Introduction

Subprime is the cause of USA Economy melt down. It is the very popular news among
everyone and it is become very serious then expected. It caused more damage to all the
industries. Subprime crisis caused big loss to the banks and now it is affecting the other
industries like AutoMobile companies (GM, Ford, etc.). In this blog I will write about
what exactly is the Subprime crisis and why USA banks created such a big mistake in
their era. Some experts comparing this disaster with the 1930 Economy slow down in
USA.

End Of Recession?

US Banks shows good results

Buffett Compares Economic Crisis With Pearl Harbor

What is Subprime lending?

Subprime Mortgage Loans (or housing loans or junk loans) are very risky. But since
profits are high where the risk is high, a lot of lenders get into this business to try and
make a quick money.These loans are given to people who have inability to repay the loan
and they don’t have stable income. For example, a person who is working on IT company
earns Rs.40000 per month and he doesn’t have any other income or assets. When the
bank gives him loan of some lakhs, the EMI for the month would be Rs.20000-Rs.30000.
If he lose the job, there is no possibility for him to pay the EMI, he will just surrender the
house to bank and go away. This is the one simple example how Subprime problem
starts.

Who opt subprime lending?

Individuals who have experienced severe financial problems are usually labeled as higher
risk and therefore have greater difficulty obtaining credit, especially for large purchases
such as automobiles or real estate. These individuals may have had job loss, previous
debt or marital problems, or unexpected medical issues, usually these events were
unforeseen and cause a major setback in finances. As a result, late payments, charge-offs,
repossessions and even foreclosures may result.

Due to these previous credit problems, these individuals may also be precluded from
obtaining any type of loan for an automobile. To meet this demand, lenders have seen
that a tiered pricing arrangement, one which allows these individuals to pay a higher
interest rate, may allow loans which otherwise may not occur.

What caused 2001 recession?

 Subprime problem is more severe then what we saw in the 2001
recession. The real fact is that, 2001 what happened is Dot Com Bubble followed by the
recession. Since the invention of internet, there is dozens of new companies coming up
with the Dot Com dreams. There is lot of hype around Dot Com is that any company can
make the billions of dollars. So, people started investing more on the Dot Com
companies and the prices of the share value is increased dramatically. The price of the
stock market is over valued. A small company without any profit valued as a billion
dollar company. Even they don’t have clear idea on how will they make profit.

To keep running the company, they are spending investors money and promising that
they will make profit in future. After some period of time, investors realized that
company is not making any profit and stared selling the shares. When selling shares is
more than buying shares, the value of the share will be coming down. It caused sudden
fall on the stock market and the companies tumble to survive. Dozens of small companies
vanished and only few big companies like Yahoo, Amazon, ebay, etc. has managed to
survive on the burst.

So, whoever working on Dot Com companies lost their jobs immediately, when there is
increase in the unemployment will decrease the country’s GDP growth. If there is two
quarters continuous fall in the GDP, it is called as recession. This is what happened in
the USA’s 2001 recession. What we are seeing as Subprime is different from the 2001
burst.

SubprimeCrisis and Banking Industry

Subprime crisis has ended history of many banks in the USA. As of now 22 banks closed
because of Subprime crisis. It is started with the Lehman Brothers, a 138 year old
company filed bankrupt. It is followed by Washington Mutual Funds. Like this 20
other small and medium size banks fallen easily. American International Group (AIG)
survived by giving the $80 billion bail out money by the USA government. Another
major collapse with Citi Bank which has written off $60 billion as the bad debts.
CitiBank also rescued by the USA government using bail out plan. It is estimated that
USA needs atleast $800 billion required to handle the Subprime crisis. It is not yet over
and now the Automobile companies are struggling. You can read that in the next section.

Survival of Automobile Biggies

Now the turn is Automobile industry and it is affected more than any other industry in the
USA. The major three companies in the USA, General Motors(GM), Ford and
Chrysler needs help from the government to survive. The discussion is going on and the
decision will be taken by the next week. The fall of automobile companies will be more,
so it is expected that government will come to the rescue. i will write the another post on
details of how automobile companies went into trouble.

