. Futures are standardized forwards traded on-exchange. An option is a contract that gives the buyer the right, but not the obligation, to buy (call) or sell (put) the underlying asset at or within a certain point in time in the futures at a predetermined price (strike price) against the payment of a premium, which represent the maximum loss for the buyer of an option (European Commission, 2009). 2.3 How and why did the 2007-2008 financial crisis happen? Understanding what happened, how and why the financial crisis came about is essential for ascertaining what role derivative instruments played in the crisis. Since 1974, 18 bank crises had occurred around the world and each shared something in common: a period of great financial liberalization and prosperity that preceded the crisis (Reavis, 2009). With this in mind, Reavis (2009) asserts that financial crises may be an unavoidable aspect of modern capitalism, a consequence of the interactions between hardwired human behavior and the unfettered ability to innovate, compete and evolve. The financial system became so crowded in terms of the bizarre amounts of capital deployed in every corner of every investable market that the overall liquidity of those markets declined drastically. The financial crisis resulted from a cascade of failures, initially triggered by the historically unanticipated depth of the fall in housing prices. Many argue that the financial crisis that began in August 2007 was a systemic event, in which the banking sector became insolvent, in the sense that it could not pay off its debt (Gorton &

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Metrick, 2010). Some economist believed that the 2007-2008 financial crisis was caused by powerful elites ( banking oligarchy) who overreached in good times and took too many risks by making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse (Reavis, 2009). From a macro-economic perspective, the collapse of the U.S. housing market was what triggered the financial crisis that began in 2008, thus the erosion of the housing market led to an erosion of wealth (Reavis, 2009). It all started when former president of the United States, Bill Clinton, passed a law in 1995 whereby common people could get easy access to bank credit for housing purposes, without any regards as to whether the loans can be repaid or not in the future (Qudrat, 2009). Commercial banks thus provided loans at sub-prime rate (rate well above the reference interest rate charged by the banks) to the common people for housing purposes. These loans were backed up against the houses - subprime mortgage loans. Subprime mortgages are mortgage loans issued to individuals who do not meet the standard requirements for conventional mortgages. This may be due to poor credit history, unstable income history, or any other factor affecting the cash flow generating ability of the individual (Qudrat, 2009). Prior to the financial crisis, lenders made mortgage loans available to even risky borrowers and charged high interest rates to offset losses. However, when home prices stopped appreciating, these borrowers could not refinance; in many cases, they defaulted (Schwarcz, 2009). In 2006 the average home cost nearly four times what the average family made. Even though household incomes remained flat during that time (Chart 2) more and more people were able to afford houses due to an easing of lending requirements (Reavis, 2009).

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Chart 2: Growth of U.S. Housing Prices versus Household Income

Source:

Reavis (2009)

By 2007 it became evident that the housing bubble was starting to burst and people began defaulting on their mortgages, sending a ripple effect through the financial system (Reavis, 2009). Schwarcz (2009) found that these defaults have caused substantial amounts of low investment-grade mortgage-backed securities to default and AAA-rated securities to be downgraded. As more people defaulted and went into foreclosure, more houses came on the market pushing housing prices down precipitously (Chart 3). This collapse in market prices meant that banks and other financial institutions holding mortgage-backed securities had to write down the values of the securities that caused these institutions to appear more financially risky, in turn triggering concern over counterparty risk; afraid these institutions might default on their contractual obligations, many parties stopped dealing with them (Schwarcz, 2009). Suddenly, banks started defaulting on their loans as well, triggering the downward spiral that by late 2008 gripped the entire world economy. Many banks were facing insolvency, thus their assets were too small to cover their liabilities, which was to say they owed more money than they had. Credit

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markets started to freeze up and individuals and businesses alike could not get loans (Glass et al., 2009, cited in Reavis, 2009). Chart 3: U.S. Housing Prices, 1990-2008 (adjusted for inflation)

Source:

Reavis (2009)

There was also the human element of greed and fear that contributed to the crisis (Reavis, 2009); in which banks were not willing to mark-to-market which meant they did not want to enter the actual market price of their assets on their books, for by doing so many would be declaring bankruptcy. Instead, many banks chose to hold on to them, thinking either that they were worth more than the market thought they were or that they would come back (Glass et al., 2009, cited in Reavis, 2009). 3.0 Discussion of the facts This section discusses some facts in relations to the 2007-2008 financial crises. It focuses on the parts played by the subprime mortgage market, derivative instruments and credit rating agencies in the financial crisis.

