Economic Crisis (Post 3) – Credit Derivatives
In my first post on the economic crisis, I reviewed the players involved and the effect lax lending standards had on the real estate market. In my second post on the crisis, I introduced the idea of a mortgage backed security and talked about their effect on the balance sheets of individuals and corporations.
In this post, I want to talk about credit derivatives and how they, in my opinion, played a very large part in exacerbating the crisis.
A credit derivative is a contract between two parties that obligates one party to pay another if certain conditions are met. The simplest analogy I can draw is to say that the contract that governs a credit derivative is very similar to an insurance policy that you and I might buy for our car or house, with two main differences.
First, in an insurance contract the party that sells the contract must reserve capital for future losses (e.g. the seller of contract for $100 might have to save $30-40 to pay for future losses). The perceived benefit of a credit derivative was that it wasn’t an insurance contract and therefore, the selling party didn’t have to reserve any of the proceeds for future payouts.
The second big difference is that credit derivatives aren’t regulated and therefore there isn’t any real way to track the volume of contracts that are being originated/sold (i.e., no one was paying attention to how big the market became and the peril that in which it placed many businesses).
So how did credit derivatives contribute to the crisis? Well, in the beginning many of the buyers of mortgage backed securities I described in the last post bought them to insure themselves against a certain degree of loss. Very similar to large purchases you and I make (house, car, etc), they wanted to obtain insurance to limit their potential losses. This probably seems like a reasonable thing to do.
However, as with many other things that start out well, the use of credit derivatives got out of hand. Soon, rather than using a credit derivative to insure against loss on a specific asset, buyers were using them to bet on a specific outcome. This enabled the market to grow to a size that no one could fully comprehend. Estimates range from $30-40 trillion in credit derivative exposure. To put this in perspective, between $1-1.5 trillion in sub-prime mortgages were originated.
If these contracts had been insurance contracts two things would have happened. First, as mentioned above, the originator would have had to reserve capital for future losses. And second, and most importantly, companies would have been limited in the volume of contracts they could originate based on the size of the balance sheet. Since they aren’t insurance contracts companies were able to originate a far higher level than they could actually afford to pay creating a huge house of cards.
The house started to crumble with the downturn in the real estate market and overall economy. As we have likely all read, mortgage default rates and foreclosures have been significantly higher than many people predicted. This meant that many of the limits set in the credit default contracts were triggered, requiring the seller to pay. As payment became required, many organizations (AIG and many of the investment and commercial banks come to mind) finally realized, the level of exposure they had and that they weren’t adequately capitalized to pay
The outcome, as we have all seen, is that the US and many other governments had to step in and prevent many of these companies from failing. These governments felt, and I tend to agree, the market faced systemic risk if these companies were allowed to fail. We, as a worldwide economy, are now in the midst of working through these issues as well as others that have developed as a result of the severe downturn in the economy.
So what does the future hold? Hopefully, we will see regulation of credit derivatives and the creation of an exchange that will be able to track the volume and level of exposure. I think we will likely see further regulation and requirements on the mortgage market and possibly a reduction in the level of credit that each of us can access.
Eventually, as the market and economy recovers, the availability of credit will likely expand and new products will be created that enable each of us to do things we previously couldn’t. It’s at this point where we will have a choice to participate in the game or function within our means as individuals and corporations. Only time will tell how we all respond.
Scott H