Financial
Derivatives
Lessons From the Subprime Crisis

T
First Quarter 2009 59
The subprime mess has triggered the most destructive financial crisis
since the stock market crash of 1929. It’s not surprising, then, that the
hunt is on for culprits. And for many, there’s no reason to look beyond
financial derivatives in general, and credit derivatives in particular. If
only Wall Street (and Washington) had listened, they say, when Warren
Buffett labeled those derivatives “financial weapons of mass destruction.”
I think the case for pinning the blame on these poorly understood
financial tools is based on a misunderstanding. There would never have
60 The Milken Institute Review
René Stulz is the Reese Chair of Banking and Monetary
Economics at Ohio State University.
been a subprime crisis if the housing bubble
had not burst. Consequently, for derivatives
to be the proximate cause of the crisis, they
would have to have influenced the path of
housing prices.
To the contrary: I would argue that a welldeveloped
market for housing-price derivatives
might have tempered the boom-bust
cycle by allowing big market players to signal
their growing concerns about escalating
prices, and by giving homeowners a means of
hedging against the loss of wealth when the
housing market headed south. There is, in
fact, a market for housing-price derivatives –
specifically, for futures contracts on housing
price indexes. But this market was small and
illiquid, and there is no reason to believe that
it had much impact on events.
As Gary Gorton discusses elsewhere in this
issue (see page 36), there were also derivatives
linked to the performance of subprime-mortgage-
backed securities. For simplicity, I’ll call
them subprime derivatives. The ABX index
derivatives that were introduced at the tail
end of the housing boom, enabled investors
to speculate (or hedge against) subprime
risks, and in the process made the crash in the
value of subprime mortgage-backed securities
more visible. However, to make a crash
visible, there has to be a crash – and again, it
seems foolish to blame the messenger for the
message.
All that said, I won’t deny that derivatives
played a role – both positive and negative – in
the way the crisis unfolded. By the same
token, I won’t deny that some sort of regulation
of derivatives makes sense in light of this.
But I worry that the failure to view the impact
of derivatives in proper perspective could lead
to regulation that does more harm than good.
the exponential growth
of derivatives
Financial derivatives, for those of you who
joined this party late, are simply financial
contracts in which the promised payoffs are
derived from the value of something else – in
finance-speak, the “underlying.” (Note that
securitized debt is not a derivative because
the holder of securitized debt has an ownership
claim to some of the cash flow from the
assets that are securitized.) The underlying is
often an asset price (perhaps a stock price) or
rate (maybe the interest rate on Treasury
bills), but it does not have to be. It could be
many other things – for example, a weather
variable (like heating degree-days in Chicago,
or rainfall in Ghana).
The most familiar derivatives are forward
contracts and options. With a forward contract,
a party commits to buy (or sell) a financial
asset at a specified price at a future date.
This “forward price” is set so that the contract/
bet has no value when it is entered into – that
is, the possible loss equals the possible gain.
