Credit Default Swaps and Banking Crisis - Report Example

Credit Default Swaps and Banking Crisis What caused the current Banking Crisis? What are some of the reasons that caused the banking crisis to emergeout of blue and affect the whole world in a manner that required extensive support from Government to inject funds to save the financial institutions from complete collapse? What is critical to understand that the mechanics behind this type of derivatives virtually forced banks and other financial institutions to neglect the impact that they can exert over the economy and its relative health.(Gilani,2008). The current crisis in financial sector indicates the effective and timely use of the various tools and techniques such as lowering interest rates as well as increase credit to consumers however, the real cause that have been ignored is the fact that credit default swaps were not particularly utilized in the manner in which they were supposed to work in their more literal meanings. The relative credit standing of the firms that issued such credit default swaps were impaired due to the liquidity crunch.(Philips,2008). The CDS market exploded during last decade of the previous century which basically allowed financial institutions to take on the risky positions and overall portfolio well exceeded $45 trillion during 2007.(Morrissey,2008). What is critical to understand that CDS market is largely unregulated whereas banks and financial institutions are heavily regulated thus most of the financial institutions as well as investors sold the credit default swaps in the secondary market in order to spread the risk however, the same could not happen because CDS were typically sold and resold to the parties with very little credit standings. It is interesting to note that most of the financial institutions that issued the CDS basically also issued the subprime mortgage loans thus faced a virtual trap like situation because in case of default on the subprime loans, these financial institutions could not execute their commitments because of the same reason.(Varchavar,2008). The CDS are easy to create instruments because fundamentally they are contracts and not the securities therefore it is relatively easy to create them in shape or form i.e. matching individual needs of the customers. CDS were basically issued to cover the credit risk because of the investors may want to spread the credit risk due to low credit ratings of the issuers of the debt. What most of the financial institutions did was the fact that they first issued the different instruments through the process of securitization and at the same also issued CDS to cover the credit risk. (Bajaj, 2008). Thus when the subprime borrowers started to default on their commitments, the financial institutions faced dilemma of first paying on their commitments against Mortgaged backed securities and in case of default, will have to pay the holders of the CDS the defaulted amount. One of the worst hit institutions of this failure is the Bears and Sterns which was believed to be holding trillions of dollars in CDS and counterparties were virtually exposed to risk that cannot be hedged despite the fact that they were technically hedged against the risk of default by the Bears and Sterns. This vicious circle therefore was more demanding and harmful for the economy as a whole rather than the subprime mortgages which formed a very tiny portion of the overall portfolio held by all the financial institutions. Similar was the case with the AIG which sold the CDS because credit default swaps are type of insurance to hedge against the defaults and as such AIG was very much into the business of underwriting the default swap against the possible defaults that financial institutions may incur due to defaults. Thus a mass scale default on the loans forced financial institutions to lodge their claims with AIG which ultimately brought down the demise of the world financial markets and the economies of the developed world.(Walsh,2010). AIG was required to pay out approximately $14 billion to the bankers in case of defaults by the subprime borrowers. Such rapid cash outflow of the funds was mostly due to the issuance of CDS which AIG issued to countless financial institutions to hedge them against the risk of default however, the mass default by the borrowers exuberated the overall impact of the crisis and resulted into the current financial meltdown experienced by the developed world and developing countries. The overall reaction or rather response that emerged due to this crisis included the strong governmental support to the financial institutions. This support was done mostly through equity injunction by the government and as such government became stakeholders in such institutions. What is however, critical to understand that this support was mostly extended at the cost of tax payers’ money? This was therefore viewed largely as a negative consequence of the overall management of the affairs which mostly believed to be engineered by the highly paid executives of the financial institutions. The reckless lending and excessive risk taking in instruments like CDS therefore the origins of the banking crisis lie mostly into the unprofessional conduct of the executives of the financial institutions. The increase in the exposure taken by the financial institutions in credit default swaps also reflects upon the failure of regulatory authorities to properly regulate the market. As indicated above that the CDS market was largely unregulated and virtually nothing was reported by the financial institutions therefore the overall exposure taken by them virtually remained unnoticed. This in turn allowed the financial institutions to take more risks in this segment and as such the increasing level of exposure forced many firms to default on their commitments. Whether the steps taken by the government and its various institutions mainly Central Bank will result into the improvement in economic conditions is one of the most critical aspects to be discussed. This is critical due to the fact that the consumption patterns cannot be adjusted in short run and consumers also have to adjust their consumption habits in order to accommodate the declining cash flows and restricted access to the consumer credit. References 1. Bajaj, V (2008) Surprises in a Closer Look at Credit-Default Swaps The New York Times, Available: http://www.nytimes.com/2008/11/05/business/05swap.html?_r=1 Last accessed 10th February, 2010 2. Gilani, S (2008) The Real Reason for the Global Financial Crisis…the Story No Ones Talking About Money Morning, Available: http://moneymorning.com/2008/09/18/credit-default-swaps/ Last accessed 6th February, 2010 3. Morrissey, J (2008) Credit Default Swaps: The Next Crisis? Time, Available: http://www.time.com/time/business/article/0,8599,1723152,00.html Last accessed 9th February, 2010 4. Philips, M (2008) The Monster That Ate Wall Street News Week, Available: http://www.newsweek.com/id/161199 Last accessed 10th February, 2010 5. Varchavar, N (2008) The $55 trillion question Fortune, Available: http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm Last accessed 10th February, 2010 6. Walsh, M (2010) Risky Trading Wasn’t Just on the Fringe at A.I.G. The New York Times, Available: http://www.nytimes.com/2010/02/01/business/01swaps.html Last accessed 10th February, 2010 Read More