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3.1

The role of the subprime mortgage market In the subprime financial crisis, for example, one of the reasons market participants have

had difficulty learning the financial condition of their counterparties is that so many firms entered into over-the-counter credit derivatives such as credit default swaps under which credit risk is bought and sold. These swaps reduced transparency, thereby increasing the appearance, if not the actuality, of counterparty risk by dispersing credit risk contractually without a central place to ascertain how the risk was ultimately allocated (Schwarcz, 2009). At the time of the housing market collapse, stocks were sold at prices 50% less than what they were worth and houses had fallen substantially in value. The point is that people were banking on these assets having a certain value and that had implications for how much they were willing to consume and how much they were willing to invest if they were firms (Gross, 2009, cited in Reavis, 2009). Even though a very high percentage loss in the mortgage market seemed manageable, given the overall size of U.S. and the world debt markets, the subprime mortgage market was about $1.3 trillion. Moreover, the world financial markets had undergone numerous shocks of seemingly similar magnitude, such as September 11, the default of Enron and the subsequent accounting scandal, and the collapse of the tech bubble (Lang & Jagtiani, 2010). Many experts have given numerous explanations for the mortgage crisis. According to Lang & Jagtiani (2010), some explanations emphasized the role of irrational exuberance in the housing market, which led to a bubble that unexpectedly burst. Others cited the originate-todistribute model as distorting incentives for risk taking, since lenders no longer had skin in the game. Other explanations emphasized market participants overconfidence in sophisticated but untested statistical models of risk which led firms to under-price risk and to engage in excessive risk taking (Lang & Jagtiani, 2010). Inflated credit ratings of securities issued by the major credit rating agencies were the explanations given by others as a principal factor in the financial crisis.

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But Lang & Jagtiani (2010) argued that taken individually or in combination, these reasons are ultimately unsatisfactory explanations for the failure of these large institutions to mitigate the effects of a large shock to the housing market. With this in mind, Lang & Jagtiani (2010) suggest that based on information available at the time, the application of fundamental principles of modern risk management would have protected large and complex financial firms from being as vulnerable as they proved to be to shocks in the mortgage market. According to Lang & Jagtiani (2010), most of the initial losses in securities markets came from collateralized debt obligations (CDOs) and other structured securities that were tied to the residential mortgage market. Thus, relative to their capital position, large financial institutions had highly concentrated exposures to this structured but complex securities market. Fitch (2006, cited in Lang & Jagtiani, 2010) found that the number of subprime downgrades during JulyOctober 2006 was the largest in its history (see Chart 4 and appendix III). Despite a large number of defaults and downgrades in subprime securities, according to Calomiris (2008, cited in Lang & Jagtiani, 2010), both subprime and AAA-rated securities originations continued to rise in 2006 and early 2007 (see appendix II). The housing loans were being sold off by the commercial banks to many of the investment banks through securitization. Securitization is the process of issuing securities collateralized by a pool of assets like loans, mortgages, etc. In this case, the securities were collateralized by the subprime mortgage loans. This brought about many new forms of financial derivatives. Most of the investment banks which invested on these derivative securities, issued by the commercial banks, issued further new derivative instruments based on the values of the securities. Thus there was an effect of chain reaction. When the housing market collapsed, all these securities lost values thereby leaving many of the financial institutions bankrupt (Qudrat, 2009).

