Economists have generally believed that financial derivatives increase economic welfare by facilitating risk-sharing among investors, by improving price discovery, and by making the allocation of capital more efficient (R. Stulz, 2010). The introduction of new instruments has transformed global credit markets in recent years. This was proven by the Subprime Crisis of 2007 that spilled over and became the Global Financial Crisis in 2008. These instruments had devastating effects on economies across the globe. The role of credit derivatives in financial crisis is still a matter of concern which needs to be addressed at a global level.
Credit Derivative as a Instrument
A credit derivative is a financial contract that allows one to take or reduce credit exposure, generally on bonds or loans of a sovereign or a corporate entity. The contract is between two parties and does not directly involve the issuer itself.
Credit derivatives have been widely adopted by credit market participants as a tool for investing in, or managing exposure to credit. The rapid growth of this market is largely attributable to the following features of credit derivatives:
Credit derivatives provide an efficient way to take credit risk.
Credit derivatives provide and efficient way to short a credit.
Credit derivatives provide ways to tailor credit investments and hedges. Though the CDS market, investors may customize currency exposure, increase risk to credits they cannot source in the cash market, or benefit from relative value transactions between credit derivatives and other asset classes.
Credit derivatives provide liquidity in times of turbulence in the credit markets.
Credit derivative transactions are confidential.
Because of the above mentioned features, the market for credit derivatives has evolved and diversified itself in the last few years. While banks remain important players in the credit derivatives market, trends indicate that asset managers should be the drivers for future growth. Figure (1) below gives the share of the market participants in the credit derivatives market.
Figure 1: Market participants in Credit Derivatives Market
Source: British Bankers' Association Credit Derivatives Report
Types of Credit Derivatives
Credit Options: Credit Options are a type of credit derivative used to hedge the risk of adverse changes in credit quality. These options allow investors to buy insurance to protect themselves against adverse moves in the credit quality of financial assets. For example, a bond investor might buy an insurance policy to hedge the value of a corporate bond. If the bond defaults, the payoff from the insurance policy would offset the loss from the bond. If there is no default, the investor would continue to receive the interest payments from the bond but receive nothing from the policy.
Total Return Swaps: A swap where the total return payer transfers all of the risks and returns associated with a defined underlying asset to the total return receiver. The transfer of risk is achieved via a series of cashflows, which mirror the changes in the value of the reference asset rather than, by legal transfer of the asset. It includes interest rate movements and exchange rate fluctuations. The protection seller (return receiver) guarantees a fixed or floating return to the originator, who in turn, agrees to pass on all of the returns from the credit asset to the protection seller.
Credit Default Swaps (CDS): A credit default swap is an agreement between two parties to exchange the credit risk of an issuer (reference entity). The buyer of the credit default swap is said to buy protection. The buyer usually pays a periodic fee and profits if the reference entity has a credit event, or if the credit worsens while the swap is outstanding. A credit event includes bankruptcy, failure to pay outstanding debt obligations or in some CDS contracts, a restructuring of a bond or loan. The seller of the credit default swap is said to sell protection. The seller collects the periodic fee and profits if the credit of the reference entity remains stable or improves while the swap is outstanding.
Figure 2: Mechanism of Credit Default Swap
The market for CDS has grown enormously since the mid 1990s when the first credit default swap provided protection on Exxon by the European Bank for Reconstruction and Development to JP Morgan. Based on survey data from the Bank for International Settlements (BIS), the total notional amount of the credit default swap market was $6 trillion in 2004 (see Figure 3 below), $57 trillion dollars by June 2008, and $41 trillion dollars by the end of 2008.
Figure 3: Notional Amount of Credit Default Swaps Outstanding
Also, if we compare CDS with other products in the market, it leads the market share by almost 96%. As we see in Figure 4 below, the CDS share in total derivatives composition was 96% in Q1 2006 and has grown to 97.40% in Q1 2010.
Figure 4: Credit Derivatives Composition by Product Type
A Synopsis: How Subprime Crisis became Global Financial Crisis of 2008
The housing market in the U.S. rose dramatically from 1998 till 2005, more than doubling over this period. The rise in housing prices reflected large increases in demand for housing and happened despite a rise in the supply of housing. This increase in demand for housing was due to low interest rates, speculation and a large support for the subprime market. This rise led to the creation of a bubble in the housing market. A bubble which was mainly created because of securitization.
By securitizing, financial institutions basically repackaged their assets into different risk classes to price these risk differently. This also allowed them to securitize their loans and take them off their balance sheets in the form of asset backed securities (ABS) and sell them in the market. The important side effect of this securitization was each time banks or financial institutions sold repackaged loans they obtained liquidity that could be used to extend new loans, which later on would be securitized again. The result was evident, layers of credit were on top of each other allowing agents to speculate in the asset markets. During the subprime crisis, the major source of credit losses for many financial institutions were collateralized debt obligations (CDOs) based on cash flows of portfolios of subprime home-equity loans.