With a call option, the holder has the right
(but not the obligation) to buy the specified
asset for a specified price at (or any time before,
in some cases) a specified date. For example,
one might purchase an option to buy
100 shares of, say, Bank of America stock at
$15 in three months. Such a right has value,
since in three months BofA could sell for $25
– in which case the holder of the option would
be ahead by $10 a share. And since options
confer a right that is valuable, they are bought
for a premium.
The largest derivatives market is for swaps.
With a swap, two parties exchange the rights
to cash flows from different assets. For instance,
one party could agree to swap the interest
on a fixed-rate bond for the interest on
financialderivatives
First Quarter 2009 61
a floating-rate bond of the same maturity.
One may be hedging against a rise in interest
rates while the other is speculating against
just that prospect.
The principal amount of the bonds is not
part of the exchange. Indeed, the parties don’t
even have to own the underlying securities.
That’s why the principal is called the “notional
amount” of the swap.
It is common to measure the size of derivatives
markets by the notional amount outstanding.
Measured this way, the derivatives
markets are humongous. According to the
Bank for International Settlements, the size of
the over-the-counter derivatives markets –
that is, the derivatives created outside organized
exchanges – was $683 trillion in June.
Derivatives are also traded on exchanges, but
the notional amount of these derivatives is
much smaller – roughly $83 trillion at the
end of June.
Over the last three decades, outstanding
derivatives have increased 300-fold. Yes, 300-
fold. When Warren Buffet raised concerns
about derivatives in early 2003, the size of the
market was $169 trillion – a quarter of its size
today.
A good way to put these numbers in perspective
is to think of insurance contracts.
The maximum amount (often called the policy
limit) that could be paid out is the insurance
equivalent of the notional amount of a
derivative. When we evaluate an insurance
company, we do not think of the amount that
it insures, but the premiums it receives (and
the likely payouts). For derivatives, the premiums
correspond to the fair value of the derivatives
contracts. Measured this way, the derivatives
markets are dramatically smaller – a
mere $20 trillion in June 2008. But this number
is also growing rapidly: it has almost doubled
in the last year.
credit-default swaps
Ten years ago, the market for now-infamous
credit-default swaps (CDSs) hardly existed.
CDSs trade solely over the counter. The best
way to understand a CDS is to think of it as
an insurance contract against the risk that a
firm will default. If, for example, you own GE
bonds and are worried that GE will default,
you could insure your holdings with a CDS.
As with an insurance contract, you would pay
regular premiums to maintain the contract. If
GE does not default, you’re out-of-pocket the
premiums. However, if GE does fail to pay,
the CDS gives you the right to exchange the
questionable GE bonds for the principal
amount, or to be reimbursed for the difference
between the face value of the bond and
its (lower) market value. Note, by the way,
that a CDS on GE bonds does not insure you
against market risk – that is, a loss in value
caused by changes in market interest rates.
There is nothing particularly exotic about
CDSs; they are as easy to understand and to
price as life- or casualty-insurance contracts

