In the recent times credit derivatives have become a very popular financial security for investors. If we take a look at the chart given below we can see how the popularity of credit derivatives increased in the past decade. The maximum volume of derivatives was traded during the years 2005 to 2007 of which 2006 was the highest at $2000bn. Then when the financial crisis occurred at the end of 2007 the trading decreased rapidly the following two years to as low as $100bn in 2009. There has been claims from financial critics that these credit derivative are the main factor that has lead to the almost collapse of the world financial markets and if corrective measures are not taken, it can happen again. I believe this claim is true and in the rest of this paper I will explain why. In the next section I will first explain how the derivatives caused the financial collapse. Then I will try to give reasons as to why control measures on the credit derivatives are needed to avoid such collapse happening again in the future. Finally I will try to give some suggestive control measures from different literature reviews.
Secondary Source: www.wikipedia.org
2.0 The Financial Crisis:
Crawford and Young (2008) explained the financial crisis that occurred recently in the financial markets as an effect of the subprime mortgage rates. The rates were reduced by the Federal Reserve in USA after the incident in 9/11 caused a slight downturn in the economy. Because of this the demand of housing and other real estate properties started to increase rapidly in the real estate market. Seeing this phenomenon, people speculated that real estate investment will give increasing returns in the near future and so everyone started to buy houses. The action of the speculators was the main reason for the housing bubble. Among the investors there were many people who could not afford to purchase a house on their own and so took mortgage loans for the purchase keeping the new house as the collateral. But due to most of their poor credit ratings these investors had to take sub-prime mortgage at a higher rate than usual. They still took the risk as they believed that their new home’s price will increase and they’ll get enough return to be able to afford high monthly installments of the sub-prime mortgage. This increase in taking sub-prime mortgages also shot up the volume of trade of mortgage-backed credit derivatives in the secondary market. More and more people sold off their previous securities and bought these credit derivatives as they also hoped of getting higher return from the increasing price of housings. There was also an increase of trading of secondary CDOs, which are basically securities that are backed by a portfolio of other derivatives backing sub-prime mortgage loans. But like any other investments, the real estates’ prices also reached its peak and the housing bubble started facing its demise in 2006. The factor causing the burst of the housing bubble was mainly the creative and complex engineering of credit derivatives that left investors vulnerable to bankruptcy risk at large (Crawford & Young, 2008). All of a sudden, in 2007 the price of all the housing and real estate properties started to go down. Now the sub-prime mortgage borrowers faced problems. They still had to payback huge portion of their loan at the high rate and they were also incurring loss from the house that they bought. So, they defaulted their loans. On the other hand, the financial institutions that provided the mortgage loans could not make use of the collateral as its price had gone down and so, they also defaulted in paying the credit derivatives and CDO investors. Panic started among the investors as they no longer wanted to hold their securities and wanted to sell them off. Thus there were no buyers for those securities in the secondary markets and the whole financial market faced the...