How to Lose a Billion - Article Example

How to Lose a Billion Introduction The recent failure of large financial institutions and banks has been largely associated to the failure of the banks to properly take care of their risk appetite. The increasing liberalization of financial markets as well as rapid financial innovation has made it possible for the firms to expand their business and invest into such areas which were traditionally considered as more risky. Above all, the creations of innovative financial products such as derivatives further increase the scope and choice of financial institutions to expand their business activities. The result was unprecedented increase in the profitability of the banks and improved and sustainable growth in short term profitability of the firms. What is also however, critical to note that the increased use of the derivative products have also increased the overall risk profile of the financial institutions also. Financial derivatives are considered as ideal instruments for hedging against the risk however, their imprudent use may result into significant losses for the firms too. The unrestricted use and relative complexity of the instruments therefore expose the firms to higher degree of risk. Such high risk involved therefore can cause heavy losses too. The recent economic downturn and the failure of financial institutions are largely the result of imprudent management and application of financial derivatives. Despite availing the benefits of the financial derivatives, financial institutions failed to take care of the other side of using the financial derivatives- that is the efficient risk management of financial derivatives. This report will attempt to study the recent economic downturn in the wake of the use of financial derivatives by the financial institutions and how they incurred losses. What are Financial Derivatives It is important to first discuss the nature of the financial derivatives before discussing their relative merits and risks and how they contributed towards the current economic meltdown. A financial derivative is anything whose values are dependent on the value of some other underlying assets and thus its value is derived from any such assets. Financial derivates however, are highly leveraged instruments with the ability to take abnormal swings in value if there are changes in the value of the underlying assets. Though the derivatives are in use since last many years however, their more regular use emerged after the oil embargo of 1970s when oil prices started to soar due to oil embargo placed against major developed countries including US. Their use also increased due to the application of sophisticated mathematical tools to price and develops new derivative products. With this improvement in the financial innovation, the overall depth and breadth of the financial derivatives and their applications significantly improved. Financial derivates now can be created against any type or class of underlying assets. There are different types of financial derivatives which are used most commonly however, the overall range of financial derivatives is quite large as rapid financial innovation has allowed the development of complex financial derivatives also. Common types of financial derivatives include forwards, futures, options and swaps whereas most of other types of financial derivatives are merely the variations of the above types of financial derivatives. Forward transactions are one of the most simple and relatively straight forward derivative transactions under which two parties agree to purchase and sell particular underlying asset at a particular price at a given date. It is critical to note that it becomes the obligation of both the parties to honor the forward transaction. Similarly, future derivative transactions are similar in nature too however they unlike forwards, they can be trade on the stock exchange. Option contracts however, provide added flexibility to both the parties to the transaction as under option derivative transaction, parties are free to exercise the option. However, there is premium that is charged in option contracts to compensate the sellers for not honoring the contract when falling due. Swap transactions are type of derivative transactions which requires the swapping of cash flows decided against a notional amount. Swap transactions are often tailored to the specific needs of the parties to the contract. Current Financial Crisis “In 2002, the world's smartest investor (and my pick for president this year), Omaha billionaire Warren Buffett, issued his annual letter to the shareholders of Berkshire Hathaway. In it, he called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”(Bryce,2008). The above quote and the advice of Warren Buffett clearly indicate the relative risks that financial derivatives can cause to the institutions that are engaged into their trading. Defining financial derivatives as financial weapons of mass destruction clearly reflects the attitude of the probably the smartest investors of all time regarding the financial derivatives. In order to properly discuss the role of financial derivatives in the current financial crisis and how they have affected the profitability of the bank, it is critical that a general overview of the recent financial crisis is provided. Current financial crisis started during 2007 mostly due to the mass defaults in the subprime mortgage market. Subprime mortgage borrowers are those borrowers who do not normally qualify for getting the credit at normal terms and conditions. However, such borrowers also provide a great opportunity to earn higher return because of their higher risk profile. Based on the principle of high risk and high return, banks often attempted to provide funding to such borrowers. With the increase in the risk appetite and increasing competition banks and other