The Financial Crisis Causing Massive Losses To Investors

Published Date: 02 Nov 2017

http://farm4.static.flickr.com/3524/3274852218_e30c8ce892.jpg?v=0Figure 1.0 Downgrade of CDOs and RMBS by S&P and Moody’s increased dramatically from 2007-2009 (cited in a Paris 2009).

CRA Task Force suggested amending the IOSCO CRA Code of Conduct (Technical Committee of The International Organization of Securities Commissions 2008, pp. 14-16). CRAs should have graded CDOs and RMBS honestly instead of evaluating it in the interest of their clients to safeguard investors. Furthermore, CRAs should be transparent in rating CDOs and RMBS by informing the public the criterions and methods the CDOs and RMBS were appraised on in a standardized form. In addition, CRAs should regulate themselves by establishing rating CDOs and RMBS guidelines and procedures for its employees to enhance CRAs’ quality of ratings. CRAs should also follow up on the performance of rated CDOs and RMBS to provide latest ratings to investors.

The second player liable for the financial tsunami is investment banks including Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill and Bear Stearns. Investment banks issued and sold CDOs and RMBS to investors using subprime loans whereby there are no requirements to borrow these loans. Therefore, investment banks faced higher risks of default payments of subprime loans. Investment banks profited from the amount of CDOs and RMBS sold. Thus, the more CDOs and RMBS sold, the higher the profits gained by investment banks and vice versa.

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Figure 1.1 Increased global CDO issuance from 2003-2006 by investment banks (Petroff 2009)

Investment banks borrowed excessively to purchase more subprime loans to innovate more CDOs and RMBS and sold more CDOs and RMBS to investors. When payments on subprime loans defaulted, investment banks cannot pay short-term debts to creditors and returns to investors. The leverage ratio was excessive signaling high risks since investment banks have inadequate capital to pay debts and returns to creditors and investors as CDOs and RMBS are rather illiquid. At the end of 2007, Goldman Sachs’ liabilities were approximately 30 times its capital while the other four investment banks had leverage ratios ranging from 36 to 39 (Carmassi, Gros & Micossi 2009). This designates that investment banks had great debts due to excessive short-term borrowing. According to Fortune Magazine (cited in Crotty 2008, p. 34), ‘Merrill's $41 billion exposure to subprime paper was more than its entire shareholders' equity of $38 billion’. This shows that investment banks borrowed excessively beyond the optimum leverage ratio. In addition, investment banks’ employees received tremendous bonuses. In 2006, Goldman Sachs paid 25, 000 employees unevenly $650, 000 bonuses amounting to $16 billion (Crotty 2008, p. 18). Crotty further states in 2007, all five investment banks paid out almost $66 billion in compensation, consisting of estimated $40 billion incentives. Investment banks which were seeking higher profits from issuing and selling more CDOs and RMBS to investors by borrowing more short-term debts from creditors had dangerous leverage ratio. This led them to being purchased or declared bankruptcy when the financial crisis struck as they had inadequate capital to repay its short-term debts to creditors and returns to investors besides rewarding high bonuses to its workers.

Investment banks should not have issued CDOs and RMBS using subprime loans as these loans have higher default risk than prime loans which assess borrowers beforehand. Besides that, investment banks should have lower leverage ratio to increase liquidity (Sanchez 2011, p.525). This ensures that investment banks can deal easily with constricted funding bases and increased deposit withdrawals to pay off debts. According to Feinberg, investment banks should reward its employees with long-term incentives instead of short-term incentives (cited in Conyon, Judge & Useem 2011, p. 403). This is vital to ensure that investment banks have sufficient cash flow in the short run to meet any unexpected obligations.