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Chart 4: Growth of Subprime Mortgages (1994-2006)

Source: Lang & Jagtiani, 2010 3.2 Derivative instruments and the financial meltdown Derivatives didnt cause the financial meltdown but they did accelerate it once the subprime mortgage collapsed, because of the interlinked investments (Global Issues, 2008). Turner (2009) points out two roles that derivative instruments played in the financial crisis. The first is mutual funds (which are not banks), taking consumer investments which are liquid in nature (immediate or very short redemption) and investing in long-term securities. The second is hedge funds, whose asset managers are present in the UK, and who are regulated as asset managers, though the actual legal fund is usually registered offshore and not subject to prudent regulation. Derivatives allowed money to flow more freely from those who had it to those who needed it. In addition to offering protection against the risk of financial loss, they offered fair returns to high-dollar investors willing to take calculated risks (Jordan, 2008, cited in Reavis,

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2009). For banks that loaned out tens of billions of dollars, derivatives, theoretically, helped mitigate risk by protecting them in case loans were defaulted. The global derivatives market expanded almost 50% during 2007, with CDS market and options markets growing exponentially (see Chart 5). The outstanding value of CDS contracts surged to more than five times the outstanding principal of global corporate bonds by the end of 2007 whilst the outstanding value of commodity derivatives rose from around US$400 billion in 1998 to US$9 trillion at the end of 2007 (Jenkinson, et al., 2008). Options markets have also grown very strongly. For example, the outstanding principal of interest rate options had increased from US$8 trillion in 1998 to US$57 trillion in 2007 (Jenkinson, et al., 2008). Chart 5: Outstanding notional amounts of derivatives

Source: Jenkinson, et al., 2008

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The risks inherent in Credit Default Swaps (CDS) and other types of over-the-counter (OTC) derivatives played crucial role in the financial crisis (European Commission, 2009). OTC markets are markets (with fairly light regulatory treatment) for professional investors, which are not directly accessible to the general public. These characteristics proved to be the bedrock of the OTC market during the financial crisis and might have, absent prompt and forceful intervention from governments, wrecked havoc to the financial system. For example, the near-collapse of Bear Sterns in March 2008, the default of Lehman Brothers on 15 September 2008 and the bailout of AIG on 16 September highlighted the fact that OTC derivatives in general and credit derivatives in particular carry systemic implications for the financial market (European Commission, 2009). EU governments have turned to derivatives and securitization as a means of removing debt from the public accounts and of raising capital without increasing their official debt burden (Wilks, 2008). Pension payments for former state employees, Export Credit Agency debts, and government real estate have all been put out to the market. The claims that are transferred through securitization are often disposed off without informing or obtaining agreement from the debtor country; and once ownership of the debt is dispersed it becomes difficult for the originating government to restructure or cancel claims (Wilks, 2008). 3.3 The Role of Credit Rating Agency Ratings of securities by the major rating agencies also played a major role in the derivative market. The market relied on the accuracy of ratings by the major rating agencies, which were greatly overstated, perhaps because of conflicts of interest in the rating process and the reliability of complex structured financial securities backed by low-quality mortgage loans (Lang & Jagtiani, 2010). Reliance on agency ratings of CDOs was a direct outcome of the difficulty in evaluating such complex financial products such as CDOs. Lang & Jagtiani (2010)

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points out that in many cases, even sophisticated financial firms will do little independent analysis of the credit risk of a security if it has an AAA rating. Thus, firms may believe that it is an inefficient use of resources to independently analyze these AAA-rated securities. While it is clear that inflated ratings played a major role in promoting mortgage-related structured financial products, Lang & Jagtiani (2010) suggest that there are several problems with relying on this as an explanation for why large firms were so vulnerable to severe negative shocks to the mortgage market. Some investors in debt securities look only at the credit ratings provided by a few rating agencies such as Moodys and Standard & Poors (S&P), which themselves evaluate credit largely using only mathematical models. But these models can ignore very important factors and possibilities (Murphy, n.d.). 4.0 Analysis of the facts Understanding the premise of how the derivative instruments played their roles in bringing about the 2007-2008 global financial crisis cannot be over-emphasized. Therefore it is important to scrutinize the relevant information surrounding the various parts played by these derivative instruments. This section provides an analysis of the major facts. 4.1 How the derivative instruments contributed to the global financial crisis