Financial derivatives, for those of you who joined this

party late, are simply financial contracts in which the
promised payoffs are derived from the value of
something
else — in finance-speak, the “underlying.”
62 The Milken Institute Review
are. However, with a few exceptions, insurance
contracts are not freely traded – the insurance
company can’t sell your car insurance
policy to a hedge fund manager. In
contrast, the market for CDSs is highly liquid
for many “names” (jargon for the issuer of the
debt being insured). This makes it possible
for investors to use CDSs to speculate (either
way) on the credit of a specific corporation.
By the same token, corporations and financial
institutions can use CDSs to hedge credit
risks. For instance, a bank that lent money to
GE could protect itself by purchasing a CDS
on the loan from a third party.
Often, the notional amount of CDSs written
on a name is much higher than the corporation’s
outstanding debt. However, such an
outcome is not unique to the CDS market –
the notional amount of exchange-traded futures
contracts on the S&P 500 index is much
larger than the capitalization of all the stocks
in the S&P 500.
In principle, CDSs make financial markets
more efficient by allowing credit risk to reside
with the investors most willing to bear it and
by introducing greater transparency in the
pricing of credit. Historically, the investors
who funded companies through debt had to
bear the credit risk of these companies. Now
these investors can offload the risk when circumstances
dictate. Typically, bonds don’t
trade much, making it hard to assess the
credit risk of many companies from the market
price of their debt securities. In contrast,
trading in CDSs on many names is brisk
enough to make it practical to assess credit
risk by tracking CDS premiums.
There are several reasons for the high volume
of trading in CDSs. First, with a CDS,
you don’t need deep pockets to take a position.
Second, CDSs can be used as insurance
for all types of debt issued by a firm, rather
than specific bond issues or loans. So the
same CDS can be used for hedging by investors
who hold different bond issues – or, for
that matter, by companies that own receivables
from names or by banks that have made
loans to them. Banks can thus lend more to
accommodate corporations with ongoing relationships,
and then hedge themselves
against the resulting risk in the CDS market.
They can also use information from the CDS
market to price loans.
While the value of CDSs as a means for
hedging by banks is pretty clear, they have not
been used much for this purpose. In my own
research with Bernadette Minton of Ohio
State and Rohan Williamson of Georgetown
Business School, we found that, in 2005, only
23 large United States banks used credit derivatives,
and that they used CDSs to hedge
an average of just 2 percent of their loans.
The Bank for International Settlements
has only published statistics on the CDS market
since the end of 2004, when the total notional
amount was $6 trillion. By mid-2008,
the market had grown to $57 trillion. The
private International Swaps and Derivatives
Dealers Association also surveys the CDS
market; its figure for mid-2008 is slightly
lower, and shows a decrease from the end
of 2007.
The Deposit Trust and Clearing Corporation,
a firm that manages a variety of housekeeping
chores for the securities industry,
runs a CDS registry. The market, as measured
by voluntary registrations with the DTCC, is
much smaller – $34 trillion. Most likely, the
actual figure is somewhere in between.
As with all derivatives, there is a dramatic
difference between the total notional amount
outstanding and the market value of the contracts
outstanding. The Bank for International
Settlements survey puts this latter figure
at $3 trillion in June 2008, just
financialderivatives
First Quarter 2009 63
tomasz walenta (all)
one-twentieth the total notional
amount.
The CDS market has suffered
substantial growing
pains. Initially, contracts
were not standardized, and
the terminology used was
ambiguous – problems since
solved by the International
Swaps and Derivatives Dealers Association.
Meanwhile, dealers’ back offices
have not been able to keep pace with
the rapid growth of trading; that situation
has improved, but it is still not
perfect. Note, too, that the market was
initially used primarily as a means for
hedging, but evolved into a market for
trading credit risks. As a result, new
methods for settlements had to be used
when defaults took place; with more contracts
outstanding than the bonds they insure,
settlements of contracts couldn’t turn solely
on the delivery of the bonds.
I would argue that, despite its short history,
the CDS market worked remarkably well during
these traumatic times. The market for
CDSs written on many corporations remained
liquid. Further, the private sector rose
to the challenge of operating in the midst of
crisis.
Take the case of the Lehman Brothers default.
The notional amount of CDSs written
on Lehman as a name is not known. We do
know, however, that the Deposit
Trust and Clearing Corporation
had registered contracts for a notional
amount of $72 billion, and
that the post-default settlement of
these contracts went smoothly. Note,
however, that Lehman was actively
engaged in the CDS market, holding
positions written on other names.
The fate of these contracts, postbankruptcy,
is not known.
