FINANCIAL WEAPONS OF MASS DESTRUCTION:

ROLE OF FINANCIAL DERIVATIVES IN FINANCIAL CRISIS OF 2008.

FINANCIAL DERIVATIVES
Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right; their value derives from the price of the underlying item (i.e. the reference price) and, unlike debt instruments, no principal amount is advanced to be repaid and no investment income accrues. OECD, 1999

Importance of Financial Derivatives

Risk management Offer some degree of leverage Ensures Liquidity Hedging activity for Asset or liability management Do not wind the markets together than loans do Absence of Derivatives result in jolt in financial markets.

Financial Crisis
Financial crisis is a situation that may affect various forms of lifestyle and every economy across the world. The basic aspect of financial crisis revolves around the fact that, most of the entities over the world are in some way or the other interdependent among themselves. Thus, if any particular sector was to be affected, the impact would disperse among all others.
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HOW FINANCIAL DERIVATIVES BECOME

FINANCIAL WEAPONS

 By the use of the derivatives, we could pretty easily take risks against various ventures hoping to make profit out of them. People started to take loans on the basis of derivatives considering the fact that it would be greater profit for them. On the other hand the individuals lending out on derivatives thought of gaining from the derivatives in case they were able to pull out a foreclosure. Thus, the entire transaction was based on the simple probability of events, which could have possibly taken place for both the entities.
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American Policy
American policy of promoting home ownership This entailed making the financing of home purchases as easy as possible. Various financial institutions were set up (Fannie Mae) This meant that if a bank granted a mortgage to someone and later the bank needed funds the bank could readily sell the mortgage to Fannie Mae.
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How Banks can access Secondary Markets

To access Secondary Market Mortgage Banks must have to abide by the rules In the past Fannie Mae prohibited the lenders it was dealing with to engage in the practice of red lining. In 1990, administration of Franklin Raines, a Clinton Administration appointee, Fannie Mae began to demand that the lending institutions that it dealt with prove that they were not redlining..
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Sub-Prime Mortgage
A subprime mortgage is a type of loan granted to individuals with poor credit histories who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate.
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Structures of Sub-Prime Mortgage

No Money Down Interest only Loan Adjustable Interest Rate Mortgages Higher interest rate to compensate for the higher risks. Fannie Mae (into the ground) understood intuitively that a poor risk for a mortgage cannot be made a better risk by charging a higher interest rate these must be pooled.
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Collateralized Debt Obligations

Creation of pools of individual loans and issuing of securities based upon the revenue received. This procedure is called securitization and the securities created are called collateralized debt obligations, CDO's.

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CDOs contd.
CDO's, or Collateralized Debt Obligations, are sophisticated financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralized because they have some type of collateral behind them.
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Significance of CDOs.
Diversification of Risk Ensures Liquidity Enables the banks to offset the debt and removes from their balance sheets Free up cash to make new loans.

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Darker Side
Allows the individuals to avoid having to collect on them, when they become due. They are so complex that often the buyers aren't really sure what they are buying. Buyers often rely on their trust of the bank selling the CDO CDOs can cause market panic if something happens to make sellers lose their trust in the product.
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Mortgage Backed Securities (MBS)

Mortgage-backed securities are a bundle of mortgages that have been sold by banks to Secondary Market, who then repackages them and sells them to individual investors and the value of which is derived by value of the mortgages in the bundle.

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Mortgage Backed Securities vs CDOs

Same as CDOs Difference is only that CDOs packages consists of auto loans, credit cards debt and corporate debt MBS packages consists of Mortgages. Main purpose of both same: enables the banks to offset debt and mortgages and take them off their balance sheets which frees up more capital and cash to make new loans
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MBS Lead to Financial Crisis

Interest only Loans Adjustable Mortgage Rate Higher Interest rate than Prime mortgages rate Sub-Prime default on their payments Value of houses decline Securitization was based upon the notion that the risks of default for the different mortgages were independent. Prime borrowers anticipation Demand and Supply
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Credit Default Swaps

A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's 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.
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Fundamental Purpose of CDSs

Fundamentally, this kind of derivative serves a real purpose as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.

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Not Standardized instruments Not Transparent Not traded on Exchange Not subject to present Securities Law (CFTC) Not regulated (Congress, 2000)

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CDS lead to Mass Destruction

Credit default swaps written on subprime mortgage securities. These subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated. Speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn't, default. Wholly based on speculation
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Linking Financial Crisis of 2008 with Great depression

Asset Bubbles Securitization Excessive Leverage Corrupt Gate Keepers Financial Engineering Lagging Regulations Market Ideology Non-Transparency
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SBP Regulations for Financial Derivatives

State Bank of Pakistan (SBP) Financial Derivatives Business Regulations (FDBR) www.sbp.org.pk/bsd/2004/C_17_FDBR.pdf

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