The 2007-2008 financial crisis has illustrated that professional investors not always understand the risks they face and the impact of the outcome. The bilateral nature of this market, coupled with the high level of concentration in the market in terms of participants makes it obscure to parties outside a particular transaction. Moreover, as the price determined in the derivatives markets may be used to calculate the price of other instruments, its obscure nature may affect other market segments (European Commission, 2009). During a recent evaluation of certain trading positions, a lot of irregularities in derivatives instruments were discovered. For

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example, there was a case of an "irregular" trading where a currency trader has reportedly lost 84 million pounds ($118.4 million) in FX bets (Laurent, 2009). The subprime crisis came about in large part because of financial instruments such as securitization where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others (Global Issues, 2008). For example, some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on. Rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up. For all the derivatives that contributed to the global financial crisis, the underlying assets, indirectly or directly, were the real-estate houses. These financial instruments provided investors with leverage- high risk and high return. When the housing bubble burst, much of these derivative instruments lost values (since their values were dependent on houses) leaving the financial institutions in huge losses (Qudrat, 2009). Many banks were taking on huge risks increasing their exposure to problems; and investment banks, not content with buying, selling and trading risk, got into home loans, mortgages, etc without the right controls and management (Global Issues, 2008). While many blame defaulting mortgages for the 2007-2008 financial crisis, it is only a component and symptom of the deeper problem. Morris (2008, cited in Murphy, n.d.) attributes the root cause of the crisis to mispricing in the massive Credit Default Swaps market. With this in mind, Simon (2008, cited in Murphy, n.d.) points out that the pricing of credit default swaps, whose principal amount has been estimated to be $55 trillion by the Securities and Exchange Commission (SEC) and may actually exceed $60 trillion (or over 4 times the publicly traded corporate and mortgage U.S. debt they are supposed to insure), are totally unregulated, and have often been contracted over the phone without documentation.

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While exchange-traded derivatives leave a transparent trail in terms of positions, prices and exposures, information available to OTC market participants and supervisors is limited (European Commission, 2009). Many analysts have therefore blamed the role derivatives instruments have played in the 2007-2008 financial crisis on the lack of transparency. But Wilks (2008) asserts that the problem is not a lack of transparency of such instruments but their complexity and the lack of controls employed by buyers and sellers. With this in mind, Wilks (2008) recommends treating derivatives like other financial instruments, increasing prosecutions of financial frauds, improving disclosure by moving from a rules-based to a standards-based reporting framework, and ensuring that regulations do not confer oligopoly power on gatekeepers such as ratings agencies or auditors. Some argue that subjective human judgment opens up for the possibility of undesirable human biases and manipulation, and can lead to crisis. Failing to charge a systematic risk premium on the credit default swaps compounded the problem of underestimating average default losses that were applied without human judgment or business common sense (Murphy, n.d.). Such under-pricing of credit default swaps resulted in a credit bubble, as investors were able to hedge their investments in bonds and loans with the insurance of the credit default swaps to reduce their risk at abnormally low costs. But according to the (Global Issues, 2008), by summer 2008, the market for credit default swaps was enormous, exceeding the entire world economic output of $50 trillion. The worlds largest insurance and financial services company, AIG alone had credit default swaps of around $400 billion at that time, which had a lot of exposure with little regulation. Furthermore, many of AIGs credit default swaps were on mortgages, which of course went downhill, and so did AIG (Global Issues, 2008). In the minds of many, one of the scariest things about the financial meltdown is how evaluating risk has changed dramatically. Federal regulators allowed banks to greatly increase

