Innovative Products

Innovative financial products have played a key role in the development of the current financial crisis, and have also compounded the difficulty of resolving it. This is because the difficulty of valuing such products has, in many cases, caused markets for them to cease functioning. This has led to great uncertainty regarding the financial position of institutions holding these products, which has, in turn, frozen the process of trying to separate “good assets” from “bad assets,” an important step in restoring the normal functioning of credit markets. The main innovative financial products relevant to the current financial crisis are derivative products—mainly credit default swaps (CDS) and asset-backed securities (ABS). (See glossary of terms in the Appendix.)

A. Derivative Products

Derivative products, i.e., products whose value is a function of the value of other underlying financial products such as stocks, bonds, or loans, are a key category of innovative products. The overall over-the-counter market for derivative products has expanded dramatically over the past decade, rising from US$90 trillion in 1998 to nearly US$700 trillion by June of last year (in notional amounts) (Bank for International Settlements 2008b). Major types of derivative instruments include those related to foreign exchange, interest rates, equities, commodities, and credit default swaps. Table 1 [ PDF 51.9KB | 1 page ] shows that interest rate contracts are still by far the largest type of derivative, making up about two-thirds of the total.

Among derivatives, credit default swaps have been the greatest source of systemic risk. A credit default swap is a financial contract in which the protection buyer (risk shedder) pays a fixed periodic fee in return for a contingent payment by the protection seller (risk taker). The contingent payment is triggered by a credit event of the entity that the contract refers to. Credit events, which are specified in CDS contracts, may include bankruptcy, default, or restructuring. On a gross notional basis, CDS grew from negligible amounts in 1998 to US$58 trillion by December 2007 (about 10% of the total), although they fell substantially last year to US$32 trillion (The Depository Trust and Clearing Corporation 2009). The gross notional value is the total value of potential payouts specified in the contract. However, the net notional level, defined when a credit event actually takes place, is much lower, at only about 3% of the gross notional value (The Depository Trust and Clearing Corporation 2009). This is because firms often both buy and sell protection on the same company, so the net exposure is reduced accordingly. The use of “trade compression,” which replaces existing trades with a smaller number having the same payoff structure, is one factor behind the recent decline in gross notional value.

This lower net estimate for risk exposure has held for individual major bankruptcies as well. For example, in the case of Lehman Brothers, the gross notional value was US$72 billion, but the net payment was only US$5.2 billion (Bank for International Settlements 2008b). This figure is not very large, but the main problem for Lehman Brothers was its exposure to collateralized debt obligations (CDOs), not to CDS. Moreover, CDS markets basically behaved as they were meant to, absorbing these losses and not freezing up the way CDO markets did.

B. Asset-Backed Securities

The main source of instability and uncertainty for financial markets has been the valuation of ABS, especially mortgagebacked securities. Traditional ABS are backed by the credit obligations of individuals, such as residential mortgage loans, auto loans, and credit card balances. Securities backed by residential mortgage loans are called residential mortgagebacked securities. In the case of mortgages bought by the three government home mortgage loan agencies (the Federal National Mortgage Association [FNMA or Fannie Mae], the Federal Home Loan Mortgage Corporation [FHLMC or Freddie Mac], and the Government National Mortgage Association [GNM or Ginnie Mae]), they are referred to as agency mortgage-backed securities. CDOs are similar in structure, but typically are backed by investment-grade corporate loans and/or bonds. These include collateralized loan obligations, which are based on loans, and collateralized bond obligations, which are based on bonds. The outstanding levels of these assets originating in the US and Europe are summarized in Table 2 [ PDF 51.7KB | 1 page ].

The bulk of securitized assets were originated in the US (about US$9.6 trillion out of a total of US$12 trillion at the end of 2008). Agency MBS, i.e., those originated by Freddie Mac, Fannie Mae, and Ginnie Mae, made up just over half of that total (US$5.0 trillion). Assets originating in Europe totaled US$2.4 trillion, the bulk of which were residential mortgagebacked securities (European Securitisation Forum 2008).