counterparty risks and
credit-default swaps
One party to a derivatives contract is generally
in the position of a debtor. For instance,
with a call option, the writer of the option has
to deliver the stock if asked to do so by the
option holder. An option may confer the
right to purchase a stock for a price that is
much lower than the market value of the
stock, but that option is, of course, worthless
if the option writer can’t honor its obligation.
The risk that the other party in a derivatives
contract will not live up to its obligations is
called counterparty risk. And with CDSs, this
64 The Milken Institute Review
risk can be very large.
Consider a hypothetical investor who had
bought protection on $50 million of Lehman
debt. After the default, this investor was owed
a net amount of roughly $45 million, so instead
of being owed Lehman’s debt by Lehman,
the writer of protection became the
debtor for $45 million.
Concerns about counterparty risk are no
different from the concerns that a buyer of
life or casualty insurance would have about
the credit of the insurance company. Insurers
typically cope with the question by maintaining
very conservative balance sheets that
merit high credit ratings from the ratings
agencies. Similarly, purchasers of credit protection
only want to buy credit protection
from highly rated sellers.
Often, the purchasers of protection go a
step further and require a CDS seller to put
up collateral for the full value of the contract.
Purchasers of protection may also put in
place triggers so that the protection seller has
to put up more collateral if its credit worsens.
As a result, relatively little extra cash is typically
needed for settlement in the event of a
default. However, contractual demands for
more collateral triggered by ratings downgrades
can have a devastating effect on the liquidity
of an institution that has written
large amounts of protection.
The much-publicized liquidity problem of
AIG was largely the result of such margin calls.
The AIG situation is unusual, however, because
it was mostly a protection writer. Financial
institutions more typically are both
protection writers and protection buyers.
Counterparty risk is a very serious problem
if there is no collateral agreement. In
such cases, the buyer of protection may end
up with only what it can collect as a creditor
financialderivatives
First Quarter 2009 65
in a counterparty’s bankruptcy proceeding.
According to a survey by the International
Swaps and Derivatives Dealers Association, 63
percent of derivatives contracts were backed
by collateral in 2007, up from 30 percent in
2003. And having a collateral agreement is still
not enough if the margin is too small.
Counterparty risk is further reduced
through netting agreements. If two firms
have entered into many derivatives contracts
as counterparties, such an agreement will net
out the exposures if one firm defaults. Net exposure
is often a small fraction of the gross
exposure.
subprime derivatives
The CDSs we have focused on so far were single-
name credit-default swaps. Such CDS
contracts effectively provide insurance for
debt issued by a single firm. There is also a
large market for CDSs based on the value of
indexes, which are calculated from the value
of credit-default swaps written on multiple
names. “Bespoke” (i.e., custom-tailored)
CDSs may be linked to a specific basket of
names reflecting the insurance needs of the
buyer and seller. When the Bank for International
Settlements started keeping track of
CDS contracts, single-name contracts constituted
80 percent of the market; at the end of
June 2008, this figure was down to 58 percent.
What interests people most these days, of
course, are CDS contracts on subprime liabilities.
Subprime mortgages carry significant
default risk. However, as with other mortgages,
subprime mortgages are generally securitized.
Mortgages are placed in a pool and
various securities are issued against that pool.
The most highly rated securities backed by a
pool are the ones that have the first claim to
cash flows of the mortgages. So when mortgages
default, the lowest rated securities suffer
first. But as default losses mount, the highly
rated securities backed by the mortgage pool
may suffer losses as well.
Consider a debt security issued against a
pool of mortgages. This debt would promise
a coupon (that is, a regular interest payment)
generally set at a premium above a widely reported
market interest rate like the London
Interbank Offered Rate (the LIBOR). If a financial
institution holding such a debt wants
to insure timely payment, it can purchase
protection through a CDS.
However, there is a complication. Debtholders
receive cash flows from the pool of
mortgages. These cash flows can fall because
of defaults on the mortgages that are securitized.
With corporate debt, default leads to restructuring
or bankruptcy. With securitized
mortgage debt, default on the underlying
mortgages leads to a reduction in debt payments
– not to bankruptcy. Because of this,
CDSs written on securitized debt work differently
from those written on corporate debt.
Suppose (1) that an investor holds a mortgage-
backed, top-rated (AAA) tranche with a
principal amount of $100 million, (2) that
the value of the other (subordinated) tranches
of the securitization have been wiped out by
mortgage defaults, (3) that during the past
month $1 million of mortgages default so

