Here's some more reading material on subprime......I want you to read it over carefully, kumquat. There are parts I have bolded. Those you are to memorize.....there will be a quiz on Monday.
And inode.........you are a bigger fool than Brumar.
Background
The crisis began with the bursting of the United States housing bubble[1][2] and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices.[3][4] Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.[5]
Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as of 17 July 2008.[6][7] The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.
The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.[8] Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.[9] Leaders of the larger developed and emerging nations met in November 2008 to formulate strategies for addressing the crisis.[10]
[edit] The mortgage market
Subprime lending is the practice of lending, mainly in the form of mortgages for the purchase of residences, to borrowers who do not meet the usual criteria for borrowing at the lowest prevailing market interest rate. These criteria pertain to the downpayment and the borrowing household's income level, both as a fraction of the amount borrowed, and to the borrowing household's employment status and credit history. If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender can take possession of the residence acquired using the proceeds from the mortgage, in a process called foreclosure.
The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, [11] with over 7.5 million first-lien subprime mortgages outstanding.[12] In the third quarter of 2007, subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures begun during that quarter.[13] By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005.[14] By January 2008, the delinquency rate had risen to 21%.[15] and by May 2008 it was 25%.[16]
The value of all outstanding residential mortgages, owed by USA households to purchase residences housing at most 4 families, was US$9.9 trillion as of yearend 2006, and US$10.6 trillion as of midyear 2008.[17] During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.[18] As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.[19] 936,439 USA residences completed foreclosure between August 2007 and October 2008.[20]
[edit] Credit risk
Understanding financial leverage.Credit risk arises because a borrower has the option of defaulting on the loan he owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to sell the right to receive the payments on the mortgages they issue, through a process called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional depository institutions. [21]
This "originate to distribute" model means that investors holding MBS and CDOs also bear several types of risks, and this has a variety of consequences. There are four primary types of risk:
[22][23] When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets.
Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor their commitments.
[edit] Causes
The reasons proposed for this crisis are varied[24][25] and complex.[26] The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments, poor judgment by borrowers and/or lenders, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary policy, and government regulation (or the lack thereof).[27]
In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes:
“ "During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions."[28] ”
Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis.[29] The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.[30] Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing.
This rise in demand fueled rising house prices and consumer spending.[31] Between 1997 and 2006, the price of the typical American house increased by 124%.[32] During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.[33] This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 142% at the end of 2007, versus 101% in 1999.[34]
A culture of consumerism is a factor "in an economy based on immediate gratification."[35] Americans spent $800 billion per year more than they earned. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income.[36] During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970.[37]
This credit and house price explosion led to a building boom and a surplus of unsold homes. House prices began to decline in the summer of 2006. Easy credit, and a belief that house prices would continue to appreciate, encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.
As of March 2008, an estimated 8.8 million homeowners — 10.8% of all homeowners — had zero or negative equity in their homes, meaning their homes were worth less than their mortgages. Homeowners in this situation have an incentive to "walk away" from the homes, even though doing so damages their credit rating for a number of years.[38] The reasons is that unlike what is the case in most other countries, American residential mortgages are non-recourse loans; once the creditor has regained the property purchased with a mortgage in default, he has no further claim against the defaulting borrower's income or assets. By November 2008, an estimated 12 million USA homeowners had negative equity. As more borrowers stop paying their mortgage payments, foreclosures and the supply of homes for sale increase. This places downward pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.[39]
Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981.[40] Furthermore, nearly four million existing homes were for sale,[41] of which almost 2.9 million were vacant.[42]
This overhang of unsold homes excess lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. By November 2007, the S&P/Case-Shiller price index of USA house prices had declined about 8% from its Q2 2006 peak,[43] and by May 2008 it had fallen 18.4%.[44] The price decline between December 2006 and December 2007, was 10.4%, and by May 2008 the index had declined 15.8%.[45] House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels.
