The Sub-Prime Mortgage Crisis & Derivatives

1. Introduction: Derivative is a very important financial instrument in modern business activity. The original objective to create derivative product is to help company to hedge the future risk or contribute liquid cash flow. Meanwhile, it also become an arbitrage instrument for speculator. Thus, people enjoy the benefit from derivative products but also prepare to receive the risk from it. In 2007, after the outbreak of subprime mortgage in US, many people blamed it in deregulated derivative product transactions. This paper tries to discussed the cause, effect and responding for this financial crisis and provide the evidence that whether the derivative is still a kind of useful financial instrument or only the speculation tools.

2. Subprime mortgage crisis began in 2007

The US subprime crisis was one of the first indicators of the late- 2000s financial crisis. An significant characteristic is that the crisis is caused by rising in subprime mortgage delinquencies and foreclosures, and the consequence of decline of securities backed by said mortgages. In US housing loan market, 80% contracts are issued as subprime mortgage by adjustable-rate mortgage. The performance is excellent when house price were maintained by increasing condition. However, after US house sales prices peaked in mid-2006 and sharply decline after that period, borrower find hard to repay their debt. It is also forces adjustable rate mortgages began to reset higher interest rate. Thus, many financial institution(e.g. investment bank) began to lose money. This panic also injured the global investor who hold the subprime mortgage derivative products to withdraw this market and stop to purchase it. Concerns about the US credit and financial markets also tightened the credit level of global market

then slow the economic growth in North America and Europe.

3. what derivate product was involved in this financial crisis

AS we referred in the previous paragraph, subprime mortgage is the primary financial product that induce the crisis. Subprime mortgage is a type of mortgage that is normally made out to borrowers with lower credit ratings. In general condition, borrower's with low credit rate is hard to get mortgage because their default probability is higher than average risk level. Lending institution still distribute loan to these customers due to high interest rate and they can sell these loan to other financial institution to liquid capital. However, this business activity also spread risk to other investment institutions. An important derivative security was introduced in this loan eligibility exchange named CDO. A CDO is a derivative security that is issued against a portfolio of underlying securities, such as mortgages. The CDO is a good derivative security to reduce the risk of subprime mortgage because it can be bonded by other financial instrument like CDS( Credit default swap). The MBS(mortgage-backed security) risk of subprime mortgage would be hedged by introducing low risk financial product in theory. Diagram 1 exhibit the complete process how loan from borrower to become a security product for general investors. The borrower hunting loan and lender offering loan through mortgage broker. For low rate borrower, they receive subprime mortgage from lender (bank).Because lender want to liquid their capital, they repacked this loan like MBS and sell it to some financial institution and exchange the eligibility of loan to these financial institutions. Borrower need to pay loan interest to financial institutions rather than bank. The risk of subprime mortgage is very high thus financial institution repacked the MBS again and combined with other low risk security product and then sell to investors and promise offer payment per given time

period. Actual mortgage securitization is more complicated because the initial CDO product can also be treated as a new financial product and combined with other subprime mortgage back security to hedge risk. Diagram 1

this diagram was desined by Sheila C. Bair (2007) from http://www.fdic.gov/news/news/speeches/archives/2007/chairman/spapr1707.html

4. The Cause of subprime mortgage crisis

4.1 Boom and bust in housing market As the report from New York Times (2008), Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. It encouraged debt consumers borrow more and lender offer more adjustable-rate

mortgages. Once house prices began to decline, it would affect both side of mortgage lender and receiver. To borrowers, they felt hard to escape higher monthly payments and began to default. When more borrowers stop to pay mortgage payments, foreclosures and the supply of homes for sale increases. This situation forced housing price to decrease. The decline in mortgage payments also reduces the value of mortgage-backed securities and induce loss to financial institutions.

4.2 Homeowner speculation Some academic researcher and commercial staffs said that Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. Nicole Gelinas (2008) of the Manhattan Institute described the negative consequences of not adjusting tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative investment. Economist Robert Shiller (2009) argued that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."

4.3 High-risk mortgage loans and lending/borrowing practices For seeking maximum profit, some financial institution reply the desire of mortgage by financial innovation such as MBS(mortgage-backed security) and CDO (collateralized debt obligation). It induce that borrower qualification checking more loose and also introduce more and more stakeholders.

4.5 Inaccurate credit rating Moody's standard and Poors, and Fith gave their AAA rating to a high fraction of mortgage backed CDOs. There are no suitable regulation to standardize the CDO rating. In addition, the rating agencies gain more profit from rating this new derivative products. It encourage investor to purchase the securities which looks "safe".

4.6 Government polices Economist Joseph Stiglitz (2009) indicate that one cause for crisis was contributed the repealing fo Glass Steagall Act. This act separated commercial banks and investment banks in business activity. He said risk-taking culture of investment banking overwhelmed the risk-taking culture of commercial bank then make bank take more risk rather than protect deposit.

4.7 Credit default swaps When the performance of banks and financial institutions become worse due to the subprime mortgage, this situation required compensation to counterparties. However, investor confused to ask who would be applied payment for mortgage defaults.

5 Benefit and risk of derivative Before discuss whether derivative is safe or dangerous in future, we need to recognize the benefit and risk of derivatives. Based on an speech by Dr Khor Hoe Ee (2001), we can conclude beefit and risk of derivatives as follow.:

5.1 Benefit of using derivative Efficient allocation of Risk Market participants for both corporate and retail markets are better able to manage financial risks using a wider range of financial products. The risk averse level for each one is different, derivative can help people to manage their risk taking in future more better. Lower Cost to Hedging Derivatives provide a low-cost, effective method for people to hedge and manage their exposures to interest rates, exchange rates and commodity prices. Improve Liquidity of Underlying Assets Derivative market offers an avenue for hedgers and speculators and help them to

improve the liquidity in the asset market. Informational Content Derivatives are windows into market expectations, it can exploit information of future price expectations for various financial assets and commodities. It help people to make decision more effictive.

