Credit Default Swaps and Mortgage Backed Securities - Essay Example

Credit Default Swaps and Mortgage Backed Securities What are Mortgage-Backed Securities? Mortgage-Backed Securities (MBS) are debt obligations purchased from banks, mortgage companies and other financial institutions. These obligations are assembled into pools by either a governmental, quasi-governmental or private entity. The institutions then sell the securities to investors (Lambert, 2009). The securities are classified by an accredited rating agency, and usually pay periodic payments similar to coupon payments (Investopedia, 2009). Summary of articles on MBS Bondi (2009) brought attention to the fact that during the development of the subprime mortgage, a substantial increase in the number of legal claims against brokers are expected to be filed by customers. The claims shall allege that brokers recommended to these investors unsuitable investments in MBSs, which caused them to realize unconscionable loss. Lambert proposes the creation of a safe harbour for brokers who provide recommendations to certain institutional investors and sophisticated individuals. The safe harbour consists of immunity against subsequent scrutiny in arbitration, if the broker has not provided any materially false or misleading information, or otherwise omitted material information, in recommending a product that later translates to huge losses for the client. The author adds that there must be “complete and truthful disclosure of all the risks” (p. 276). Amoss (2007), in an article written a good twelve months before the subprime crisis, called attention to the likelihood of human error and the existence of moral hazard in the operation of mortgage-backed securities. In order to maintain the illusion among the public that an “asset-based” economy is sustainable in the long run, he wrote, house prices must stay elevated and should continue to appreciate faster than the CPI inflation rate. This is obviously highly unlikely, as scenarios created by supercomputers could not fully input raw human emotion into the formulas, and human error and the chances that default risk would have been underprices could not be fully anticipated. Mason & Rosner (2007) sought to measure the efficacy of ratings agencies in assessing in assessing market and credit risks. They note that the greatest obstacle to effective risk assessment is due to lack of transparency. They found that even investment grade MBSs will experience significant losses if home prices depreciated, resulting in broader imbalances in the economy. Rom (2009) also called attention to the central role played by the credit rating agencies in the subprime crisis. The details in residential mortgage-backed securities, as well as collateralized debt obligations, are admittedly difficult to analyze. Thus, despite reliance on “tranches” that represent offering of various levels of interest risk, there still materialized a high degree of risk that the was seriously misjudged by the credit ratings agencies. What are Credit Default Swaps? Credit default swaps (CDSs) are contracts whereby a third party assumes the risk of default on securitized debt. This was viewed technically as insurance contracts on the losses that may be incurred on certain securities if ever they should default (Morissey, 2008; Brummer, 2008; Brown, 2008). Typically, these applied to municipal bonds, corporate debt and mortgage securities. The buyer of the CDS, similar to all types of insurance, pays premiums over time in consideration of the peace of mind that comes from knowing that any losses on defaults will be covered by the insurer. The concept is very much like a home insurance intended to protect against losses due to theft or fire. Summary of articles on CDSs Morissey (2008) makes the point that in many ways the CDS is far from an ordinary insurance. CDSs are tradable securities, but the market for CDS is unregulated. On the other hand, banks and insurance companies are heavily regulated institutions, precisely to contain the level of risk assumed by them in their transactions. CDSs can be passed in the secondary market from one investor to another, just like stocks. Unlike stocks, though, the underlying value is difficult to assess. According to Philips (2008), the CDS was created by JPMorgan in the mid 1990s. At that time, the bank’s books were weighed down by loans to corporations and foreign governments, running into the tens of billions of dollars. By Federal law, JPMorgan was required to maintain a large amount of capital in reserve, commensurate to the loans extended, as a risk-containment measure in case any of the loans would default. The idea came up to find a device by which the risk of the loans could be passed on or by which the bank could be protected from the risk of default. In such a scenario, the bank would no longer be constrained to keep the same amount of reserves, thus freeing up the capital that could be made productive for the bank. Brown (2008) likens the CDS to a ponzi scheme, which is a form of pyramiding where new investors must continually be enticed into the bottom of the pyramid so as to support those at the top. The scheme is built on “fractional reserve” lending which allows banks to create “credit” with accounting entries. In this manner, banks are thus allowed to lend anywhere from 10 to 30 times their reserves. Such aggressive lending eventually comes to a saturation in the market, prompting banks to turn their attention to subprime borrowers – those individuals whose credit ratings are so low and sometimes non-existent (as in the case of illegal immigrants). This greatly exacerbated the subsequent avalanche of defaults that marked the beginning of the subprime crisis. Finally, the studies conducted by Bonfim (2009), Capinski (2007) and Westgaard and Van de Wijst (2001) explored various econometric approaches to the estimation of the risk of default. Capinski approached it from the view of a regression model built on the cash flow; Westgaard and Van de Wijst sought to create an EL (expected loss) and EDF (expected default frequency) indicator, and Bonfim viewed it from firm level information and macroeconomic dynamics. In each attempt there did not materialize any fully reliable model for assessing credit risk, proving Amoss’s point that quantitative modelling will fail for inability to factor in the human element. Discussion The two instruments discussed here, the CDS and the MBS, are both species of derivatives that have played an important part in contemporary financial markets. These are, in particular, classed as credit derivatives because their