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their loan to asset ratios whilst all sorts of higher mathematical equations popped up that seemed to justify trading in murky derivatives in ways not considered before (Galuszka, 2009). Pykhtin & Zhu (2007) found that for years, the standard practice in the financial industry was to mark derivatives portfolios to market without taking the counterparty credit quality into account. This practice is risky, especially if exposure tends to increase when counterparty credit quality worsens. There have been a number of attempts to mitigate risk (using securitization), or insure against problems. While these are legitimate things to do, the instruments that allowed this to happen helped aggravated the financial crisis. In an attempt to take on risk and make money more effectively, many hedge fund managers and bankers fooled themselves into thinking they were safe and on high ground (Global Issues, 2008). Thus the whole system was heavily grounded in bad theories, bad statistics, misunderstanding of probability and greed. As people became successful quickly, they used derivatives not to reduce their risk, but to take on more risk to make more money; thus they were making more bets speculating or gambling. Hedge funds have received a lot of criticism for betting on things going badly. In the 2007-2008 crisis, they were criticized for shorting on banks, driving down their prices. In some regards, hedge funds may have been signaling an underlying weakness with banks, which were encouraging borrowing beyond peoples means. On the other hand the more it continued the more they could profit (Global Issues, 2008). The extent of the financial crisis has been so severe that some of the worlds largest financial institutions have collapsed. Others have been bought out by their competitors at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out (see appendix IV) and rescue packages for the remaining large banks and financial institutions (Global Issues, 2008). According to Laurent (2009), the 2007-2008

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financial crisis have landed several traders of derivative instruments into trouble, such as the infamous rogue trader, Jerome Kerviel who lost billions at French bank Societe Generale. That notwithstanding, volatile financial markets are still luring ambitious traders into dangerous territory. 5.0 Conclusions Derivatives instruments are the key mechanism in todays shadow banking system. While derivatives provide the market's view on future developments in market variables, they can cause havoc to the entire financial market if not properly regulated. Many financial analysts and economists have underscored the role that excessive risk-taking through the use of derivative has played in the 20072008 financial crisis. The high risks taken by the various financial institutions through issue of various derivative instruments were the prime reason for such crisis starting with the collapse of the housing market. Most of these instruments were traded via the OTC markets which were poorly regulated. Several experts in the industry have blamed the role derivatives instruments have played in the 2007-2008 financial crisis on subjective human judgment, lack of transparency of the instruments, complexity and the lack of controls employed by buyers and sellers. While all these factors are critical, the financial crisis could have been avoided if the financial institutions adopted effective risk management practices in their derivative trading. It is worth noting that derivatives have revolutionized the financial markets and will likely be here to stay because there is such a demand for insurance and risk mitigation. 6.0 Recommendations Financial derivatives are the underlying reasons for the growth of the capital market. However, much of these instruments must be transparent and must reflect their true market

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prices. They must be closely monitored by the SEC in order to ensure that investors are not taking uncalculated risk-return positions in the market. Also credit rating agencies should appropriately rate the derivative instruments in order for the investors to know the extent of risks of their investments. The obvious regulatory solution is to require that parties to these types of derivatives transactions, or intermediaries for those parties, keep a registry of the transactions from which market participants can ascertain risk allocation. 7.0 Areas for further research This paper analyzes the part derivative instruments played in the 2007-2008 global financial crisis. It is not surprising to know how evolving industry structures and institutional roles are changing the nature of risk in the derivative market. At present most discussions emphasize transparency reforms such as ensuring that any derivatives or similar trades are only done via exchanges. A further research should focus on the role of the regulating agencies in promoting transparency in the derivative market.

