Derivatives: Part 2 of the 2008 Financial Crisis

This is a continuation from my first post. In this post I will try and explain how the US housing bubble bursting became a global melt down and caused the 2008 financial crisis.

Before we get into this I need to explain about securities and derivatives. Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages. This is a mortgage backed security(MBS)

derivative is a financial instrument that derives its value from another form of asset. There are many forms of derivatives. A credit default swap is one.

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument – typically a bond or loan – goes into default (fails to pay). Credit default swaps peaked at trillion by the end of 2007 (Bank for international settlements).

So thousands of mortgages were being sold in America. These were grouped into packages and sold as securities. Large volumes of these securities were traded on the London stock exchange and bought by overseas brokers/investment bankers etc. When purchasing these securities they also bought credit default swaps with other banks. They did this as an insurance policy in case the borrowers on the original mortgages didn’t pay. These derivatives are also traded amongst the banks and brokers and become a whole different source of revenue in themselves. 43% of all derivatives are traded on the London Stock Exchange. As a side note, London brokers received 8,5 BILLION pounds in bonuses in 2007. 4000 of these were over 1 million pounds each.

Unfortunately by doing this, the bankers or buyers of these securities and derivatives thought they were in a win, win situation and so started to trade even more recklessly. This would be like you or me playing both the black and red on a roulette table. It doesn’t feel like gambling if you are insured against your losses. Plus everyone is making huge profits and with those huge profits come nice fat bonus payments. So there was definitely no incentive to slow down. Rather the reverse is true.

So through securitization  American bonds were traded all over the world. Then some of the sub-prime lenders started to default on their loans as the housing bubble burst. These few bad apples soon turned all the mortgage backed securities toxic as the buyers didn’t know what was good and what was bad. This started to send the global markets into a spin. The insurance that the bankers had taken out in the form of credit default swaps became worthless as all these had been traded between the banks and so all of the banks owed each other money. But this was another hit for the banks as they had been trading these derivatives and making profits.

Global Crisis: How sub prime bonds become AAA

How sub-prime bonds were turned into AAA assets and traded globally

This all happens towards the end of 2007 and the beginning of 2008. Next we will be talking about the impact of the above and how it forced Lehman Brothers to file for bankruptcy. The largest bankruptcy in American history ever filed of billion. The previous largest bankruptcy was Worldcom which was billion and we all remember Enron which was billion. Both were pocket change compared to Lehman Brothers.

Hope that wasn’t  confusing. See you on my next blog post.

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