[edit] Speculation
Speculation in residential real estate has been a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."[46]
While homes had not traditionally been treated as investments, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them.[47] Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.[48]
Economist Robert Shiller argues that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."[49] Keynesian economist Hyman Minsky described three types of speculative borrowing that contribute to rising debt and an eventual collapse of asset values:[50][51]
The "hedge borrower," who expects to make debt payments from cash flows from other investments;
The "speculative borrower," who borrows believing that he can service the interest on his loan, but who must continually roll over the principal into new investments;
The "Ponzi borrower," who relies on the appreciation of the value of his assets to refinance or pay off his debt, while being unable to repay the original loan.
Speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.[52]
[edit] High-risk mortgage loans and lending practices
Lenders began to offer more and more loans to higher-risk borrowers,[53] including illegal immigrants.[54] Subprime mortgages amounted to $35 billion (5% of total originations) in 1994,[55] 9% in 1996,[56] $160 billion (13%) in 1999,[55] and $600 billion (20%) in 2006.[56][57][58] A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined from 280 basis points in 2001, to 130 basis points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though the credit ratings of subprime borrowers, and the characteristics of subprime loans, both declined during the 2001–2006 period, which should have had the opposite effect. The combination of declining risk premia and credit standards is common to classic boom and bust credit cycles.[59]
In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.[60]
One high-risk option was the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[61]
Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation.[62] In 2007, 40% of all subprime loans resulted from automated underwriting.[63][64] The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.[65] Outright fraud has also increased.[66]
[edit] Securitization practices
Borrowing under a securitization structure.Securitization, a form of structured finance, involves the pooling of financial assets, especially those for which there is no ready secondary market, such as mortgages, credit card receivables, student loans. The pooled assets serve as collateral for new financial assets issued by the entity (mostly GSEs and investment banks) owning the underlying assets.[67] The diagram at right shows how there are many parties involved.
Securitization, combined with investor appetite for mortgage-backed securities (MBS), and the high ratings formerly granted to MBSs by rating agencies, meant that mortgages with a high risk of default could be originated almost at will, with the risk shifted from the mortgage issuer to investors at large. Securitization meant that issuers could repeatedly relend a given sum, greatly increasing their fee income. Since issuers no longer carried any default risk, they had every incentive to lower their underwriting standards to increase their loan volume and total profit.
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining the credit (default) risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors through MBS and CDOs. Securitization created a secondary market for mortgages, and meant that those issuing mortgages were no longer required to hold them to maturity.
Asset securitization began with the creation of private mortgage pools in the 1970s.[68] Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.[59] Alan Greenspan has stated that the current global credit crisis cannot be blamed on mortgages being issued to households with poor credit, but rather on the securitization of such mortgages.[69]
Investment banks sometimes placed the MBS they originated or purchased into off-balance sheet entities called structured investment vehicles or special purpose entities. Moving the debt "off the books" enabled large financial institutions to circumvent capital requirements, thereby increasing profits but augmenting risk. Such off-balance sheet financing is sometimes referred to as the shadow banking system, and is thinly regulated.[70]
Some believe that mortgage standards became lax because securitization gave rise to a form of moral hazard, whereby each link in the mortgage chain made a profit while passing any associated credit risk to the next link in the chain.[71][72] At the same time, some financial firms retained significant amounts of the MBS they originated, thereby retaining significant amounts of credit risk and so were less guilty of moral hazard. Some argue this was not a flaw in the securitization concept per se, but in its implementation.[22]
In 1995, the Community Reinvestment Act (CRA) was revised to allow CRA mortgages to be securitized. In 1997, Bear Sterns was the first to take advantage of this law.[73] Under the CRA guidelines, a mortgage issuer receives credit for originating subprime mortgages, or buying mortgages on a whole loan basis, but not holding subprime mortgages. This rewarded issuers for originating subprime mortgages, then selling them to others who would securitize them. Thus any credit risk in subprime mortgages was passed from the issuer to others, including financial firms and investors around the globe.
