They own your loans, your income and your life – how to take it back?

This entry is part 5 of 8 in the series Deriving Capital's Future

A student is given education loan, the bank takes a bet on his future employment and income stream. A worker takes a home loan, the bank takes a bet on his continued employment and monthly pay check. This risk is then passed on to third parties.

student-debt-cartoon-englehartEssentially, lender gives the loan and someone not connected to either the borrower or lender agrees to take the risk associated with it. The lender can forget about due diligence on the borrower and keep lending more and more. On what basis? There comes credit rating agencies. They also work with de-personalized bot driven mode to assign a credit score to each individual, a company, or a security backed by loans. Loans are given based on these credit scores and the risk is passed on via derivatives. The bank, the rating agency, the derivative trader every one is happy as long as the markets keep booming.

Thus a house of cards is built up, each layer relying on the other and no one taking final responsibility. When the house collapses, the whole society carries the burden, the gamblers go scot-free with all their assets intact. After pushing crores of people into misery, they resume their game of building a new card house.

A ‘cornerstone’ of such houses of cards is the derivatives market. Derivatives on assets and income streams are mind boggling inventions by highly paid professionals using latest computer technology and mathematical advances. In the last analysis all they achieve is gambling among capital owners. This is where human progress is stuck. How to untangle it?

Read on for the 5th part of analysis of derivatives market by Dick Bryan and Michael Refferty. This was originally published in Socialist Register. We are publishing the tamil translation of the same along with the English text (for reference) for our readers.


Derivatives on assets

house-mirageAs technology in financial markets developed, it became simpler to invent and list new products on financial exchanges. In addition to their traditional role, initially in commodity futures and options and then money derivatives, existing exchanges such as Eurex and the Chicago Mercantile Exchange have more recently introduced derivatives markets for a broader range of products, mainly involving the reinvention of everyday things as financial assets to be traded. There has been a growth in derivative markets for equities, the weather, metal prices, energy prices, real estate and macroeconomic indicators such as wage movements, and a vast range of indices which measure certain characteristics of each of these, and composite attributes of combinations of them.25 In addition, over-the-counter brokers, working mainly in investment banks, have imagined and compiled all sorts of risk trades between particular parities with unique but tradeable risks.

The emergence of each of these new products can be explained in terms of providing hedging facilities against direct exposures – for example, energy providers have an exposure to temperature, farmers to frost, industry to wage trends. More broadly understood, these new risk products provided a means for portfolio diversification.

Credit derivatives, especially credit default swaps (CDS) are critical in this regard and warrant particular attention because of their sudden expansion and their prominence before and during the global financial crisis (see Figure 1).

mortage-bondageCredit derivatives involve trades on the likelihood of a credit event (essentially, an inability to repay a loan). They became the fastest growing derivative product between 2001 and 2007,26 and their collapse in 2008 was at the centre of the insolvency of leading investment banks.

Unlike many of the new products listed above, credit derivatives are constructed both for long-term purposes (essentially for institutions to hedge credit risks) and the short term, where they are traded actively as part of diversified asset portfolios. In a standard credit derivative, the ‘protection seller’ receives regular payments from the ‘protection buyer’ but, in return, the former has to guarantee to the latter particular agreed payments in the case of default or some other incapacity to pay.

Within this process, credit default swaps were initially developed for hedging purposes. Banks would use credit default swaps to hedge their loan books and their exposures to securitizations. Relieved of repayment/default risk, a bank’s lending activity effectively becomes a straight play on interest spreads. Industrial corporations also found them effective.

student-loan-relationshipTwo corporations with quite different default risks (for example, one in agriculture, the other in electronics) could swap an exposure to each other’s default risks and thereby diversify their individual risks. In CDS markets, this hedging takes place predominantly through what are called ‘single-name instruments’. They are often contracts lasting multiple years.

From around 2004 credit derivatives rapidly spread beyond that direct hedging role. Because a derivative allows for a price exposure to a default without the need for ownership of (direct exposure to) a default event, credit derivatives could be held in the asset portfolio of third parties, unrelated to the default event. To meet this demand by third parties, credit derivatives developed into forms more appropriate to third party portfolios, such as credit-linked notes and portfolio correlation products.27

home-mortageThese products also came to be applied to a wider range of ‘events’ and to securitized obligations. They involve what are called ‘multi-name instruments’. In essentially the same process that applied in the ‘originate-to-distribute’ models now familiar in relation to mortage-backed securities and other CDOs, multi-name credit derivatives involve either products where a diverse range of risks are bundled together, tranched, credit-rated, and sold into global financial markets or products based on trading a credit default index. In effect, these multi-name credit derivatives became just another asset class within a diversified portfolio.28 They were anticipated to generate an attractive return and their price would predictably cycle differently to that of other assets classes. In a sense, the specific risk exposures it attached to was secondary to the fact that it was different from other products and hence associated with diversification of risk.

It is notable that, despite their ‘bad press’ in the global financial crisis, the subsequent decline in CDS transactions has been modest. In 2009, the notional amounts outstanding in credit default swaps markets was still around 2006 levels for both single-name and multi-name products.29 No doubt, credit derivatives showed in a stark way what is inherent in all derivatives: that the commodification of risks permits diversification of risk portfolios, and feeds the search for yield. With diversification comes more widespread exposure to any particular risk, such that where risks are dramatically mispriced, the possibility of contagion increases dramatically. Nonetheless, they are playing a functional role for capital in providing facilities for hedging credit risk and in portfolio diversification.

Student LoansDerivatives on income streams

Derivatives on income streams, as distinct from derivatives based on changes in asset values or events, are generally styled as securities, and the process as securitization. They actually have a long history – longer than financial derivatives proper – but they have not historically been framed as derivatives. Indeed, it could be said that the global financial crisis has brought them to prominence as derivatives, for it is precisely their derivative dimension that was central to the crisis. This specific issue will be considered shortly.

As with derivatives on newly-conceived assets, derivatives on income streams started growing in the 1980s, especially through state-issued securities, but by the 1990s private label securities were growing. Figure 2 shows global private-label securities issuance between 2000 and 2009 for the primary category of securities: asset-backed commercial paper (ABCP) (used by corporations to bring forward payments on receivables); asset backed securities (ABS); mortage backed securities (MBS) and collataralized debt obligations (CDO and CDO2).30 In aggregate they grew from almost nothing in the early 1990s to $1.3 trillion in 200 and $4.7 trillion in 2006, but slumped to $1 trillion in 2009. Since 2000 most of the growth and subsequent decline in security issuance has been in mortage backed securities and collateralized debt obligations (CDOs).

Figure 2:

derivatives-figure-2student-debtApart from mortages, what sorts of income streams have formed the basis of securities issuance? Moody’s lists the following class of assets on which asset-backed securities are built: ‘aircraft leases, home equity loans, auto loans and leases, manufactured housing, credit card receivables, small business loans, dealer floor plan loans, student loans, equipment loans and leases, franchise loans, time share loans, health care receivables, and tobacco settlements’.32

From analysis of derivatives markets  by Dick Bryan and Michael Refferty. originally published in Socialist Register vol 47 in 2011

Series Navigation<< How globalized gambling started driving our livesHow the 1% drove 99% to debt and destruction – US experience >>

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