Contractual demands for

more collateral triggered
by ratings downgrades can
have a devastating effect on
the liquidity of an institution
that has written large
amounts of protection.
66 The Milken Institute Review
that the principal balance falls from $100 million
to $99 million, and (d) that the investor’s
tranche is insured with a CDS. When those
latest mortgage defaults occur, the investor
would be paid $1 million by the writer of the
CDS. But that’s not the end of it: the CDS –
and the resulting liability to the writer –
would still exist after that payment if and
when other mortgages backing the tranche
defaulted.
CDSs were used widely to insure subprime
debt in various guises, including what’s called
collateralized debt obligations. With a CDO,
debt issues or loans are placed in a pool and
securities are issued against the pool. But the
complexity of CDOs makes them difficult to
price, which means that credit-default swaps
on CDOs are hard to price as well. Further
muddying the waters, CDSs were also used to
create “synthetic” CDOs in which the risk
profile of a regular CDO was mimicked without
collateralization by actual loans or mortgages.
This allowed the total value of CDOs in
existence to far exceed the value of mortgages
and other loans made in the economy.
In 2006, derivatives based on indexes of
CDSs on subprime securitizations were introduced.
These so-called ABX indexes were created
every six months for different credit
tranches of securitizations, with each based
on an average of CDSs for same-seniority securitization
tranches. For instance, the AAA
index for 2007-1 would be based on an average
of individual CDSs on the largest AAArated
securitization tranches issued in the
second half of 2006. In 2007, these indexes
fell sharply, reflecting a loss in value of subprime
securities. By that time, housing had
already stopped appreciating.
The ABX indexes made it possible for investors
to take positions – long or short – on
the subprime market without owning subprime
mortgages or securities collateralized
by subprime mortgages. CDOs could be written
with payoffs depending solely on the ABX
indexes. As a result, it was possible for investors
to bear more subprime risk than the risk
in outstanding mortgages.
It is not really possible to gauge either the
extent of such synthetic exposure to the subprime
market or where the risk resides. However,
we do have a sense of the size of the notional
amounts of subprime CDSs that are
registered with the Deposit Trust and Clearing
Corporation. Since October 2008, the
corporation has been estimating the notional
amount of contracts written on various
names. And, surprisingly, less than 1 percent
of the CDS registered with it as of early November
were subprime CDS contracts – a notional
amount of just $330 billion. It is possible,
of course, that the size of the subprime
CDS market was much larger before the financial
crisis and that many contracts have
been subsequently settled.
The price discovery provided by the ABX
indexes is useful, since it helps financial institutions
and investors assess the value of subprime
securities. But it is not clear how accurate
that price-discovery mechanism was.

