Dissertation: Financial Derivatives on Sub-Prime Crisis Impact

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¶ … Financial Derivatives on Sub-Prime Crisis

Impact of Financial Derivatives on the Sub-Prime Crisis

Over the last several years, the world has been struggling with a financial crisis, unlike anything that has occurred since the Great Depression. At the heart of issue, are various financial related derivates tied to what is known as subprime loans in real estate. Simply put, a derivative is financial product (based upon a contract) where the value is determined by another asset class or security. (Derivatives 2011)While subprime loans, were given to those individuals who may not have the ability to qualify for a traditional loan to purchase a home. This usually involved, the person making some kind of down payment on the property at the time of purchase (usually 10%) and they are in good financial standing with the different credit bureaus. In the case of a subprime borrower, there was usually something that prevented them from being able to qualify for a traditional mortgage (such as: low income, bad credit and someone who has large amounts of credit card debt / outstanding loans). For the larger risk, the investors in different subprime-based products were rewarded with: higher interest rates and the ability to have them adjusted upward (once the Federal Funds Rate began to rise). (Pritchard 2011) This is important, because within these two basic definitions, are the root causes of the financial crisis that is continuing to have an impact upon the world economy. As result, the aims and objectives of this project are to examine the overall effects and the how the lack of oversight of derivatives would lead to the crisis itself.


The Subprime crisis began in late 2006. What happened was the real estate market had been performing relatively well for many years. However, since the late 1990's, the upward price appreciation and demand for real estate would increase rapidly. This would have an impact upon how properties were being sold to investors. As financial institutions wanted to offer mortgages, to those individuals who may not be able to qualify for a traditional mortgage through various loans. The idea was that there could be a low introductory rate offered to buyers, with little to money down. Since interest rates were relatively low and the economy was performing well, these kinds of products became incredibly popular during the early 2000's. (Schiller 2008) a good example of this can be seen with the total number of subprime mortgages that were sold to homeowners between: 2000 and 2006 (as this accounted for 1 million mortgages). At the time, many of the leading economists felt that the mortgage market was strong enough to withstand any kind of potential defaults from some buyers. Evidence of this can be seen with comment from Yuliya Demyanyk of the Cleveland Federal Reserve who said, "The subprime mortgage market was too small to cause big problems." (Ten Myths About Sub-Prime Crisis 2009) This is important, because it showing how the subprime crisis had a number of different working parts that all contributed to the underlying problems. As a lack of: supervision, regulation and common sense would fuel one of the largest asset bubbles the world has ever seen. To fully understand the scope of the crisis requires: examining how the use of derivatives and the lack of oversight would lead directly to the various predicaments and the subsequent recession. This will be accomplished through: conducting a literature review, looking at the role of the financial derivates market, how a lack of oversight contributed to the situation and possible recommendations about how these kinds of issues should be addressed in the future. Together, these different elements will provide the greatest insights, as to the how the U.S. mortgage market was the main contributor to: the worst global financial crisis the world has seen since the Great Depression.

Chapter 1: Literature Review

To identify the total impact that subprime mortgages would have the world economy requires conducting a literature review. This will be accomplished by focusing on three different areas to include: providing an overview of the financial crisis, how financial derivatives were utilized and possible lessons that can be learned from the research. Once this takes place, it will provide specific insights, as to what were the direct causes of the crisis and how it can be avoided in the future.

1.1: Overview of the Subprime Crisis

The piece of literature that was written by Schiller (2008) discusses the impact that subprime mortgages would play in: contributing to the financial crisis and implosion in asset values. Where, the source discusses how this crisis began with the increased amounts of deregulation that occurred in the area of finance during the 1980's and the 1990's. This would set the stage for, new derivate-based products to be bundled together and sold to investors in what is known as tranche. This is where the various mortgages would be combined into one package. Then, sold to investors offering: higher potential returns and they spread out the risk. The idea was that by offering these kinds of mortgages to investors and large institutions, they would provide another way of increasing their overall return (while improving diversification). However, the reduction in various regulations and the improvements in technology allowed these kinds of investments to be sold around the world. These two elements would cause the financial crisis to become more severe, as it would impact every nation on the planet. This information is useful, because it establishes a basic background as to the events surrounding how: subprime mortgages contributed to the crisis and the lack of oversight / regulations would help the situation to become worse. (Schiller 2008)

The article that was written by Gleason (2011), talks about the total impact of the financial crisis on the economy. This is accomplished by looking at: housing price increases, speculation and failures. The housing price increases and speculation, would work together to create the meteoric rise in home prices. Where, this caused many buyers and financial institutions to discount the overall amounts of risk. Once this took place, it meant that a host of financial institutions would face rising numbers of defaulting mortgages (placing their overall liquidity position in jeopardy). A good example of this occurred with insurance companies. Even though they were not directly selling these kinds of investments; the collapse in the real estate market would have an impact on their overall bottom line. This is because they were insuring the various mortgages against possible buyer defaults. Once these numbers began to rise sharply, is when insurance companies would not be able to cover the losses that were being seen. This is important, because it shows how the situation surrounding subprime mortgages would become more extreme (as time went by). Therefore, the information from this source is useful because it identifies various issues that affected the entire financial system.

The piece of literature that was written by Jansesn (2008), discusses the total impact of the financial crisis, by looking at the overall causes including: deregulation, the financial institutions, the economic backdrop, the stock market, greed, the rating agencies, the central banks and the risks that were posed to the system. These different elements are important, because they are highlighting how the subprime crisis was a number of factors working together, to create an implosion in asset prices. The information from this source is useful, because it is identifying the various causes and effects of the financial crisis. As a result, this can be corroborated with the previous sources, to understand the overall scope the different events that took place.

When you step back and look at the information that was examined, it is clear that the financial crisis began with deregulation and an attempt to offer consumers greater choices when purchasing a home. Over the course of time, these two factors would spiral out of control, as financial institutions became more creative in the way that were selling these different products. This would have an impact upon the economy by: interconnecting banking, insurance and other sectors together. Once real estate prices began to decline and interest rates were increasing, this would have an adverse impact upon economic growth. Where, many different institutions and investors were purchasers of numerous derivative-based subprime products. Over the course of time, this would mean that their risks increased and their liquidity positions would be placed in jeopardy. This is because, these institutions were left holding mortgages that were: in default and foreclosed properties that they could not sell. At which point, this would have negative implications on credit and their ability to withstand the financial storm. This is important, because the different sources are showing how the subprime crisis is a host of events that were interconnected (which led to the economic tsunami).

1.2: Financial Derivatives

Within the different subprime loans were a host of derivative products that were sold to investors. In this section, we review the most common and their impact upon the mortgage market. Once this… [END OF PREVIEW]

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"Financial Derivatives on Sub-Prime Crisis Impact."  Essaytown.com.  February 14, 2011.  Accessed August 22, 2019.