C. Role of Innovative Products in the Crisis

As described above, the CDS market performed fairly well during the crisis period. However, there has been criticism that buyers of CDS used short-selling of stocks as a hedge against losses, thereby aggravating market downturns. The main victim of CDS during the crisis was the insurer American International Group (AIG), which suffered total losses of US$99 billion in 2008 and had to be effectively nationalized by the US government. AIG's decline was triggered by losses on its portfolio of mortgage-backed securities held by its financial products subsidiary, which resulted in a reduction of AIG's capital reserves. This decline in capital reserves, in turn, led Standard & Poor's and Moody's Investors Service to downgrade AIG from an AAA to an A rating. These downgrades then triggered collateralization requirements under AIG's CDS contracts, which were estimated to total US$450 billion. The amount of collateral that AIG had to produce was about US$100 billion, which it simply did not have. In other words, AIG's whole model was based on the company preserving its AAA rating.

The main contribution of these products to the worsening of the crisis was that the markets for various kinds of asset-backed securities products froze up due to the difficulty of valuing such products. The lack of a functioning market for these assets contributed greatly to market uncertainty about the financial position of many financial institutions, and complicated attempts to aid those institutions. This undermined the banks' originateto- distribute model, which has made it much more difficult for them to increase lending, as it means they have been unable to move existing loans off their balance sheets. For example, mutual funds stopped buying CDOs after some money-market fund values dropped below par due to losses incurred on those CDOs.

The most spectacular bankruptcy arising from these losses and market freeze-ups was that of Lehman Brothers in September 2008. At the time of its collapse, it was estimated to hold about US$54 billion worth of mortgage-backed securities, while reporting only US$26 billion worth of equity in its last quarterly report for the period ending May 2008. Even that equity estimate was somewhat overstated. If the company's mortgagebacked securities had lost half of their value, a not unlikely scenario, it would have wiped out the firm's equity, even without taking other losses into account.

The direct impact on financial institutions in Asia of the losses arising from asset-backed securities was limited due to their relatively small holdings of these assets. US and European bank losses arising from holdings of such assets amounted to about US$910 billion as of June 2009 (Reuters 2009). Including losses from other financial institutions, the total is likely to have reached about US$1.1 trillion. However, losses by Asian institutions due to such holdings were much smaller, accounting for only about 3% of this total. Nevertheless, the magnitude of the losses has been significant for some institutions, primarily Japanese banks. Most of the impacts on Asia have been indirect, arising either from a liquidity crunch due to a shortage of US dollars in specific countries, or from the deterioration in economic conditions arising from the sharp decline in export demand across the region. In some cases, particularly in Singapore and Hong Kong, China, many individuals suffered losses on derivatives-related savings products whose risks were often not adequately explained.

D. Reform Proposals

The magnitude and widespread nature of the current financial crisis highlights failures in many areas of monitoring and regulation that need to be analyzed and reformed. These include regulations for origination, distribution, and trading of derivatives and asset-backed securities; gaps in regulatory coverage; the Basel II capital adequacy rules; rules regarding government takeover of systemically important financial institutions that are failing; the scope for international cooperation and surveillance; and the role of rating agencies and regulators. Greater efforts to educate directors, market participants, regulators, and credit agencies are also needed.

Regarding CDS, reforms should have a number of targets. First, CDS contracts should be standardized in order to facilitate trade compression, thereby reducing the size of the net exposure. Second, transactions should be moved onto exchanges run by centralized clearing counterparties (CCPs) in order to increase transparency and reduce counterparty risk. This process has started. The main question is whether there will be one or multiple markets. It looks as though the US and Europe will have at least one market apiece. The Tokyo Stock Exchange is also developing a CCP, and is looking to establish links between its CCP and those in other regions. Even if one single global market is not feasible, for political and other reasons, markets ought at least to be consistent and standardized. Third, it is necessary to revive securitization markets, because without them, it will be difficult to see a recovery in credit markets. Finally, there have been calls to require banks that securitize debt to hold a certain share of such products in order to maintain a degree of risk exposure to such assets. This could be counterproductive, however, as part of the problem leading up to the current financial crisis was that banks were too willing to hold such products, and, in fact, should have held less, which would have reduced their losses considerably.

