Derivatives Markets and Risk Management Techniques in the Liquidity Crisis in 2007

Derivatives markets and risk management techniques in the Liquidity crisis in 2007, and the Orange County crisis The liquidity crisis was a first stage of the financial crisis of 2007-2008, which was the worst financial crisis since the Great Depression era of the 1930s. As institutions had high uncertainty about one another’s solvency, they stopped lending to each other, which also led to the liquidity crisis. Another prominent crisis happened in a municipality in California, the USA – Orange County, which filed for Chapter 9 protection and declared bankruptcy on December 6, 1994. Municipal bankruptcies usually are rare events and occur only in rural places, as large cities manage to avoid bankruptcies through government rescue programmes. The Orange County bankruptcy was the biggest municipal bankruptcy in U.S. history, and, therefore, a shocking event for a rich and thriving county “with a national reputation for its affluent residents and conservative politicians”. At a first glance, these two crises seem different. The liquidity crisis happened on the global level and had a uniting problem of moral hazard, i.e. the incentive of compensation that motivated managers, bankers and traders. In contrast, the Orange County crisis occurred on more local level. Moreover, County Treasurer, Robert Citron, had no financial incentives to motivate him. Citron’s ignorance of other perspectives was based on his arrogance and over-confidence in his strategy. However, this essay argues, that there were also main derivatives and risk management techniques, which contributed to the development of both crises in a similar way. These are discussed and assessed in the following sections of the essay. In the conclusions section the similarities of two crises are provided.