By Melvin J. Howard
Just look at the history of the United States from the beginning of its independence from England it has always had some crisis going on. Social, Economical, Political, and Racial yet the US with its great diversity always comes back. For all the faults the US has its people who come from many diverse ethnic backgrounds come together when crises arises. So I am very bullish on the US market and economy and let’s not forget it is an election year. This has got to be one of the most exciting elections that has taken place for decades. Even cynics are starting to take notice who would think politics would be so appealing. Now getting back to how the subprime market developed it is word that the general population might have heard about but does not know what it means that word is called derivative.
Derivatives in general are financial contracts on a pre-determined payoff structure of securities, indices, commodities or any other assets of varied maturities. Derivatives assume economic gains from both efficient price discovery and risk shifting and supplement cash markets as alternatives to trading underlying assets by providing hedging and low-cost arbitrage opportunities. Risk diversification improves the pricing and managing of risk, increases stability at all levels of the financial system and enhances general welfare.
Derivatives in general are financial contracts on a pre-determined payoff structure of securities, indices, commodities or any other assets of varied maturities. Derivatives assume economic gains from both efficient price discovery and risk shifting and supplement cash markets as alternatives to trading underlying assets by providing hedging and low-cost arbitrage opportunities. Risk diversification improves the pricing and managing of risk, increases stability at all levels of the financial system and enhances general welfare.
Credit derivatives are predicated on the isolation and transfer of credit risk as reference asset. As a common working principle, they involve the sale of contingent credit protection for pre-defined credit events and/or asset performance. In their basic concept, the sale of credit derivatives severs the link between the loan origination and associated credit risk, but leave the original borrower-creditor relationship intact. The protection buyer of a credit derivative hedges specific credit risk at the expense of periodic premium payments to the protection seller, who assumes the credit exposure of the underlying transaction.
The significance of credit derivatives lies less in their market share next to other derivative instruments (e.g. interest rate and foreign exchange derivatives) but in their ability to supplement traditional ways of hedging credit risk through the transfer of credit-related exposures to a third party. Other, non-credit derivative based forms of credit risk transfer include credit insurance, syndicated loans, loan sales, bond trading and asset swaps.
We distinguish between credit derivatives in the narrower and in a wider sense. In addition to pure credit derivatives, such as credit default swaps (CDSs), total return swaps and credit spread options, the broader classification of derivatives in a wider sense also includes hybrid and securitization products with constituent credit derivative elements, such as traditional collateralized debt obligations (CDOs) of bonds and loans, or other partially funded or unfunded structured finance products, e. g. credit-linked notes (CLNs) and synthetic CDOs, which are essentially securitization transactions for refinancing (through cash flow restructuring) and tranche-specific credit risk transfer5 (though the sale of credit protection or the issuance of leveraged super-senior (LSS) tranches). In these transactions the repayment of securitized debt depends on a defined credit event in a bilateral hedge (in the case of CLNs), the premium income generated from writing credit protection on certain reference assets, or the returns from investing (i.e. long position on credit risk) in single assets or diversified pooled assets (in the case of synthetic CDOs), which also includes securitization transactions of CDOs and/or asset-backed securities (ABSs) (“pools of pools”) or newly formed CDS and collateralized debt indices.
CDOs have been the fastest growing area of structured finance. Since its inception in the late 1980s the CDO market has rapidly evolved into a globally accepted structured finance technique, spanning the U.S., Europe and large parts of Asia. CDOs have gained significant prominence in 1996, when some U.S. banks started using CDOs as expedient risk-transfer mechanism. Since then, the annual issuance volume has grown tenfold over the last 10 years with little sign of impending moderation. CDOs are investment vehicles that allow issuers to refinance the purchase of debt instruments by repackaging them into different slices of risk and maturity. This is where we find ourselves today the repacking of mortgage loans that went bad. The bet that housing prices were going to continue to climb came to abrupt halt this year. While repacking loans in the debt market is a useful tool the repackaging got very complicated. In layman terms good loans got packaged with not very good loans i.e. ( subprime mortgages). Subprime could also mean not very good credit card, automobile and consumer loans. The credit agencies that grade some of the debt played apart in this as well by downgrading a lot of the tranches it triggered default clauses in some of the repackaged loans. Lets not forget the monolines that insured these repackaged loans. Now they are becoming victims of some of the loans they insured what this all means. Is to sit tight there are some bright minds on wall street I have worked with a few they are very creative. They won’t need government bailout plans just like a canoe that has tipped over upside down just like the canoe wall street will right itself back on top of the water. Just like the beginning of my statement I am bullish on the US of A.
