1. Class 5: Derivatives- Financial WMDs?
The Financial Crisis
Class 5: Derivatives- Financial WMDs?

2. Discussion so far…
What were the contributing factors to the financial crisis?
How did the crisis begin?
What did the government do in response?
We focused mostly on big pictures

3. What are derivatives?
Dictionary definition: “financial instrument whose value is derived from one or more other underlying assets”
i.e. However much a derivative is worth depends on the price of an underlying asset—e.g. stocks, etc.

4. Short History of Derivatives
Derivatives have existed for a long time
Some simple derivatives: futures, options, etc.
But we’ve seen an explosion in the scale of the market in the last decade

5. Why are derivatives important?
Many banks were heavily invested in derivatives
When the market soured, the value of these derivates fell catastrophically
They also allowed banks to leverage heavily
They also made the resolution of the crisis difficult

6. Basic Derivatives: Futures
Basically, person A goes to person B and agrees to buy/sell a certain thing at a certain price at a future date
“I’ll buy 100 lb of corn from you at $2 per pound on November 15”
Producer is guaranteed a price
Buyer has the potential for a big gain (or a big loss)

7. Basic Derivatives: Options
Quite similar to futures, but the transaction need not happen
“I will buy the right to buy 100 lb of corn from you at $2 per pound on Nov. 15”
If you get the right to buy: call
If you get the right to sell: put
The buyer of the option pays a premium

8. Basic Derivatives: Swaps
You exchange one stream of cash flow for another
Can be used for any type of cash flow stream
Most common: interest rate swap
I will give you interest payments based on fixed 5% rate, and you give me the payment based on floating LIBOR+3%p rate.

9. More Complex Ones There are many more types of derivatives
Some of them played a major role in the crisis
Mortgage Backed Securities
Credit Default Swaps

10. Mortgage Backed Securities
Can be pass-through or tranched
Basic ideas are the same
You pool mortgages together, securitize them, and sell the securities to investors
Investors get the interest and principal payments from the homeowners
Tranche: different classes of MBS
Lowest tranche gets the worst loss but highest return

11. Arguments for and against
Allows the banks to make more loans
Connects the secondary investors to the homeowners
Against
Mortgage originators may not make the right loans
Makes the resolution process more difficult

12. Credit Default Swaps Basically, an insurance plan
You pay the insurance company some premium and when a security defaults, you get money from the insurance company
KEY: This is essentially different from an insurance in that you don’t have to hold the security to buy CDS on it

14. Credit Default Swaps It was originally meant as a diversifying tool
You hold a security, and you want to mitigate your risks, so you buy CDS
But since you didn’t have to hold the security, you could make it into a gambling tool
Betting on the market going down

15. Credit Default Swap
The explosion of the CDS market allowed significant leverage in the financial markets
CDS market also enabled pricing of other securities, like MBS and CDO

16. Arguments for CDS CDS can be a very useful diversifying tool
You certainly don’t want to hold all the risk in an investment
You can mitigate that risk

17. Arguments against CDS It’s too risky Makes everyone interconnected
Basically a gambling tool in its perverse state
Makes everyone interconnected

18. So what happened? The housing market soured MBSs start to take losses
The lower tranches take catastrophic losses
As the market goes down, sellers of CDS faced the obligation to pay out a lot of money
AIG (American International Group)

19. Next week… Regulation and the crisis
Did deregulation contribute to the crisis?
If yes, how much?