Derivatives Discussion 4 Completed

Use the Internet to research the role of credit default swaps (CDSs) and other derivatives in the financial collapse of 2008. Examine the derivatives that were involved in the financial collapse of 2008.

A credit default swap is a financial agreement between banks that will compensate the buyer in the event of a loan default. It is like mortgage insurance, you make a series of payments to the seller, and the seller makes a payment to you if something goes wrong. The only difference is this is debt insurance.

Here is an example of how credit defaults swaps should be used and the coverage according to USA Today. “A bank that holds another bank’s bonds could insure those bonds against loss by buying swaps. If a bond held by an investor lost so much value that it was worth only 8 cents on the dollar, the holder of that investor’s credit default swap would owe him 92 cents for each dollar covered by the swaps” (Stulz, R. M. 2010).

Many believed that credit swaps were being used inappropriately and not for their actual purpose Investors were wagering on the performance of credit default swaps on subprime mortgages. Did you know that investors were wagering against the performance of credit default swaps on subprime mortgages? Many investors did not even own the mortgages but could earn the same amount as the holder if a loan defaulted. “For instance, if the mortgages defaulted and were worth 8 cents on the dollar, you’d make 92 cents on each dollar of the mortgages” (usatoday.com).

Credit default swaps magnified each crisis because they were used as debt insurance (and side wagers) on other derivatives such as subprime mortgages, mortgage backed securities, bonds, and corporate debt. So when the other derivatives went over under the credit default swap risk could expand rapidly and continuously grow without ever stopping. This could have been avoided if this derivative had a regulator like some of the others. If credit default swap was being abused can you imagine what was being done with the other derivatives such as subprime mortgage loan, mortgage backed securities, bonds, and many others

“New York Times, Christopher Cox, chairman of the Securities and Exchange Commission, estimated there were $55 trillion in credit default swaps outstanding and according to a New York state’s insurance regulator, there was $6 trillion in outstanding corporate debt and $7.5 trillion in mortgage-backed debt securities” (usatoday.com).

Speculate on the most likely cause(s) of the collapse. Support your position with one (1) example.

Savage loaning was a major cause of the collapse. Savage loaning alludes to the act of corrupt banks, luring borrowers to go into “perilous” or “unsound” secured advances for wrong purposes. An exemplary draw and-switch strategy was utilized by Countrywide Financial, publicizing low financing costs for home renegotiating (Midrigan, V. 2010). Such advances were built into broadly itemized contracts, and swapped for more costly credit items upon the arrival of shutting. Though the ad may express that 1% or 1.5% interest would be charged, the shopper would be put into a customizable rate contract (ARM) in which the interest charged would be more noteworthy than the measure of interest paid. This made negative amortization, which the credit customer won’t not see until long after the advance exchange had been culminated.

It is my opinion that the subprime mortgages and predatory lending were the primary cause of the collapse. Many consumers that were considered mortgage brokers targeted risky borrowers (first time home buyers, buyers with average credit scores, and the elderly) and put in risky loans that eventually defaulted because they could not afford them. The use of predatory lending practices contributed to the high mortgage defaults and started the domino effect of the crisis.

References

(Midrigan, V. 2010). The Great Trade Collapse of 2008–09: An Inventory Adjustment quest. IMF Economic Review, 58(2), 254-294.

Stulz, R. M. (2010). Credit Default Swaps and the Credit Crisis. Journal of Economic Perspectives, 24(1), 73-92. doi:10.1257/jep.24.1.73

RESPONSE,

Hello,

Great discussion this week, well detailed and informative. Just to add to your good post, the subsidiaries market includes more than simply put and call choices. There are likewise contracts including swapping altered loan cost installment streams for flexible or drifting financing cost installment streams. An organization may have acquired cash under a flexible loan fee security, for example, a home loan and is currently dreadful that the financing cost is going to rise. It needs to ensure itself against ascends in the loan fees without experiencing the renegotiating of the mortgage. The organization or individual at risk for a flexible rate searches for somebody who will pay the customizable interest installments consequently for receipt of settled rate installments. This is known as a swap. The starting point of swaps can be distinguished as an arrangement made amongst IBM and the World Bank. For additional on swaps and their history see Swaps.

Keep up the good work.