underlying value lies in bundled or securitized debt. In the world of derivatives, it is easy to see distinctive demarcations between these derivatives and the likes of options, futures, forwards, warrants, and so forth. In the latter, the underlying value is an asset with a discernible value, such as stocks, bonds and commodities. There is real intrinsic value in commodities, and the basis for valuation of stocks and bonds have a relative certainty and are capable of pecuniary estimation. On the other hand, derivatives which are valued against their underlying debt security becomes tenuous when the terms of credit are uncertain and the risk of default is high. In the case of credit default swaps, the individual debtors are obscured in the process of bundling and securitisation. While they are supposedly pertaining to debtors of the same risk, the studies have shown that credit rating systems have failed in the proper assessment of market risk, let alone company risk. Morissey, Philips, Brown and a host of other writers have commented on the lack of a regulatory framework for CDSs as a crucial consideration. Being unregulated, there is no overseer from either the industry or the government. The instrument can be bought or sold from both parties to the contract, that is, from the insured as well as the insurer, without any regulatory body ascertaining the capacity of the buyer in assuming the risk. As it turned out, the institutions dealing in CDSs were those that were also heavily invested in the subprime mortgage market. At the height of the crisis, the top 25 commercial banks in the country held more than $13 trillion in credit default swaps (Morissey, 2008). There is clearly a doubt as to the value of the underlying debt in such a market, and whether this collective debt is truly valued at $13 trillion. From all apparent indications, an asset bubble has emerged overstating the value of the underlying debt. The matter of the “insurance” concept is another bothersome aspect in the study of CDSs. All CDS authors mentioned, and a host of other writers, have pointed at the bothersome conception of CDSs as a “sort-of” insurance policy, where a third party assumes the risk of debt in exchange for regular “premium” payments from the bank. Other institutions were eager to extend such insurance, because the 1990s was a boom market where hardly any defaults were incurred, and so the premium payments made the insurers easy revenues in what they thought was a low-risk market. But government regulators and finance experts should have acknowledged the cyclical nature of financial markets, and the impossibility of keeping a market in a bullish run indefinitely. At this point, in the crisis, it is also worthwhile to note the recommendation of Bondi (2009). It is ironic that brokers should be insulated against claims by a safe harbour policy on the theory that institutional and sophisticated investors were knowledgeable of the risks of the brokers’ recommended investments, whereas in the same study, Bondi admits that “Certain MBS…may be so complex that some institutional investors cannot appreciate the risk” (p.273) Where a broker employs hard-sell recommendation to invest in a product, they should have studies that product carefully. Finally, in the case of mortgage-backed securities, the inherent weakness in the subprime market has proved a risky foundation for derivatives. Aggressive extension of mortgage credit to households with poor credit profiles is clearly a matter of greed. Financial institutions were blinded by the glint of gold to ignore the time-tested principle of conservatism. Warning signs have been given years ago, but the lure of so-called exotic instruments, the absence of regulatory controls, and the deliberate disregard of warning signals and questionable practices are reasons why the present crisis could not be easily dismissed as “market failures”. In conclusion, the free hand given by financial regulators of the nineties, especially the likes of Alan Greenspan, on the creation and unleashing of “exotic” instruments upon an unwary public, all in the name of “free market forces,” is cause to hold them responsible for neglecting their mandate to serve and protect the public interest. As it is, the subprime mess, instruments such as the CDS and the MBS, the greed motive and the evasion of regulation, all contributed to the loss of jobs and erosion of wealth of citizens in the hitherto most powerful economy in the world. References: Amoss, Dan. What mortgage-backed securities mean for the US housing market. MoneyWeek, 5 September 2007 Bondi, Bradley J. Securities Arbitrations Involving Mortgage-Backed Securities and Collateralized Mortgage Obligations: Suitable for Unsuitability Claims? Fordham Journal of Corporate and Financial Law, vol. XIV, pp. 251-279, 2009 Bonfim, Diana. Credit risk drivers: Evaluating the contribution of firm level information and of macroeconomic dynamics. Journal of Banking & Finance, vol. 33, pp. 281-299, 2009 Brown, Ellen. Credit Default Swaps: Evolving Financial Meltdown and Derivative Disaster Du Jour. 11 April 2008. Accessed 9 December 2009 from http://www.globalresearch.ca/index.php?context=va&aid=8634 Brummer, Alex. Where the Credit Crash Came From. Management Today, London, May 2008, p. 34 Capinski, Marek. A model of credit risk based on cash flow. An International Journal of Computers and Mathematics with Applications. Vol. 54, pp. 499-506, 2007. Investopedia, A Forbes Digital Company. Mortgage-Backed Securities. Accessed 9 December 2009 from http://www.investopedia.com/articles/06/mortgagebackedsecurities.asp?viewed=1 Lambert, George D. Profit from Mortgage Debt with MBS. Investopedia, A Forbes Digital Company. Accessed 9 December 2009 from http://www.investopedia.com/articles/06/mortgagebackedsecurities.asp?viewed=1 Mason, Joseph R. & Rosner, Joshua. How Resilient are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? Unpublished paper. Hudson Institute, 15 February 2007. Morissey, Janet. Credit Default Swaps: The Next Crisis? TIME.com. 17 March 2008. Accessed 9 December 2009 from http://www.time.com/time/business/article/0,8599,1723152,00.html Philips, Matthew. The Monster that Ate Wall Street. Economy. Newsweek, 27 September 2008. Accessed 9 December 2009 from http://www.newsweek.com/id/161199 Rom, Mark Carl. The Credit Rating Agencies and the Subprime Mess: Greedy, Ignorant, and Stressed? Public Administration Review, Jul/Aug2009, Vol. 69 Issue 4, p640-650 Westgaard, Sjur & Van der Wijst, Nico. Default probabilities in a corporate bank portfolio: A logistic model approach. Elsevier Science B.V., 2001 Read More