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Study On The Risk In Sub Prime Mortgages


Soros (2009) emphasized that the overall financial system has been built on false premises. Although credit crisis do not arise out of defaults in mortgage loans alone; they are mostly the product of credit at various points in the financing system (Cudahy, 2009). The financial crisis was aggregated by highly leveraged credit derivatives that were not well understood by both lenders and borrowers (Markowitz,2009).

In the recent credit crisis, the risk in sub-prime mortgages began to affect the financial system generally because the mortgages were resold in various forms .Although some causes could be detected, the full process of collapse that led to a severe unavailability of credit was startling. It all appears to have started with the sub-prime mortgage crisis. The sub-prime lending involves the extension of credit in situations where the chances of default exceed those associated with normal business practices Cudahy(2009).Large complex financial institutions (LCFIs) were the primary catalysts for the negative credit boom that led to the subprime financial crisis, the main centre of the recent global financial crisis (Wilmarth,2009).

The Key source of the instability in the financial system which led to the financial crisis is the absence of regulation of some vital credit derivatives, some of which are the collateralized debt obligations (CDOs) and credit default swaps (CDSs), which are trade over the counter (OTC) and not subjected to regulation (Cudahy,2009).By 2006, the United States housing market was used as a system in which borrowers took new loans to pay off old ones due to the securitization by the LCFI’s. When home prices fell in 2007, and nonprime homeowners could no longer refinance, defaults increased drastically and the subprime financial crisis began (Wilmarth,2009).

The main issue with the CDO’s and the CDS is that banks and other financial institutions that originate the securitizations of the loans did not use the right credit ratings measures for the loans given out. Because they had it at the back of their minds that the loans have been pushed out of their books to the various investors that bought the CDO, CDS and other credit derivatives that were issued (Wilmarth,2009).

This write up includes an introduction on credit derivatives and its effects on the financial market. A literature review on the contribution of credit derivatives to the financial crisis and regulatory measures that can be adopted, in order to avoid the reoccurrence of such crisis in the future. And the conclusion of the write up.


The CDO’s and CDS’s and other credit derivatives traded OTC, are more flexible than exchange-traded derivatives, but they have greater counterparty and operational risks, with less transparency (Acharya, Engle, Figlewski, Lynch and subrahmanyam,2009). ‘‘LCFIs used the originate to distribute (OTD) business model. This enabled LCFIs to collect fees at each stage of the OTD process, including originating, securitizing and servicing loans, and structuring and selling additionally securities and other financial instruments (e.g., CDOs and CDS) based on those loans’’ (Wilmarth 2009,p.995).

During the financial crisis, Citigroup and several other major LCFIs were crippled by losses as a result of their exposure to nonprime mortgages and related instruments. The LCFIs and credit rating agencies (CRA) created several layers of financial stake that depended on the performance of nonprime mortgages. This occurred because both the LCFI’s and CRA’s assumed that housing prices would keep rising for the foreseeable future. Also the risk models used by financial multinationals and CRA’s did not include any circumstance that calculated possible losses resulting from a significant nationwide reduction in housing prices (WIlmarth,2009).

The CRA’s assumed that senior tranches of Residential Mortgage-Backed Securities (RMBS) and CDOs derived from large pools of nonprime mortgages would have very low default risks, due to the benefits of risk diversification due to pooling and payment seniority from tranchings. They failed to consider that senior tranches of nonprime RMBS and CDO’s were exposed to large systematic risks. The high demand for nonprime-related investments caused lenders to reduce their standards for nonprime loans as the housing boom persisted, and a serious recession in the economy caused large losses on holders of CDOs and RMBS, due to the exposed financial situation of most nonprime borrowers (Wilmarth,2009).

