The Ghost of Subprime Crisis

Being jobless sometimes gives you luxury to do things that you enjoy doing, but still can't do because of lack of time and commitment or just due to laziness. I was a regular author on this blog till the time I joined my first job. But now with the market crashing and all of my efforts failed to secure me a new job, I decided to continue with my one time love and that’s blogging.

Choosing a topic was not a tough choice for me as market which has given me this tough time, deserves all possible attention as a tribute. Lot has been written in financial media about current market meltdown. Sometimes back I got an article from one of my former colleagues about Credit default Swap and I decided to share a simplified version of same story.

The Ghost of subprime crisis is still there and fueling what has been described as worst recession after 1929 great depression. This post is about one of the biggest name in Insurance industry that is AIG. Last month with fall of Investment Banking giants like Lehman Brothers and Merill Lynch, AIG was also on the verge of collapse before Fed taking control of situation by putting $85 billion. AIG with presence in almost 130 countries and ranked 18^th biggest company by Forbes Global 2000 list is another example of consequences of bad bets on subprime related assets.

What Went Wrong With AIG?

Fundamentally core business of AIG is doing fine. Root cause of problem was exposure in Credit default swap.

A credit default swap is an OTC insurance instrument whereby two parties enter into an agreement, one insurance seller and one insurance buyer (who want to cover default risk on Loans disbursed by him). Insurance buyer pays an upfront fee and yearly premium (same as we pay for life or any other insurance) to insurance seller. Now if the loan on which insurance buyer has taken this insurance defaults insurance seller has to pay the full loan amount.

Suppose you are an institution engaged in housing finance. You (let’s say A) has given loan to some person (say B). Now there are chances that B can default on loan repayment. So to protect yourself from default risk you go to an insurance seller (say C). You pay an upfront fee and yearly premium. If B repays loan, C keeps all upfront fee and premium, thus making profit. But in case of default by B, C will be required to pay the full loan amount to A.

Basic purpose of this instrument is to serve as a hedging tool for institution who provides loan,buy bonds or in broad sense holds loan portfolio, thus subjected to default risk by borrowers.

As discussed CDS is basically an OTC instrument hence they are subject to counter-party risk. One more serious problem with CDS is that Investment Banks, Insurance Companies often use them in excess of their actual capital base. Lack of regulation on CDS exposure results in institutions taking as much as exposure they want.

Final Blow

With the collapse of housing market and subprime crisis most of institution in this market was in red. Firms like AIG before this crisis written insurance in the form of credit default swap for corporate and kept all upfront fee and premium as default rate on loans was low, thus making handsome profit. But once the housing bubble busted and default rate on loan increased AIG has to pay for insured loans. CDS that AIG has written as an insurer had much of toxic debts, asset backed security that has started to default as housing bubble busted. The mortgage pool that AIG insured started to fall rapidly. Losses started mounting and it was only after Fed’s intervention company could be saved by the way of injecting $85 Bn.

The biggest lesson from this crisis, that has emerged is need of proper regulation on OTC market. OTC market indeed helps hedgers and other market participants to take customizable position in the market, but lack of regulation results in reckless exposure by companies. Accounting principles has largely misused in this case.

OTC markets now needs proper attention by regulators. Even capital base requirement for firms needs to be updated in the light of emergence of more complex financial instrument.