Sub-prime mortgages and credit default swaps Essay Example

level for mortgage qualification, due to either poor credit reports or limited experience with debt. Birger (2008) identifies this type of consumer loan as being particularly risky. Unfortunately, some lenders have provided mortgage loans to clients who have previously undergone bankruptcy, which is extremely risky and akin to giving away money without assurance of recovery. Such actions by banks are reckless and have greatly contributed to the current worldwide financial crisis and credit crunch.

Financial analysts attribute the sub-prime mortgage crisis to risky speculation, predatory lending, insufficient government regulation, and heightened debt levels resulting from high default rates. The crisis was triggered by the US housing bubble between 2005 and 2006, which caused a surge in mortgage defaults (Annis, 2009). Banks enticed investors with attractive initial loan terms and the prospect of increasing home prices, leading them to take out riskier mortgages in anticipation of refinancing their loans effortlessly.

The financial crisis resulting from sub-prime mortgages was caused by the increase in high risk lending, which was exacerbated by minimal government regulation on the financial sector. Defaults and house foreclosures accelerated when interest rates rose and house prices dropped, leading to the crisis. In his book The Return of the Depression, Krugan criticizes the United States' financial system for going out of control due to the government's laxity in regulating the sector.

Annis (2009) points out that the reckless practices employed in the Canadian mortgage market have raised the risk associated with mortgages. The Federal government's authorization of an extension of the mortgage repayment period from 25 to 40 years has enabled financial institutions to resort to predatory tactics to lure clients with the attractive repayment

plans. Customers are often ensnared by these tempting installment options, but defaulting on payments results in substantial losses. This circumstance is unsurprising given the prevalence of home foreclosures in Alberta and B.

According to Annis (2009), Credit Default Swaps (CDS) have experienced a doubling in volume since 2007. CDS are instruments in the financial sector that provide protection against default risk for debt holders and also serve as a hedge for speculation on financial instruments such as bonds and securities. These instruments function like insurance, with creditors paying payoffs to the CDS seller (usually an insurance company). In the event of default, the insurance company pays the outstanding amount, thereby minimizing losses. The CDS crisis contributed to the current economic crisis as many people were unable to pay their loans, especially mortgage loans (Jubak, 2008).

The lack of regulation in the operation of CDS poses a huge risk as there is no assurance that a CDS seller can pay the default amount for their client. The federal government has not taken enough action in this area, leaving the CDS system to develop independently and contributing to the current financial crisis. In general, CDS sellers are not legally required to keep side reserves, and there are no industry standards for the funds they do maintain, despite banks' insistence on some level of funding. Essentially, CDS are private contracts made between individuals through telephone or over-the-counter transactions. These contracts are highly risky, as if the seller goes bankrupt after receiving premiums, neither the premiums nor the defaulted amount can be recovered.

According to Jubak (2008), companies acting as buyers of excess CDS protection have suffered losses due to

the possibility of declines in the entities' value, making payment for losses difficult. This trend may lead to severe financial crises caused by chain reactions in the CDS market. The CDS crisis's progression mirrors that of the sub-prime mortgage crisis, where mortgage defaulters force sellers of CDS to make payments that may be difficult to fulfill.

The banks' liability will result in reduced lending funds.