Economic Crises Case Study

Exotic Financial Derivatives: The Root Cause of US Financial Disaster

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Abstract:
2008 witnessed a catastrophe in the US financial market. Investment banks like Lehman Brothers went bankrupt, insurance companies like AIG had to be bailed out by the Federal Reserve, and the gloom shrouded the whole globe. Analysts attributed the catastrophe to the abundant use of financial derivatives. Many of them started quoting Warren Buffet's famous statement on derivatives 'Derivatives were time bombs both for the parties that deal in them and economic system'. But was the derivative the only reason for such a large scale financial disaster? Was it a consequence of the huge dependence on market dynamics? Was capitalism at a crossroads? Or did the US forget the lesson of the great depression and the subsequent legislations that Roosevelt introduced? Was it merely a consequence of proper check valves lacking in the US financial sector?

Pedagogical Objectives:

• To understand the US financial service sector.
• To analyse the debt bubble and the housing bubble in the US.
• To discuss the role of derivatives products in the debt bubble and the housing bubble.

Keywords :  US financial market, Credit led consumerism, Reconstruction Finance Corporation (RFC), Glass-Stegall Act, Federal Deposit Insurance Corporation (FDIC), Securities Act and Security Exchange Act, Originate and hold model, Originate and distribute model, Primary mortgage market, Secondary mortgage market, Securitisation and resecuritisation, Assets backed commercial paper (ABCP), Special purpose vehicle (SPV), structure investment vehicle (SIV) and hedge funds, Mortgage backed securities (MBS), Collateralised debt obligation (CDO), Collateralised loan obligation (CLO), Credit default swap (CDS), Debt bubble and housing bubble, Alt-A borrower and sub-prime borrower, Adjusted rate mortgage, Over leverage, Market liquidity