The Derivatives That Sunk Banks In The Global Crisis

Mortgage-backed securities played a significant role in the Global Financial Crisis of 2008. These securities had attractive interest rates and were given next to perfect ratings by credit rating agencies such as Moodys and Standard and Poor. Large amounts of funding were put into the housing market through the mortgage backed securities and this funding became a cycle. People were looking to buy homes so mortgage companies sold mortgages to banks, which led to banks packaging the mortgages with other investments, and the mortgage-backed securities were sold to investors. The investors’ money created more money for mortgage lenders to offer. 

Since lenders were contributing funds to subprime mortgages, people who have lower credit scores, many of these homeowners began to default on their mortgage payments. In April of 2007, New Century, a U.S. Financial Mortgage Corporation, filed for bankruptcy because of poor mortgage lending decisions. Soon after, Countrywide, the largest U.S. subprime mortgage lender, filed for bankruptcy. Following these two mortgage lenders filing for bankruptcy, U.S. banks’ balance sheets decreased.

While subprime mortgages and mortgage back securities were instruments that harmed the banks of the United States, derivatives such as credit default swaps ruined banks. A credit default swap is an insurance contract between a buyer and a seller protecting a company’s bond or loan. A credit default swap buyer gives to the credit default seller an upfront payment and premiums for the seller to protect the buyer if the company’s bond or loan were to default during the term of the derivative. Although the contract sounds good, the instrument is subject to counter-party risk and is essentially just a hedging instrument.

When homeowners started to default on their loans because they could not pay the mortgage payments, mortgage lenders filed for bankruptcy because of their losses. While the banks take a hit due to the bankruptcy of mortgage lenders, banks were truly hit because of the credit default swaps investors had in these mortgage backed securities. Banks were liable to pay investors who had purchased credit default swaps when the mortgage lenders went bankrupt and mortgage backed securities’ ratings decreased. This led to Bear Stearns, which is now JP Morgan Chase, and AIG to have to be bailed out by the Federal Reserve because these banks were on the verge of bankruptcy due to all the insurance they owed to investors. Therefore, while the subprime mortgage crisis hurt banks, credit default swaps truly wiped banks.

 

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