CDOs are structured finance securities that are pooled and tranched. CDOs are backed by a pool of assets, like other structured finance securities, but they issue classes of securities with some investors having priority over others. Large quantities of subprime asset-backed CDOs were issued during the past several years and were known to be one of the most important financial innovations of the past decade. This can be proven from the fact, that the total U.S issuance of asset-backed securities during 2005-2008 was $2.154 trillion, and the total U.S issuance of CDOs during the same period was $987 billion. Large quantities of subprime asset-backed CDOs were issued during the past several years and were known to be one of the most important financial innovations of the past decade. This can be proven from the fact, that the total U.S issuance of asset-backed securities during 2005-2008 was $2.154 trillion, and the total U.S issuance of CDOs during the same period was $987 billion. Figure 5. shows the rise in CDO issuance from 2004 to 2007.
Figure 5. shows us the rise in CDO issuance from 2004 to 2007.
The issuance of these CDOs in the market followed an intricate process where the initial loans were passed through a number of agents, and ended up scattered across financial markets. Because of this, the problems that arose from the housing bubble multiplied exponentially and became the foundation for the financial crisis.
On the other hand, banks and other financial institutions needed to manage their risk and to meet their capital requirements. If they packaged loans in securities and held them on their balance sheets, they were able to hold less regulatory capital. Further, some banks and financial institutions believed that it was advantageous for them to hold super-senior tranches of securitizations on their books if they insured them with credit default swap. In many countries regulators allowed financial institutions to set aside less capital because these institutions had bought protection through credit default swaps (CDS). Because of the nature of the contract, CDS as an instrument not only gained popularity but its market also grew tremendously as we have seen before in figure 3 and 4. Table 1. shows a timeline of the subprime and financial market crises.
Table: 1
Timeline of the subprime and financial market crises.
Source: Reuters, Federal Reserve of St. Louis.
Late 2006
The U.S.housing market slows after two years of increases in official interest rates. Delinquencies rise; a wave of bankruptcies.
Feb-7-2007
Europe's biggest bank, HSBC Holdings, blamed soured U.S. Subprime loans for it's first-ever profit warning.
Apr-2-2007
Subprime lender New Century Financial Corp. files for bankruptcy.
Jun-20-2007
Two Bear Stearns funds sell $4 billion of assets to cover redemptions and expected margin calls arising from subprime losses.
Jul-10-2007
Standard &Poor's said it may cut ratings on some $12 billion of subprime debt.
Jul-17-2007
Bear Stearns says two hedge funds with subprime exposure have very little value; credit spreads soar.
Jul-20-2007
Home foreclosures soar 93% from the previous year.
Aug-9-2007
BNP Paribas suspends redemptions in $2.2 billion of asset-backed funds; says it cannot determine security values.
Sep-13-2007
UK mortgage lender Northern Rock seeks financial support from the Bank of England; report sparks a run by worried depositors.
Oct-1-2007
Swiss bank UBS said it would write down $3.4 billion in its fixed-income portfolio; first quarterly loss in nine years.
Oct-30-2007
Merrill Lynch ousts Chairman and Chief Executive Stan O'Neal after reporting biggest quarterly loss in company's history.
Nov-4-2007
Citigroup announces a further $8-11 billion of subprime-related write downs and losses. Charles Prince resigns as CEO.
Dec-12-2007
Central banks coordinate the launch of the temporary Term Auction Facility (TAF) to address pressures in short-term funding markets.
Jan-1-2008
Bank of America purchases Countrywide Financial in an all-stock transaction.
Feb-13-2008
President Bush signs the Economic Stimulus Act of 2008 into law.
Mar-11-2008
Federal Reserve announces creation of Term Securities Lending Facility (TSLF).
Mar-16-2008
Federal Reserve announces creation of Primary Dealer Credit Facility (PDCF).
Mar-24-2008
JP Morgan acquires Bear Stearns in rescue partially financed by Federal Reserve Bank of New York.
Jun-5-2008
Standard &Poor's announces downgrade of monoline insurers AMBAC and MBIA.
Jul-11-2008
Office of Thrift Supervision closes Indy Mac Bank, F.S.B.
Sep-7-2008
Federal Housing Finance Agency places Fannie Mae and Freddie Mac in government conservatorship.
Sep-15-2008
Bank of America announces purchase of Merrill Lynch; Lehman Brothers files Chapter 11 bankruptcy.
Sep-16-2008
Federal Reserve authorizes lending up to $85 billion to AIG.
Sep-25-2008
Office of Thrift Supervision closes Washington Mutual Bank.
Sep-29-2008
Federal Deposit Insurance Corporation (FDIC) announces that Citigroup will purchase the banking operations of Wachovia Corp.
Oct-3-2008
Congress passes Emergency Economic Stabilization Act establishing $700 billion The Troubled Asset Relief Program (TARP).
Nov-25-2008
Federal Reserve Board announces creation of Term Asset-Backed Securities Lending Facility (TALF).
Dec-19-2008
U.S. Treasury authorizes loans for General Motors and Chrysler from the TARP.
This prompts us to examine the role of these instruments in financial crisis. We therefore begin, by analyzing quarterly data on banks' derivative acitivites and we compare them with their market capitalization for each year, from Q1 2006 to Q1 2010. We compare them to find out the amount of money banks invested in credit derivatives compared to their total market capitalization. For this study, we consider the top 5 banks in every quarter starting 2006.
The rest of the paper is organized as follows. Section 2 reviews and discusses the extensive literature on subprime and financial crisis by noted researchers and presents their findings. Section 3 presents data and analysis and the results for the same are discussed in Section 4. We end in Section 5 with some concluding remarks and recommendations, if any.