financial institutions kept on lending to the subprime mortgage borrowers and other risky areas. The real problem however was in the practice of securitization wherein banks and financial institutions, in order to recoup their lost liquidity, attempted to issue securities against the mortgages held as security. The process of securitization involves the issuance of securities which are normally collateralized against the securities held by the financial institutions against their different portfolios such as mortgage, autos etc. The cash flows received through repayment of mortgage and other loans are used to pay off the liabilities against such securities issued by the banks and financial institutions. The problem started to emerge when the subprime mortgage borrowers started to default on their obligations and banks have to pay off from their own resources to the securities issued against their mortgage portfolios. This mismatching of the cash flows therefore started to take its toll on the banks and financial institutions and credit crunch started to emerge. This mismatching of the cash flows generated due to mortgage based securities therefore reduce the amount of credit available to other institutions and banks started to drain their cash flows in paying off their obligations against the mortgage based securities. Role of Credit Derivatives The above discussion indicated how the use of derivatives resulted into the credit crunch and engulfed the whole banking system with the crisis. The increasing role of derivatives as well as the complexities of the various derivative products further increased the risk for the banks. Credit derivatives specially were the type of instruments that were used by the banks and financial institutions extensively however; they also resulted into the great losses for the banks and financial institutions also. (Leith,2002). One of the most significant and important contribution towards the market failure and losses to the banks and financial institutions was the spread of credit derivatives. It is now generally accepted that the sudden and unexpected rise of credit derivatives was one of the chief reasons as to why the banks and financial institutions incurred losses. The industrialization of credit derivatives by Lehman Brothers allowed the banks and financial institutions to acquire the more toxic debt and rather than reducing the risk, exposure into credit derivatives further multiplied the risk for the banks and financial institutions. “A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan. Typically, the insurance is for five years. Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”(Gilani,2008). It is also important to note that the relative role of the credit rating agencies have been not praiseworthy too in this whole crisis as they failed to properly rate the overall risk profile of the derivative products used by the banks and financial institutions and relative changes in the risk profile of the banks and financial institutions with changes in the values of financial derivatives. The above description of the credit default swaps indicates that they serve as double edged sword instruments wherein in every case they increase the risk for the firms. Banks suffered most because by issuing credit default swaps, they were actually underwriting the counterparty risk. Counter party risk arises when one party defaults on its obligation and as such the grieved party has to bear the burden. In the case of financial crisis, the counterparty credit risk arisen mainly due to defaults committed by the bank in repaying their obligations. Due to credit crunch, banks and financial institutions faced liquidity crunch and they were severely short of the funds to pay off their liabilities. Resultantly they started to default on their obligations undertaken through acquiring credit default swaps. Above discussion also indicate that the banks and financial institutions basically failed to account for the relative risks that may be arising due to taking excessive exposure into financial derivatives. The current crisis therefore clearly makes a case for the assumption that the overall risks of using the financial derivatives are higher than the benefits enjoyed by using the financial derivatives. Following sections will therefore discuss the relative risks and benefits of financial derivatives. Benefits of financial Derivatives As discussed above that financial derivatives serve as one of the strongest tools for hedging against the risk. In more technical sense, financial derivatives work as insurance against the risk of losses and as such provide firms an added advantage to secure themselves against the volatility. The sources of volatility can be different and vary according to the nature of asset and as such different varieties of financial derivatives are used to hedge against the risk of any particular asset. It is also critical to note that financial derivatives are also highly leverage products therefore they offer great opportunity to take advantage of the leverage. Financial derivatives offer great opportunity for hedging against the risk and provide necessary comfort level against the volatilities in the values of the underlying assets. However, from the perspective of the banks and financial institutions, counterparty risk is most significant at given point in time, therefore banks and financial institutions often use derivatives to limit their counterparty credit risk. Similarly, exposure in international currencies can also be one of the sources of risk and banks can use financial derivatives to hedge themselves against the abnormal changes in the values of the currency. Similarly, banks and financial institutions can use financial derivatives in order to hedge themselves against the changes in the interest rates. Banks and financial institutions offer loans at variable as well as