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References Alliance of Liberals and Democrats for Europe (ALDE). (2008, February). The International Financial Crisis: its causes and what to do about it? Retrieved February 03, 2012 from http://www.alde.eu/fileadmin/webdocs/key_docs/Finance-book_EN.pdf. Barnes, R. (2001). Accounting for derivatives and corporate risk management policies. Retrieved from Blackboard Learning Resource. Bomfim, A. N. (2001, July). Understanding Credit Derivatives and their Potential to Synthesize Riskless Assets. Retrieved from SMC Blackboard Learning Resource. European Commission. (2009). Ensuring efficient, safe and sound derivatives markets. Retrieved February 03, 2012 from http://ec.europa.eu/internal_market/financialmarkets/docs/derivatives/report_en.pdf. Falkenstein, E. (2010, October). Risk and Return in General: Theory and Evidence. Retrieved from SMC Blackboard Learning Resource. Galuszka, P. (2009, February, 24). The quant that ate New York. Retrieved from SMC Blackboard Learning Resource. Global Issues. (2008). Global Financial Crisis. Updated 2010. Retrieved February 03, 2012 from http://www.globalissues.org/article/768/global-financial-crisis. Gorton, G. & Metrick, A. (2010, November, 09). Securitized Banking and the Run on Repo. Retrieved from SMC Blackboard Learning Resource. Jenkinson, N., Penalver, A., & Vause, N. (2008). Financial innovation: What have we learnt? Quarterly Bulletin. Retrieved from SMC Blackboard Learning Resource. Jobst, A. A. (n.d.). A primer on structured finance. Retrieved from SMC Blackboard Learning Resource.

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Lang, W. W. & Jagtiani, J. (2010, February). The Mortgage and Financial Crises: The Role `of Credit Risk Management and Corporate Governance. Atlantic Economic Journal. Retrieved February 03, 2011 from http://fic.wharton.upenn.edu/fic/papers/10/10-12.pdf. Laurent, L. (2009, March). Merrill Lynch Uncovers a 'Rogue' Trader. Retrieved from SMC Blackboard Learning Resource. Meulbroek, L. K. (2002). Integrated Risk Management for the Firm: A Senior Managers Guide. Retrieved from SMC Blackboard Learning Resource. Murphy, A. (n.d.). An Analysis of the Financial Crisis of 2008: Causes and Solutions. Retrieved from SMC Blackboard Learning Resource. Nocera, J. (2009, January). Risk Mismanagement. New York Times. Retrieved from SMC Blackboard Learning Resource. Pykhtin, M. & Zhu, S. (2007). A Guide to Modelling Counterparty Credit Risk. Retrieved from SMC Blackboard Learning Resource. Qudrat, A. (2009, January). The Financial Express. Retrieved February 03, 2012 from http://www.thefinancialexpress-bd.com/2009/01/02/54822.html. Reavis, C. (2009, July). The Global Financial Crisis of 2008 2009: The Role of Greed, Fear and Oligarchs. MITSloan Management, 9(93), 1-22. Retrieved February 03, 2012 from https://mitsloan.mit.edu/MSTIR/world-economy/Crisis-2008-2009/Documents/09093%20The%20Financial%20Crisis%20of%202008-2009.pdf. Schwarcz, S. L. (2009, May). Understanding the Subprime Financial Crisis. South Carolina Law Review, 60 (549). Retrieved from SMC Blackboard Learning Resource. Turner, A. (2009, January). The financial crisis and the future of financial regulation. Retrieved from SMC Blackboard Learning Resource. Wilks, A. (2008, October). Dangerous derivatives at the heart of the financial crisis.

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Retrieved January 20, 2012 from http://www.eurodad.org/whatsnew/articles.aspx?id=3024.

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Appendices Appendix I: Overview of credit risk transfer instruments

Source: Jobst, n.d.

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Appendix II: Mortgage-Backed CDO Issuance Prior to the Financial Crisis

Source: Lang & Jagtiani, 2010

Appendix III: Subprime Share of Mortgage Market

Source: Lang & Jagtiani, 2010

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Appendix IV: Losses and Bailouts for US and European countries during the global financial crisis

Source: Global Issues, 2008