Derivatives are considered one of the main causes of the financial crisis in 2008. They are complex financial products that derive their value from an underlying asset or index. A good example of a derivative is a mortgage-backed security.
How do derivatives work?
Most derivatives start with a real asset. Here’s how they work, using mortgage-backed securities as an example. A bank provides a loan to a homebuyer. Then the bank sells the mortgage to Fannie Mae. This gives the bank more money to make new loans. Fannie Mae then resells the mortgage in a bundle of other mortgages in the secondary market. This is the mortgage-backed security. Its value is derived from the value of the mortgages in the bundle. A hedge fund or investment bank splits the mortgages into different parts. For example, the second and third tranches of interest-only loans are riskier because they are further out. There is a greater chance that the homeowner will default. But it offers a higher interest payment. The bank uses sophisticated computer programs to calculate all these complexities. Then it packages them with similar risk levels of other mortgages and resells that part only, called a “tranche,” to other hedge funds. Everything goes smoothly until home prices drop or interest rates reset and defaults on mortgages start.
The role of derivatives in the financial crisis
This is what happened between 2004 and 2006 when the Federal Reserve began raising interest rates. Many borrowers had interest-only loans, a type of adjustable-rate loan. Unlike a traditional loan, interest rates rise with federal interest rates. When the Fed started raising rates, those borrowers holding mortgages found that they could no longer afford the payments. This occurred at the same time that interest rates were resetting, usually after three years.
As interest rates rose, demand for housing and home prices fell. Those borrowers holding mortgages found they could not meet their payments or sell their homes, so they defaulted.
More importantly, some portions of the mortgages were worthless, but no one could tell which portions. Because no one really understood what was in the mortgages, no one knew the true value of the mortgages. This uncertainty led to a shutdown of the secondary market. Banks and hedge funds had many derivatives that were losing value and could not sell them. Soon, banks stopped lending to each other altogether. They were afraid of receiving more defaulted derivatives as collateral. When that happened, they began hoarding cash to cover their daily operational costs.
This was what drove the bank bailout bill. It was originally intended for these derivatives to be taken off banks’ books so they could start lending again.
Not just mortgages provide the underlying value for derivatives
Mortgages do not only provide the underlying value for derivatives. Other types of loans and assets can also provide it. For example, if the underlying value is corporate debt, credit card debt, or auto loans, the derivative is called collateralized debt obligations. One type of collateralized debt obligation is asset-backed commercial paper, which is a debt that is due within a year. If it is a debt hedge, the derivative is called a credit default swap.
Sources:
- Corporate Finance Institute. “Credit Default Swap.”
- Corporate Finance Institute. “Mortgage-Backed Security (MBS).”
- Institution
Federal Insurance. “Crisis Assets”, pages 13-23.
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Sources:
- The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
- Corporate Finance Institute. “Virtual Credit Exchange”.
- Corporate Finance Institute. “Mortgage-Backed Securities (MBS)”.
- Federal Insurance Corporation. “Crisis Assets”, pages 13-23.
- Citi Bank. “Asset-Backed Commercial Paper: An Introduction”.
Source: https://www.thebalancemoney.com/role-of-derivatives-in-creating-mortgage-crisis-3970477
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