at fixed rates however; adverse changes in the interest rates can create significant risk for the banks. As such banks and financial institutions can use financial derivatives to hedge themselves against the changes in the interest rates. What is also critical to note that the exact benefits of using financial derivatives, in modern financial system, was mostly to take advantage of the leverage. Financial derivatives offered a very good opportunity to take advantage of the leverage power of the derivatives and take on larger exposures at relatively low cost. Since, in most of the transactions, real assets are not actually transferred, therefore, financial derivatives provide strong leverage option at relatively low cost. It was also because of this critical feature of financial derivatives that it witnessed an explosive growth in its popularity. Risks of using financial derivative contracts As discussed above that financial derivative contracts are highly leveraged in nature and there is already an inherent risk in the leverage. Higher leverage corresponds to higher risk and therefore the potential for losses in using financial derivative contracts is unlimited. Such nature of financial derivatives therefore requires that the firms as well as investors must take extreme care while executing derivative transactions because of the possibility of unlimited losses and counterparty defaults. The overall nature of the risks emerging from the financial derivatives is mostly due to the changes in the pricing of the underlying assets. The factors which can effectively affect the pricing of the underlying assets can also affect the value of the financial derivatives hence the chances of risk emerge due to their use Interest rate risk The changes in interest rates can significantly change the value of the derivatives because of the changes in the values of the underlying assets. It is however, critical to note that the instruments of longer maturity are more sensitive to the changes in the interest rates as compared to the instruments of short term nature. Thus holding derivatives itself is risky because of the above factor. Foreign Exchange Risk This type of risk arises when underlying assets for derivatives is a class of foreign currencies which a can hold. Since banks and financial institutions extensively deal in foreign currency, taking exposure against such currencies expose the banks towards risks. As such forwards and futures are booked to hedge against the changes in the foreign exchange rates however, movement in the values of the relative exchange rates changes the value of the derivatives also and hence increasing the overall risk of conducting the financial derivative transactions. Pricing Risk Another important risk that can become significant is the changes in the value of financial derivatives due to changes in the pricing of the underlying instruments. The basis risk as well as changes in the commodity prices comprehensively indicates as to how the financial derivatives can serve as strong contenders for increasing the overall risk and can cause losses. Counterparty Risk In a derivative transaction, counter-party default risk arises mainly due to the risk that the counterparty will default on its obligations. When a derivative transaction is conducted, the buyer and the seller agree to execute the derivative transaction under certain terms and conditions. However, a financial derivative transaction is always a zero sum game indicating that loss of one party will be the gain of other party. This also implies that if losses incurred by one party increase by a certain threshold, it can seriously increase the risk that counterparty will default on its obligations. The above mentioned are some sources of the risks which financial derivatives can pose to a financial institution. However, what is critical to note that almost all the cases of rouge trading indicating that there was very little check and balance over the activities of the traders who used to take positions in the derivatives. The relative lack of control therefore allowed many financial institutions to keep on taking risks which went beyond a certain limit and financial institutions started to incur losses against such positions.(Leith,2002). Conclusion The financial derivatives are one of the most important financial instruments that are now used by most of the financial institutions and firms. They not provide significant hedging against the risk but also provide an opportunity to limit the probability of losses. However, due to their leveraged nature, financial derivatives are also risky instruments and can create unlimited losses for the firms. Warren Buffett described financial derivatives as the financial weapons of mass destruction owing to their power of creating losses. And this has been proved correct in the aftermath of the current financial crisis which largely emerged out of the use of financial derivatives. The process of securitization by the banks and financial institutions was done in order to utilize the mortgage portfolio of the banks to create pass through securities however, due to imprudent lending decisions of the banks and financial institutions, the use of financial derivatives proved fatal for the financial institutions. The current losses by the financial institutions is largely therefore a result of how the banks and financial institutions basically mis-assessed the relative risks involved in conducting transactions in the financial derivatives. References 1. Bryce,R (2008). From Enron to the Financial Crisis, With Alan Greenspan in Between [online]. [Accessed 18th April 2010]. Available from: 2. Leith, W (2002). How to lose a billion [online]. [Accessed 18th April 2010]. Available from: . 3. Shah Gilani (2008). The Real Reason for the Global Financial Crisis [online]. [Accessed 19 April 2010]. Available from: . Read More