Role of Credit Default Swaps in Subprime Crisis

Background of Subprime Crisis

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005-2006. High default rates on “subprime” and adjustable rate mortgages (ARM) began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008.

In the years leading up to the crisis, high consumption and low savings rates in the U.S. contributed to significant amounts of foreign money flowing into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 2002-2004 resulted in easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.

While the housing and credit bubbles built, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations. These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%. Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations met in November 2008 and March 2009 to formulate strategies for addressing the crisis. As of April 2009, many of the root causes of the crisis had yet to be addressed. A variety of solutions have been proposed by government officials, central bankers, economists, and business executives.

Role of Credit Default Swaps in Subprime Crisis

We already learned about the basics of Credit Default Swaps. Let’s now understand the role played by Credit Default Swaps in the subprime crisis.

We learnt about the securitization process in which the collateral of borrowings was pooled and tranches at different levels were created. The subprime crisis is the unravelling of a stupendously leveraged speculative bubble on real estate that built itself up for about seven years from the beginning of this decade (and century); this speculative bubble was mediated by fancy financial instruments fashioned by Wall Street, running all the way from sub-prime mortgages, asset backed securities (ABS) and mortgage backed securities (MBS), collateralized debt obligations (CDO) to credit default swaps (CDS).

The CDS played a major role in the spread of the financial crisis. The first impact they had on the crisis was to hide who was really bearing risks. Credit default swap transactions are not visible on the balance sheet of financial institutions. This implies that investors cannot accurately assess the real risks born by financial institutions. The lack of transparency affected the whole system and made it more vulnerable because of the decrease of trust in the counter-parties. The best example of this is when the “subprime” crises occurred. When the subprime mortgage-backed securities (MBS) started to default, everybody was wondering about who were going to face the losses. This led to a shrink in counterparty trust, which led to the collapse of key financial markets. One key market that was affected was the interbank lending market. Banks were not willing to lend money to other banks as they did not really know if they were exposed to high risk or not. Therefore, banks were not able to borrow money to meet their liquidity needs and so were assessed as risky institutions. This was the beginning of a vicious circle.

The second big impact that the spread of CDS had on the importance of the financial distress in 2008 is that they made CDS sellers become very connected and therefore exposed to the failure of the weakest ones. That is to say that if any CDS dealers fails it will affect the other ones because they are dealing credit default swaps to one another. The reason of such a collective vulnerability lies in the fact that most CDSs were traded over-the-counter (OTC). The problem linked to this way of trade is that investors cannot assess the riskiness of dealing with one particular dealer. In order to do so, they have to know at which level of risk this dealer is involved in its other contracts. Over-the-counter deals do not allow this. On the other hand, an exchange has the power and the duty to impose a reflection, through the securities prices, of risk-taking to its members.

Let’s understand with real life example to know where exactly CDS fits in. Suppose you take a loan from Countrywide Financial (the largest US mortgage lender) for purchasing a house. Many such loans are collateralized, put into many tranches, rated by Moody’s as investment grade securities and bought by Lehman Brothers. Now Lehman Brothers sells. This clearly indicates how severely the market was interlinked and perforated.

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