The third party responsible is insurance companies including American International Group (AIG) and others. Insurance companies devised Credit Default Swap (CDS) whereby the insuring company shields the protection purchaser against credit risk occasions related with specified basic securities by paying the protection purchaser cash or the estimated amount of the underlying securities in exchange for the underlying securities when the specified credit event happens (Harrington 2009, p. 9). Harrington further pronounces that U.S. insurance regulation outlaws insurance companies from issuing CDS. For instance, AIG issued 490 billion of CDS exposures on securitized products at the end of 2006 (Fang et al. n.d., p. 5). Schich (2009, p. 15) identified that AIG traded CDS that were not funded by sufficient capital. This implies that if a credit event occurred, AIG would not be able to pay its protection buyers. Moreover, insurance companies conducted securities lending program through life insurance divisions whereby they reinvest collaterals and underlying securities dispatched by borrowers and gains from returns on the invested collaterals and underlying securities (Harrington 2009, p. 10). Harrington further states at the end of August 2008, AIG had $69 billion securities lending loan outstanding from its securities lending program which further increased their leverage ratio dramatically. Insurance companies with high leverage ratio were vastly susceptible to rising subprime loan defaults. At the end of 2007, AIG had $163 billion long-term liability besides $82 billion securities lending liabilities (Harrington 2009, p. 12). This clearly denotes that insurance companies issued CDS which is illegal and conducted securities lending program with high leverage ratios attributed to the financial crisis causing huge debts that cannot be returned to speculators and protection purchasers.

Figure 1.2 According to BIS, Semiannual OTC derivatives statistics at end-June 2009, speculative amounts of outstanding CDS in USD trillion increased greatly from 2004-2008 (Schich 2010, pg. 47).

Insurance companies should increase its transparency and responsibility (Ferrell, Ferrell & Fraedrich 2013, p. 371). Insurance companies should not have issued CDS as it is against U.S. insurance regulation. Besides that, insurance companies should not conduct securities lending program when they have high leverage ratios. They should have reduced their leverage ratios which caused most of them to be acquired by the government or other institutions or declared bankruptcy.

One actively traded famous financial instruments in the stock markets to generate fortune that ultimately caused the failure of financial systems globally is Collateralized Debt Obligations (CDOs) which are mostly made up of collections of subprime loans, car loans and others. CDOs are typically issued by investment banks divided into 3 key categories which are the safest, middle-risk and highest risk CDOs. The safest risk CDOs have the lowest returns and the highest-risk CDOs have the utmost returns. Most CDOs were rated AAA by CRAs. Hence, demand for CDOs rose significantly. Since CDOs are backed up with subprime loans, default risk on CDOs are rather high. When prices of property crashed, many subprime loans defaulted causing investment banks misfortune as they do not have adequate capital to pay returns to investors.

Figure 2.1 Issuance of CDOs using subprime loans increased greatly from 1998-2006 (Barnett-Hart 2009, p. 11).

This denotes that AAA ratings of CDOs by CRAs increased demand for CDOs by investors causing issuance of CDOs using subprime loans to increase greatly from 1998-2006.

Another financial instrument is Credit Default Swap (CDS) which is a contract between 1-5 years whereby the insuring company shields the protection purchaser against credit risk occasions related with specified basic securities by paying the protection purchaser cash or the estimated amount of the underlying securities in exchange for the underlying securities when the specified credit event happens. CDS is issued predominantly by insurance companies and some investment banks. CDS can be bought by investors owning CDOs and speculators of CDOs. CDS assisted financial institutions to sell CDS without posting necessary collateral or equity capital due to credit risk misrating and CDS portfolio risk underestimation (Jarrow 2011, p. 14). Hence, when specified credit events happened, insuring companies were greatly distressed as they did not have abundant capital to pay the protection purchaser who bought CDS to insure CDOs which were affected by the property market crash as many subprime loans which were used to create CDOs defaulted. CDS are against U.S. insurance regulation.

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Figure 2.1 According to BIS, the market value of worldwide outstanding CDS increased greatly from 2004-2008 (cited in Reserve Bank of Australia 2011).

This indicates that default of subprime loans caused defaults on CDOs which were increasing from 2004-2008 causing insuring companies which have high leverage ratio to have increasing outstanding CDS.