Regarding hedging strategies involving short-selling of stock to offset buying of CDS, some have suggested that such shortselling should be banned, and this should be examined further. Some countries already have partial or blanket bans on shortselling of stocks, and these should also be reviewed.

Heavy losses on ABS made the greatest contribution to triggering and worsening the financial crisis, and hence deserve to be paid the greatest attention in monitoring and regulation activities. As the bulk of ABS were originated in the US, and the remainder came largely from Europe, the immediate tasks for regulation and monitoring should fall in those two regions, rather than in Asia, where there was very little origination of ABS. However, the origination industry may well take hold in Asia in the future, and a regulatory framework is needed. This includes requirements for monitoring of the quality of underlying assets used as collateral for securitization, requirements for disclosure of greater information to help value such assets, and requirements for disclosure by systemically important institutions of their holdings of securitized products. Perhaps more relevantly for Asia, there needs to be greater disclosure about the risks inherent in such assets, and regulation of their distribution. This is particularly important for derivative-type products that are sold to individual investors, such as the Lehman Brothers' so-called mini-bonds.

Heavy use of innovations, such as structured investment vehicles to escape regulations and keep assets off bank balance sheets, contributed to the huge expansion of the “shadow banking system,” which ended up rivaling regulated banking in size in the US. This greatly reduced transparency in the financial system and the effective reach of regulators. There have been calls to oblige issuers of complex securities to retain on their books for the life of the instrument a meaningful account of the underlying risk (non-hedged). However, some banks got into trouble precisely because they kept too many of such assets on their balance sheets.

Market participants frequently resorted to regulatory arbitrage or made use of gaps in existing relations. Perhaps most egregious was the lack of supervision of the investment operations of insurance companies like AIG. US Federal Reserve Chairman Ben Bernanke noted, “…the AIG situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms” (Bernanke 2009). There needs to be a thorough review of the regulatory architecture to ensure that systemically important institutions are monitored and regulated in a holistic way, that gaps in regulation are eliminated, and that opportunities for regulatory arbitrage are limited. This includes reviewing the status of offshore financial institutions. There also needs to be greater monitoring of hedge funds and other lightly-regulated institutions, and perhaps further regulation in the case of systemically important institutions.

The Basel II rules for bank capital adequacy clearly failed to ensure that banks had sufficient capital to deal with the current financial crisis. There needs to be a general review of where guidelines for capital fell short, particularly with regard to systemically important institutions. Capital requirements need to take into account overall risk exposure, not just look at individual assets in isolation.

The international scope of the crisis, including the activities of global banks and the worldwide distribution of innovative but opaque financial products, highlights the need for greater oversight and regulation at the global level. Cooperation among national regulators needs to be strengthened, but, beyond that, there are strong arguments in favor of creating an international regulatory authority and international “colleges” of regulators to oversee systemically important global financial institutions.

More generally, the disastrous performance of financial institutions as a result of shifting to the originate-to-distribute model and their reliance on complex securitized products suggests that there was a failure to educate directors, regulators, accountants, and rating agencies about the risks involved in both the model and the products used. Therefore, education efforts in this area clearly need to be improved. It may also be desirable to set up a global task force to monitor new financial products.

Finally, the high reliance on risky securitized assets and offbalance- sheet investment vehicles for bank profitability suggests that there was a broad-based misalignment of incentives, not only in terms of compensation of bank executives, but also for regulators and credit-rating agencies. There was too much emphasis on short-term profitability and on the use of risk models. Credit ratings that were derived from those models were, in hindsight, clearly too optimistic. These issues all need to be reviewed as part of a general revision of the global financial architecture. Accounting standards; risk analysis procedures—especially those related to “value-at-risk” models, i.e., model-based estimates of total expected financial losses; and credit rating procedures all failed broadly during this episode, and need to be reviewed.

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