In 2008, financial institutions

faced counterparty
risks in derivatives that
they had never factored into
their calculations, and
these plainly aggravated
problems with origins in the
fall of housing prices.
financialderivatives
First Quarter 2009 67
Some observers argue that the ABX indexes
overreacted to the troubles of the subprime
market.
With the ABX indexes, financial institutions
could hedge subprime risk. However,
for ABX indexes to be good hedge instruments
for subprime-related securities, the returns
on the specific ABX index have to be
highly correlated with the returns of the security
being hedged. And since there was so
much variation in securities that included
subprime mortgages as collateral, the ABX
indexes often failed this test.
what went wrong, and how
to fix it
With a derivative, one party to the contract’s
gain is the other party’s loss. Consequently,
derivatives losses neither create nor destroy
wealth – they redistribute it. In many instances,
this redistribution has no impact beyond
the parties involved in the derivatives
contract. Indeed, every day millions of people
enter into contracts of one sort or another in
which one party stands to make money at the
expense of the other. And as a general rule,
the more trading/contracting opportunities
that exist, the better the economy functions.
With financial intermediaries, however,
such wealth redistribution can have external
consequences, because these institutions routinely
operate with a lot of leverage. Suppose
that an institution has equity capital of $50
million, equal to 5 percent of its $1 billion assets.
If it loses just $25 million in, say, a derivatives
contract with another firm, it has lost
fully half its capital. Now, at first glance, the
total quantity of wealth hasn’t changed – our
institution’s $25 million loss is exactly
matched by the counterparty’s $25 million
gain. But to restore its leverage to preloss figures,
the financial institution must either
raise $25 million in equity capital or sell $500
million in assets. And if the financial institution
in question is a bank, its resulting reluctance
to make new loans or to renew old ones
can lead to a credit crunch that does destroy
wealth.
Consider, too, that highly leveraged financial
institutions typically rely on short-term
debt to sustain their capital, and are thus at
the mercy of lenders. Their capacity to roll
over this debt can vanish at the slightest hint
that they will be unable to repay. Thus even
an unfounded rumor of derivatives losses
may be enough to drive a financial institution
to collapse. But the fact that the institution
has invested in derivatives is not the root of
the problem – the degree of leverage and the
short-term nature of the institution’s debts is.
In general, financial institutions have managed
the risks of derivatives well. Indeed, they
have long used derivatives to manage risks associated
with other investments. However, in
2008, they faced counterparty risks in derivatives
that they had never factored into their
calculations, and these plainly aggravated
problems with origins in the fall of housing
prices.
To understand what happened, consider a
hypothetical financial institution with, say,
$20 billion in equity capital and $200 billion
in gross notional amount of CDSs outstanding.
Suppose, further, that it has sold $50 billion
in protection and bought $50 billion in
protection on a single name.
Now imagine that this name defaults on
all its debts and that there is no recovery, so
that our financial institution ends up owing
the $50 billion on the CDSs it had sold. That
should be no problem, since the institution
exactly offset this potential $50 billion liability
by purchasing $50 billion in protection.
But there’s a catch. The parties our financial
institution owes aren’t the same as the
parties who owe it. And if the parties that
68 The Milken Institute Review
have insured our institution against loss can’t
pay up, it’s in big trouble. Indeed, if it can’t
collect at least $30 billion from them, its capital
will be wiped out in the process of paying
off its $50 billion in liabilities. So our financial
institution, which thought it was bearing
no net risk, was in fact betting the firm’s existence
on the credit of its counterparties.
That blithe position wasn’t as unreasonable
as it appears in retrospect. After all, disaster
required the simultaneous default of
the name and of the CDS writers. What’s
more, most CDSs are backed by some collateral.
And to get our financial institution in
trouble, the losses associated with the name’s
default would first have to burn through the
collateral to expose it to “gap risk” – the difference
between the value of the collateral
and the liability.
It is fair to say that until last year financial
institutions considered the probability of one
of the largest derivatives dealers collapsing to
be sufficiently small to be ignored. With
hindsight, however, one can see why the way
the over-the-counter derivatives market
works made huge buildups of counterparty
risk likely.
Suppose that a big manufacturing company
wants to take a position in a derivative
to hedge a risk – say the risk that interest rates
will rise. It will enter into a swap contract,
and most likely the counterparty will be a financial
institution. The financial institution
will typically not want to bear all the risk of
the contract and will therefore seek to acquire
an offsetting contract.
The interest-rate-swap market is very liquid,
so the financial institution should have
no trouble finding a counterparty willing to
take the risk. But that counterparty will probably
seek to make yet another offsetting swap.
As a result, a swap with a nonfinancial firm
can lead to swaps among financial firms with
many times the notional amount of the original
contract. And what goes for swaps goes
for all derivatives – including CDSs.
One way to eliminate counterparty risk is
to create a well-capitalized clearinghouse that
stands between the derivatives counterparties.
Organized futures and options markets – the
hundreds of markets ranging from the Chicago
Board Options Exchange to the Tokyo
International Financial Futures Exchange –
work that way. The clearinghouse is the counterparty
to each side in every contract. Thus
if an investor defaults on a futures contract
obligation, there are no consequences for
other investors who took positions on the
other side of the contract as long as the clearinghouse
is solvent. The clearinghouse makes
sure that it can honor its obligations by requiring
collateral from all its counterparties.
There has been much discussion about
making the use of clearinghouses mandatory
for all derivatives, or even forcing derivatives
to trade on exchanges. A clearinghouse would
almost eliminate counterparty risk as long as
it were well run and well capitalized. This approach
would also introduce substantial discipline
to the market, since the clearinghouse
would have to confirm the details of trades
with both sides before being able to assume
the role of counterparty to both – though
dealers that register their derivatives with the

