Explain the various possible causes of the 2008 financial collapse. In your opin

Question

Explain the various possible causes of the 2008 financial collapse. In your opinion, what, if anything, should the American government do to prevent future collapses?

You should minimally address the following questions:

Who is Blythe Masters and for which firm did she work?

What are Synthetic CDOs? a) How are synthetic CDOs related to CDOs and CDSs??

How could the above instruments lead to moral hazard (taking on more risk because you or the firm are shielded from bad consequences)?

Explain why some economist and financial analyst have called the above instruments part of the Dark Market or Shadow Market? a) What are your thoughts on derivatives, should they be regulated? How? b) What type of enforcement or penalties would discourage financial abuses?

Some films that could demonstrate the financial concepts: The Big Short (2015) Too Big to Fail (2011) The Flaw (2011) Margin Call (2011) Inside Job (2010)

Explanation / Answer

The major causes for 2008 financial collapse are -

1. Poor Corporate Governance - The regulation surrounding launch of financial instruments and companies operating in the financial space was not as desired. The authenticity of the derivative instruments and the strength of the books of accounts based on which the derivative instruments such as credit swaps, loan syndicate instruments were built were not examined.

2. Artificial bubble - The real estate market was artificially hyped by means of the derivative instruments which were built on unsecured loans. The default of which led to the emergence of sub-prime crises. The artificial real estate bubble brought the economy crashing down.

3. Improper valuation methods - Derivatives derive their values from underlying assets. The underlying assets have to be carefully valued after considering the risk assoicated, the valuation methods applied were arhaic which failed to see the magnitude of fall that could happen. The draw down analysis missed key risk factors especially from the perspective of default risk, interest rate risk, unemployement risk etc.,

The American Government has to strengthen its regulation to ensure that the accountability is more stringent. The companies floating financial instruments should have a liquidity reserve enough to honour the payments incase of a draw down. The Corporate Governance has to be strengthened, there should also be enough investment by these financial companies in research to develop new valuation methods which are able to predict accurate draw down analysis.

Blythe Masters was an employee with JP MOrgan Chase, she is credited for being solely responsible for creation of Credit default swaps as financial derivative instruments. These instruments were used to manage credit exposure to underlying reference entities.

Synthetic CDOs are a variation of CDOs. It uses credit default swaps and other derivative instruments to achieve exposure to debt instruments and attain its investment goals. The underlying instruments are not real mortgage instruments and are often instruments linked to real mortgage instruments. These instruments thrived because they were easier to create and cost effective. The real mortgages were drying up and hence, synthetic CDOs emerged, they were launched in tranches ranked as per risk levels. Synthetic CDOs derive their value based on underlying instruments which could include CDOs, CDSs which inturn may be related to real mortgage.

Most of these instruments were launched were companies and hence, the promoters were protected against any personal liabillity based on failure of the products so launched. These were inherently highly risky instruments. The valuation of these instruments had multiple layers and was very complex to comprehend. The economic risks which would have a ripple effect (manifold times) on these instruments were beyond the comprehension of analysts. Hence, these instruments lead to moral hazard, as the institutions which launched these products were unable to provide full information / disclosures based on which the investor could make an informed decisions.

Many economists and financial analysts have called the above instruments part of dark market or shadow market due to their complex nature and the layers of risk exposure which is extremely tough to comprehend. The underlying assets could be multiple layers of synthetic CDOs which could finally be attached to real mortgage. Since they are merely a shadow of the real mortgage and cannot be valued based on the risk / return dynamics of the debt components directly, they have been named so.

Derivatives are instruments used for hedging, they can help reduce risk or transfer risk substantially. However, they need to be regulated to ensure that the insititutions provide full disclosure of the risk / return perspective. Accountability by institutions, accuracy of valuation, timeliness of information flow are critical alongside audits / valuation at regular intervals. While penalties and license cancellations are typcially applied after the happening of the event, there is a need to regulate such that the company provides precaution against failures of this kind. As with the banking industry, where there are cash reserves, statutory reserves and liquidity reserves to ensure that the investor interests are protected. There has to be similar measures which will ensure that even the behemoths are held accountable, there has to be measures to strengthen the Corporate Governance which can avoid situations such as insider trading, promoter offloading etc.

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