‘‘LCFI’s and CRA’s ignored the risks involved in those instruments because of the ability to earn profitable fees from rating and distributing nonprime RMBS and CDO’s. Senior managers and investment bankers at LCFI’s also received incentive-based compensation that strongly encouraged them to incur excessive risks in order to produce short-term profits. Also some of the institutions that suffered the greatest losses were driven by management's willingness to take excessive risks to catch up with more profitable competitors’’(Wilmarth 2009,p.1035).The investors and all the participants desire for easy money was also emphasized by Varchaver(2008) stating that the financial derivatives markets grew quickly because the hedge funds poured in sensing easy money, forgetting that if they were asked to pay off on a lot of the CDS they will simply go out of business.

Blundell-wignall, Atkinson and Lee (2008) are of the opinion that corporate governance also placed a role in the crisis. One is that the culture of investment banking is much harder to control by individuals that do not understand what the process entails ( i.e controlling it by managements from the boardroom) . The risk control practices for credit derivatives are much more difficult because credit derivatives and models used for their valuations are complex and difficult to understand. Varchaner (2008) emphasized that the CDS market is unregulated and that the market is not transparent as nothing is being disclosed publicly. The recent financial and economic disaster has been mostly blamed on deregulation. Due to the financial crash, there is a high possibility that regulation as a reaction to economic crisis will re-emerge, in most areas in the financial sectors that are not regulated (Cudahy,2009).

Regulations in the financial industries had often been rejected where proposed in the anticipation that market forces and self-regulation could accomplish the same goals the regulations will achieve. The most highly visible of these developments in the financial area was the cancelation of the Glass-Steagall Act, the purpose of the act was to keep commercial banking separate from investment banking, with the aim to keep the banks out of the securities business. The cancellation of this legislation lifted the restriction, allowed commercial banks to acquire investment firms and to put commercial banks in a central position in investment activity. This act placed a critical role in the financial crisis (Cudahy,2009).

According to Acharya,Engle,Figlewski,Lynch and subrahmanyam (2009) the fact that the OTC environment offers nearly no transparency regarding the counterparties’ overall risk exposure, became clear in the case of AIG, which had accumulated a huge exposure to CDS, and had to be bailed out after a credit rating downgrade, sudden collateral calls that it could not meet. Fukao (2009) highlighted the fact that its collapse was caused by its derivatives. Most opponents of regulation see it as a retardant force oppressive initiative and innovation and hinder market tendency to regulate itself and good economic performance. While the regulatory advocators see regulation as a vital imposition of social needs on a chaotic economic process (Cudahy,2009).

Credit derivative contracts traded OTC could be required to provide information to a central registry on each transaction it is involved in. Information collected through this means should be accessible to regulators and the public in a form that allows counterparties to be able to evaluate each other’s risk exposures (Acharya, Engle, Figlewski, Lynch and Subrahmanyam,2009). The derivates traded OTC can also be controlled and monitored by setting up derivatives exchange and require the reporting of all its trades. This would provide complete transparency; this is one of the most popular proposals that were raised with regards to credit derivatives matters (Cudahy, 2009).

An exchange provides the advantages of visible prices and volumes, larger market participation, and removal of counterparty risk through standardized margins and a contract guarantee supported by the capital of both a clearinghouse and independent market makers. ‘‘One significant inconvenience of exchange trading is that contracts need to be standardized to permit a large amount of trading in the same instrument. This would not be a big problem for CDSs, which are already quite standardized, but would be difficult for more individualized instruments, like CDO tranches. A major issue is that setting up and running an exchange is costly, so it is not suitable for thinly traded instruments’’ (Acharya,Engle,Figlewski,Lynch and Subrahmanyam 2009,p.169).


The most important form of regulation needed in the market is to increase truth and accuracy in the promotional statements and activities of the lenders and CRA’s, this will go a long way to reduce the risk of default and will be beneficial to both the consumer and the lender (Cudahy,2009). Basically the causes of the collapse of the big institutions during the financial crisis should be investigated and provided to the public to learn from this will help in ensuring that the same mistakes do not re occur in the financial system (Fukao ,2009).

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