[edit] Inaccurate credit ratings
Main article: Credit rating agencies and the subprime crisis
MBS credit rating downgrades, by quarter.Credit rating agencies are now under scrutiny for having given investment-grade ratings to CDOs and MBSs based on subprime mortgage loans. These high ratings were believed justified because of risk reducing practices, including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. Emails exchanged between employees of rating agencies, dated before credit markets deteriorated and put in the public domain by USA Congressional investigators, suggest that some rating agency employees suspected that lax standards for rating structured credit products would result in major problems.[74] For example, one 2006 internal Email from Standard & Poor's stated that "Rating agencies continue to create and [sic] even bigger monster—the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."[75]
High ratings encouraged investors to buy securities backed by subprime mortgages, helping finance the housing boom. The reliance on agency ratings and the way ratings were used to justify investments led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities. This was exacerbated by the SEC's removal of regulatory barriers and its reduction of disclosure requirements, all in the wake of the Enron scandal.[76] Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.[77] On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities.[78]
Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.[79]
[edit] Government policies
Main article: Government policies and the subprime mortgage crisis
Both government action and inaction have contributed to the crisis. Some are of the opinion that the current American regulatory framework is outdated. President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws."[80] The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis.[81][82]
Increasing home ownership was a goal of the Clinton and Bush administrations.[83][84][85] There is evidence that the Federal government leaned on the mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower lending standards.[86][87][88] Also, the U.S. Department of Housing and Urban Development's (HUD) mortgage policies fueled the trend towards issuing risky loans.[89][90]
In 1995, the GSE began receiving government incentive payments for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the GSE with the subprime market.[91] Subprime mortgage originations rose by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of subprime mortgages in just nine years.[92] The relatively high yields on these securities, in a time of low interest rates, were very attractive to Wall Street, and while Fannie and Freddie generally bought only the least risky subprime mortgages, these purchases encouraged the entire subprime market.[93] In 1996, HUD directed the GSE that at least 42% of the mortgages they purchased should have been issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005.[94]
By 2008, the GSE owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the amount outstanding.[95] The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion.[96] When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers' expense.[97][98]
Liberal economist Robert Kuttner has suggested that the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 may have contributed to the subprime meltdown, but this is controversial.[99][100] The Federal government bailout of thrifts during the savings and loan crisis of the late 1980s may have encouraged other lenders to make risky loans, and thus given rise to moral hazard.[101]
Economists have also debated the possible effects of the Community Reinvestment Act (CRA), with detractors claiming that the Act encouraged lending to uncreditworthy borrowers.[102][103][104][105] and defenders claiming a thirty year history of lending without increased risk.[106][107][108][109] Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of mortgages issued to otherwise unqualified low-income borrowers, and also allowed for the first time the securitization of CRA-regulated mortgages even though some of these were subprime.[110][111]
[edit] Policies of central banks
Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists.[112][113]
Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard. Some industry officials said that the Federal Reserve Bank of New York's rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to believe that the Federal Reserve would intervene on their behalf if things went sour because they had made risky loans.[114]
A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[115] This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.[112] The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low; it disregarded other important factors. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, said that the Fed's interest rate policy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble.[116]
[edit] Financial institution debt levels and incentives
Leverage Ratios of Investment Banks Increased Significantly 2003–2007Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–2007, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.[23]
A 2004 SEC ruling allowed USA investment banks to issue substantially more debt, which was then used to purchase MBS. Over 2004-07, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Three investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch) during September 2008. The failure of 3 of the 5 large USA investment banks augmented the instability in the global financial system. The remaining two investment banks, J P Morgan and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation.[117]
The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."[33]
[edit] Credit default swaps
Credit defaults swaps (CDS) are insurance contracts used to protect debtholders, in particular MBS investors, from the risk of default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the insurance would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.
Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion.[118] CDS are lightly regulated. As of 2008, there was no central clearinghouse to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.[119]
Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.[120][121] Merrill Lynch's large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill's CDOs. The loss of condidence of trading partners in Merrill Lynch's solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America.[122][123]
[edit] Impact
Main articles: Financial crisis
en.wikipedia.org
Background
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