With hindsight, one can see

why the way the over-thecounter
derivatives market
works made huge buildups of
counterparty risk likely.
financialderivatives
First Quarter 2009 69
Deposit Trust and Clearing Corporation already
face that discipline.
A clearinghouse for some types of CDSs is
in the works. For a clearinghouse mechanism
to work, however, it has to require collateral –
which means that it would have to mark-tomarket
all contracts (that is, recalculate their
value on a regular basis) and to devise margining
systems. And while such an approach
would work for the most active CDS contracts,
like contracts on indexes, it could
prove very expensive to implement for some
kinds of derivatives. Mandating the use of a
clearinghouse mechanism for all derivatives
would thus reduce the variety of derivatives
available in the markets.
For new types of derivatives to be introduced,
the clearinghouse would have to agree
to change its systems to add these derivatives.
To protect itself, the clearinghouse might impose
extremely high margin requirements on
derivatives it finds hard to understand, like
new derivatives or derivatives whose pricing
requires a substantial investment that the
clearinghouse cannot amortize across many
contracts.
For a financial product to trade on an exchange,
there has to be liquidity. And there is
no way that there would be enough liquidity
to support exchange trading for most derivatives.
Getting rid of derivatives that didn’t
make the liquidity grade might seem a good
thing. But think of it this way: most loans and
many bonds do not trade on exchanges. It is
thus unclear why derivatives should be treated
differently.
Still, there is much that could and should
be done to limit the systemic risks aggravated
by the use of derivatives.
• Regulators should push the derivatives
markets toward greater use of well-run clearinghouses
by treating derivatives protected in
this way as free of counterparty risk for purposes
of computing the minimum capital requirements
of financial institutions.
• Regulators should demand greater transparency
on the counterparty exposures of
systemically important financial institutions –
the big banks and securities dealers whose
failure would put other institutions at risk. In
fact, these institutions should be required to
measure of firm-wide counterparty risk in
70 The Milken Institute Review
real time and to share the information with
regulators.
• By the same token, financial institutions
should be required to disclose their largest
counterparty risk exposures in public filings.
With CDSs, financial institutions should provide
estimates of the worst gap risk to which
they would be exposed in the event of the failure
of a counterparty.
• Finally, systematically important financial
institutions should be required to run “stress
tests” – computer simulations of changes in
the value of their assets and liabilities – to
show that they could survive the collapse of
their biggest counterparty.
It’s been charged that during the crisis, the
CDS market was manipulated in ways that
endangered financial institutions. Certainly it
has, at times, become hugely expensive to insure
debt of some financial institutions. For
instance, the annualized cost of insuring
Morgan Stanley debt during September 2008
at times exceeded $15 for $100 of debt covered.
However, this high cost proves nothing:
it could have simply reflected the market’s
best assessment of the fragility of these institutions,
as well as the high demand for hedging
these risks.
Nor is the fact that traders in CDSs informally
exchange a lot of information in itself
evidence of manipulation. That’s how dealer
markets work, and how they help to create liquidity.
In any event, there’s a built-in deterrent
to manipulation: Traders who attempt to
misuse the market are at risk of being frozen
out of future transactions and exchanges of
information.
The chairman of the Securities and Exchange
Commission has expressed concerns
that investors can take “naked” positions in
CDSs – that is, buy protection without owning
debts issued by the name – because this
might open the door to manipulation of CDS
premiums and increase the cost of funding of
corporations. But prohibiting naked short
positions in CDSs would destroy most of the
CDS market.
Derivatives markets are liquid because
speculators and dealers are willing to take one
side of the transaction. To put it another way,
in a market for risk in which only hedging is
permitted, little hedging can take place. And
market prices cannot reflect all available information
if investors who see profit opportunities
cannot exploit them. In the long run,
economic growth would suffer because of
poorer allocation of capital.
last words
Derivatives did not create the subprime mess.
However, the panic that took place in 2008
was worsened by uncertainty about the risks
created by the derivatives positions of some
financial institutions. Hence, derivatives activities
of systemically important financial institutions
have to be regulated more effectively.
The counterparty risks incurred by
these institutions should be made clear to
regulators and to investors. And systemically
important financial institutions should be required
to demonstrate to regulators that they
could survive the collapse of a major derivatives
dealer.
That said, the role of derivatives in bringing
down Wall Street has been vastly overstated.
For the most part, derivatives markets
worked well during the subprime crisis, allowing
hedgers to shift risks they were not
well equipped to bear. I believe that the global
economic growth of the last three decades
was in part made possible by rapid financial
innovation. Regulation that impedes innovation
in the name of saving investors from the
real and imagined perils of risk-taking would
exact a high price. m
financialderivatives