Derivative products

Résumé du document

It is an indisputable fact that the present financial and economical tsunami is one of the worst slowdowns just close to the previous one, being the economic collapse in 1929. Indeed each semester previsions a particular percentage of growth. However, this foresight is depleting in terms of the growth scenario deteriorating and getting worse from time to time. This impact is adverse as the plummeting vision states that the world economy might even endure recession. Then a chain of reactions led to a major crisis and final losses could stand between one and two trillions of dollars. Well established banks such as Lehman Brothers, Bear Stearns or Northern Rock have reached a stage of bankruptcy and the governments of most of the developed countries have had to set up rescue operations. While encountering such a severe turmoil, the next step is to infer the possible causes for this kind of an economic slump. Identifying the factors that has led to the crisis is necessary to implement reforms and avoid future disasters. Many explanations have been provided and several of them have been condemned as derivative products. To quote more precisely, the concept focuses on credit derivative products. Warren Buffet who is the greatest investor of all times, and has proved in ever so many situations that his time tested strategy in the investment area is a success has critically declared the derivative products as 'financial weapons of mass destruction' in 2003. The hypothesis based on which Warren declared this statement was insignificant as the statement was made without having the forethought of something like the actual crisis.

Extraits

[...] B Evolution of CDOs leading to a flawed model CDOs based on RMBS had a good return on investment and demand was growing. Mortgage brokers and banks did not bear the risk and had little incentive to pay attention to the ability to repay of the borrowers. New models known as “quants models” were developped to evaluate loans conditions. Instead of being based on an estimation of the indiviual situation of each borrower, “quants models” use historical data regarding default rate from comparable borrowers. [...]

[...] When real estate prices started to stabilize and decline the scheme went wrong. B A model of increasing riskiness If we accept Minsky approach derivative products are just one one the symptoms of a general evolution toward more risk during perdiods of stability. Derivative products are part of the inovations that were used to bypass regulations and the reduction of the criteria to grant loans correspond to a reduction of the margins of safety. Nevertheless the evolution of the model is wider and depends on incentive schemes, corporate governance and control mechanisms. [...]

[...] His description of unstable stability perfectly fits to the events of the last decade and the present crisis. If Minsky is right then we can only hope that the present crisis will not turn into a great depression and try to implement new regulations where they lacked. If Minsky is wrong and if the present crisis is just a consequence of subprime securitization, which I do not believe, the solution to try to prevent further crisis should be the same : more regulation and more cocnerns about non-understood risks. [...]

[...] B Hidden exposure to high risks Many investors such as hedge funds had bought CDOs with a high leverage and the required funds were provided by banks (the same who originated the CDOs) with the bought assets used as collateral. This led banks to be indirectly exposed to the products they had sold. Moreover banks themselves were buying CDOs through Structured Investment Vehicles which were off balance sheet. This mean that most institutionnal or alternative investors were exposed to credit derivative products but this exposure was often hidden, it did not appear directly on the balance-sheet and this contributed to the panic when losses started to generalize. Another problem came upon these: credit default swaps. [...]

[...] Conclusion Credit derivative products and their exagerrated development clearly launched the crisis and thus there are responsible for the current problems in the financial sector. Nevertheless a precise analyse of the crisis spreading show that other parameters were involved. Without loose regulations concerning over-the-counter trading, accounting standards or risk evaluation the crisis could have been more limited. The general climate of “greediness” of the last decade, as L. Randall Wray wrote, has been a major root of the crisis. This race for profits tends to give Minsky's ideas more credit. [...]