5.2 Risk of derivatives Moral hazard Derivative are used to protect the safety of firm's or individual's asset. However, some firms or people may gain the profit via legal loophole. Facilitate efforts to undermine regulations It can help firms help firms avoid capital requirements, manipulate accounting rules and credit ratings, and escape tax payment. Complicates risk assessment by regulators Derivative introduce more capital items and this may complicate the valuation working for supervision department. Increases market volatility Derivative also cause more significant volatility of market. It make cash flow more liquid and involved more financial institution into market.

5.3 Derivative risk estimation. Hentschel (1995) detailed which kind of risk was involved in derivatives product with mathematic estimation process . It summarized the risk by these categories: Price risk, Default risk, Systemic risk and agency risk.

6 Derivatives market performance

Can we talk about derivatives becomes more dangerous after subprime mortgage crisis? Not really. Someone may blamed that these series of crisis are caused by the

misuse of subprime mortgage derivatives product (CDO, CDS). However, Derivatives are just a tool of financial institution. The responsibility is only induced by financial institution but have not been related to derivative product itself. We can observe the performance of derivatives market in recent year to prove our viewpoint.

6.1 OTC derivatives market Development The OTC(over the counter) derivative market is the largest market for derivatives, the characterize of OTC make reporting OTC amounts is difficult because transactions can occur in private. This kind of private transactions will hard to seek due to no activity being visible on exchange. However, we still can get useful information via statistic administration

Figure 1. The global OTC Derivatives markets - percentage of types of contracts in the years 2002-2010 Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.

The figure 2 exhibit the percentage of each derivate product in total OTC market. it also report the on-going performance after 2007 financial crisis. According to this diagram, we can find that interest rate contracts enjoy the highest percentage in total market. It even increase after crisis. CDS is a kind of derivative which introduce to

CDO for hedge the risk. we can find that the total weight of CDS is not very high. The history of CDS is very short (the available information only began in 2004). It suffer a reversion after 2007 crisis.

Figure 2. Global OTC Derivatives markets - Gross notional amounts outstanding, in billions of U.S. dollars in the years 2002-2010 Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.

Figure 2 report the value of total amount of OTC derivatives market. The statistic result suggest the OTC market did not suffer heavy impact of financial crisis. Figure 3 offer a clear movement of CDS in past 6 years. we can find the growth of CDS is very rapidly and reach peak of 2007 to 2008. The finical crisis injured the growing of this new derivate product

Figure 3. Credit Default Swaps market - Gross notional amounts outstanding, in billions of U.S. dollars Source: Own work based on: BIS Quarterly Review, International Banking and Financial Market Developments, Bank for International Settlements, December 2004 - December 2010.

6.2 OTC derivatives market regulation After the financial crisis, both the Americans and Europeans began to introduce some new regulation or ACT into derivatives market. for example, Dodd-Frank Wall Street Reform & Consumer Protection Act, Private Fund Transparency Act and restoring American financial stability act. Key elements of the framework include: Require clearing of all standardized over-the-counter (OTC) derivatives through regulated central counterparties (CCPs); Robust margin and capital requirements for key market participants; Financial reporting and disclosure requirements; Clarify regulatory enforcement authorities of the U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC); and Limiting the types of counterparties that can participate in derivative transactions.

7 Conclusion The subprime mortgage crisis is still on-gonging and spread to global market. Some regulations has been applied but need long period of observation to improve it. The safety of derivatives is only relate to market surveillance but also concern to investors confidence rebuilding. AS we emphasized in part 6, derivate product is only a financial instrument for business activity. The primarily objective is only for benefit commercial activity. The risk and benefit is only depend on how to use it.

Reference: Hentschel L., Smith C. 1995. Risks in Derivatives Markets. Wharton working papers. Dr Khor Hoe Ee (2001), Derivatives and Macroeconomic Management in Post-Crisis Asia, Monetary authority of Singapore from http://www.mas.gov.sg/news_room/statements/2001/Speech_by_Dr_Khor_Hoe_Ee_o n_Derivatives_and_Macroeconomic_Management_in_Post_Crisis_Asia__25_Sep_20 01.html Joseph E. Stiglitz (2009), Capitalist Fools, vanity fair. from http://www.vanityfair.com/magazine/2009/01/stiglitz200901 Robert J. Shiller (2009), Infectious Exuberance Financial bubbles are like epidemics and we should treat them both the same way. Theatlantic.com. from http://www.theatlantic.com/doc/200807/housing , Sheila C. Bair (2007), Federal Deposit Insurance Corporation on Possible Responses to Rising Mortgage Foreclosures before the Committee on Financial Services. from http://www.fdic.gov/news/news/speeches/archives/2007/chairman/spapr1707.html

President Bush's Address to Nation. The New York Times. 2008-09-24. from http://www.nytimes.com/2008/09/24/business/economy/24text-bush.html?_r=2&page wanted=1&oref=slogin

Nicole Gelinas (2008), Sheltering Speculation-How we could have contained the housing bubble, from http://www.city-journal.org/2008/eon1029ng.html

Bank for International Settlements (2010), BIS Quarterly Review, International banking and financial market developments, p. A 121.