Sub-prime mortgages and credit default swaps
Introduction Economic crisis has become an issue of concern in almost all countries of the world. Financial analysts are blaming the crisis on various aspects of the economy ranging from the interest rates to the political climate. The crisis is threatening the world economy with many companies at a risk of going bankrupt or operating at high levels of debt. Subsequent loss of jobs due to the closure of firms has had even more detrimental effects all over the world. This is similar to what happened in Canada in the 90’s increasing the unemployment rate from 8% to 11% (Laidler and Robson , 2001).
Sub-prime mortgages and credit default swaps which were at one time considered as methods of avoiding risk are becoming increasingly risky themselves. Banks and financial institutions are suffering major losses as value of houses go down and mortgage creditors default in paying up the loans owed. This coupled with the burden being felt by the sellers of credit default swaps with the increased rate of loan defaults makes the financial crisis a dreaded topic of debate. Losses to banks can only mean tightening of credit such that individuals and companies wishing to obtain finances for investment cannot do so.
Just like in other economic factors, the financial analysts have faced a challenge in identifying which of these two; sub-prime mortgages and credit default swaps could be said to blame for the current crisis. This paper will focus on an analysis of sub-prime mortgages and credit default swaps studying in detail the causes of each and the consequences to the economy. Having effectively analyzed the two issues at hand, the paper should be able to come up with a conclusion as to which of the above economic issues is to blame for the current crisis.
Sub-prime Mortgage Crisis Sub-prime mortgages refer to loan advancements given to borrowers who in normal circumstances cannot qualify for a loan. Sub-prime in this case is used to refer to a borrower who is below the required level to qualify for a mortgage. This is the riskiest kind of consumer loan in the market so far as these borrowers are more likely to show poor credit reports or limited experience in debt (Birger, 2008). There are also cases of borrowers who have undergone bankruptcy in the past easily obtaining mortgage loans from banks.
Lending to clients who are not credit worthy resembles giving money which the banks are not assured of recovering. As a matter of fact, it is absolute recklessness on the part of the banks and it is this practice that has led to most of the financial crisis and credit crunch being experienced in the world economies today. Financial analysts have placed the blame of sub-prime mortgage crisis on risky speculation during the boom period, predatory lending, lack of government regulation, and increase in debt levels following the high levels of defaulting.
The crisis can be traced to the U. S housing bubble in 2005 to 2006 which caused high default rates on mortgages (Annis, 2009). As a result of the attractive initial loan terms offered by banks and the promising rise in house prices, investors were encouraged to borrow more and take up more difficult mortgages in the hope that they could easily refinance their existing loans. Their plans were however curtailed when interest rates began to rise and house prices started dropping. This is when the crisis began as defaults and house foreclosures accelerated.
The lax government regulation has been blamed for the financial crisis resulting from sub-prime mortgages. The minimal control on the financial sector has led to the increase in what is known as high risk lending (Yuliya and Hemert, 2008). Krugan in his book The Return of the Depression notes how the financial system in the United States has gone out of control and the government’s laxity in regulation of the sector has taken things out of hand. Annis (2009) also notes that the mortgage market in Canada has taken to reckless practices which have increased the risks involved in mortgages.
The Federal government allowed an increase in mortgage repayment period from twenty five years to forty years and this has given the financial institutions mandate to engage in predatory practices in order to attract customers. The customers are falling prey to the attractive repayment installments and when they finally fail to pay up huge losses are incurred. This is not surprising given that home foreclosures in Alberta and B. C have doubled since 2007 (Annis, 2009 Credit Default Swaps Credit Default Swaps (CDS) refer to instruments in the financial sector which help to shield debt holders from default risk.
They also act as a hedge for speculation of profits in financial instruments such as bonds and securities. It is almost like insurance since a creditor pays certain amounts of payoffs to the seller of the credit default swap in most cases an insurance company such that incase the creditor defaults in payment the insurance company pays the outstanding amount (Jubak, 2008). The CDS crisis has resulted with the current economic crisis as a result of people’s reduced inability to pay their loans and more so mortgage loans.
Operation of CDS is entirely unregulated and there is no way of knowing whether a CDS seller is capable of paying the defaulted amount on behalf of their client (Gilani, 2008). This is another area where the federal government has not taken much initiative and the CDS system has been left to develop on its own leading to the current crisis in the financial sector (Engdal, 2008). The CDS sellers are not usually required by the law to put up side reserves and even though banks require sellers to put up some funds when making the sales, there are no set standards for the industry (Engdal, 2008).
CDS are like private contracts between private individuals usually made over the telephone or sold over the counter. They are risky in that once premiums have been made and by bad luck the seller goes bankrupt there is no way of recovering neither the premiums nor the defaulted amount (Engdal, 2008). Companies acting as buyers have suffered losses as a result of selling excess CDS protection without considering that the entities in question could decline in value so that it would be difficult for them to pay for the losses (Jubak, 2008).
The chain reactions that are likely to emerge following failures in the CDS market could lead to untold financial crisis. The trail of the CDS crisis actually follows the same path as the sub-prime mortgage crisis. Once borrowers default in payment of mortgages, sellers of CDS will be forced to pay them off. The increased burden will most definitely weigh too heavily on them such that they may not afford to honor all the CDS. The liability will be felt by the banks and hence there will be less funds to lend out.