The Role of CDOs in Subprime Crisis

8/11/2019 The Role of CDOs in Subprime Crisis

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ContentsIntroduction ............................................................................................................................................ 2

The Housing Bubble ................................................................................................................................ 3

Tranches .................................................................................................................................................. 4

The Final Fall ........................................................................................................................................... 5

The Role of

CDOs in

subprime Crisis

Security Analysis and

Portfolio

Management

KUNAL BHODIA

FSB2013002291


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Introduction

It is to be understood that instruments are not the cause of the crisis;

It is how they were used which caused the crisis.

There are two key terms which are necessary to be defined before going any

further.

First Subprime:- Subprime Mortgage is a type of mortgage that is primarily

given out to borrowers with lower credit ratings. As a result of the borrower's

lower credit rating, a predictable mortgage is not offered because the lender

views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charged intere

t on subprime mortgages at a rate which is higher than a normal mortgage in

order to shield them for carrying more risk.

Second CDOs:- A Collateralized Debt Obligation (CDO) is a security whose value

is collaterized by a pool of underlying fixed-income assets. It is an investment

that yields a standard return, its payments being derived from the

performance of this pool. It is a financial instrument that traders use to sellsecurities that individually would be hard to sell.

The Mechanics of the System

In a CDO, an investment bank collected a series of assets -- often high-yield

junk bonds, mortgage backed instruments, credit-default swaps and other

high-risk, high-yield products from the fixed-income market. The investment

bank then created a corporate structure -- the CDO -- that would distribute the

cash flows from those assets to investors in the CDO.

CDOs were marketed as investments with a defined risk and reward and

divided them into tranches. In other words, if you bought one you would know

how much of a return you could expect in exchange for risking your capital.

The investment banks that were creating the CDOs presented them as

investments in which the key factors were not the underlying assets. Rather,

the key to CDOs was the use of mathematical calculations to create and

distribute the cash flows. In other words, the basis of a CDO wasn't a


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mortgage, a bond or even a derivative -- it was the metrics and algorithms

ofmathematics and traders. In particular, the CDO market skyrocketed in 2001

with the invention of a formula called theGaussian Copula, which made it

easier to price CDOs quickly.

In early 2007, Wall Street began to feel the first tremors in the CDO

world. Defaults were rising in the mortgage market. And many CDOs

included derivatives that were built upon mortgages -- including risky,

subprime mortgages.

Hedge fund managers, commercial and investment banks, and pension

funds, all of which had been big buyers of CDOs, found themselves in

trouble. The assets at the core of CDOs were going under. More

importantly, the math models that were supposed to protectinvestors against risk weren't working.

Complicating matters was that there was no market on which to sell the

CDOs. CDOs aren't traded on exchanges. CDOs aren't really

structured to be traded at all. If you had one in your portfolio, there

wasn't much you could do to unload it.

The CDO managers were in a similar bind. As fear began to spread, the

market for CDOs' underlying assets also began to disappear. Suddenly itwas impossible to dump the swaps, subprime-mortgage derivatives and

other securities held by the CDOs.

The Housing Bubble

The price of housing, like the price of any good or service in a free market, is

driven by supply and demand. When demand increases and/or supply decreases,

prices go up. In the absence of a natural disaster that might decrease the supply

of housing, prices rise because demand trends outpace current supply trends.Just as important is that the supply of housing is slow to react to increases in

demand because it takes a long time to build a house, and in highly developed

areas there simply isn't any more land to build on. So, if there is a sudden or

prolonged increase in demand, prices are sure to rise. The flip side, what the

causes of that increase in demand are. There are several: First, an improvement

in general economic activity and prosperity that puts more disposable income

and encourages home ownership. Second, an increase in the population or the

demographic segment of the population entering the housing market can simply

increase the demand. Third and finally the important one for our issue, a low
http://bonds.about.com/od/workinginthebondtrade/a/quants.htmhttp://en.wikipedia.org/wiki/Gaussian_copula_model#Gaussian_copulahttp://en.wikipedia.org/wiki/Gaussian_copula_model#Gaussian_copulahttp://en.wikipedia.org/wiki/Gaussian_copula_model#Gaussian_copulahttp://en.wikipedia.org/wiki/Gaussian_copula_model#Gaussian_copulahttp://bonds.about.com/od/workinginthebondtrade/a/quants.htm


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general level of interest rates, particularly short-term interest rates, innovative

mortgage products with low initial monthly payment sand easy access to credit

that makes homes more affordable. Hence, all of these variable scan combine to

cause a housing bubble.

Tranches

A CDO is divided into tranches containing securities with varyingdegrees of risk. Tranching means taking an income stream and dividingit into multiple tradable instruments. The 'senior' tranche contains thesafest securities (lowest risk). Payments are made in order of seniority,so the most junior tranche (otherwise known as the equity tranche or'toxic waste') is at greatest risk of not receiving a payment, and as such

offers the highest coupon payments to offset the increased risk of such adefault. Investors can therefore specify the exact credit, yield, maturityand currency characteristics of the security they wish to invest in.

It was the junior tranches that were backed in a large part by thesubprime mortgages. These were mortgages given to customers withthe lowest credit-ratings and debt-to-income ratios, and hence at thegreatest risk of being unable to make their payments. The dividends forthese CDOs were high to offset the increased risk, and while times weregood, interest rates low and the housing market headed steadily

upwards, the demand for these securities particularly from hedge fundslooking to speculate on the markets did likewise. Indeed institutions suchas Freddie Mac and Fannie Mae set up by the US federal governmentprovided guarantees on loans made to farmers, students and the poor,which went to exacerbate the US housing bubble. Loans could be madeto subprime borrowers as while the property prices rose, if a borrowerdefaulted on their mortgage the lender could sell the house and covertheir losses or even make a profit.

With fees earned on each loan sold on via securitisation, the high yieldsthat US subprime mortage backed securities provided, and the beliefthat there were not high risk as the housing market rose, these CDOsspread throughout the International Financial Markets like wildfire.Everyone from banks to pension funds, investment funds and insurancecompanies were buying them up.


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The Final Fall

Banks were finding themselves increasingly stuck with toxic tranchesthey could no longer shift. In February 2007 HSBC wrote down $10

billion worth of its US mortgage book. Shortly after Century, the main

subprime lender in the US filed for bankruptcy. Many CDOs were

downgraded by ratings agencies, forcing pension funds to sell them as

they were now no longer legally entitled to have their investments tied

up in them.

By early 2008, the CDO crisis had morphed into what we now call the

credit crisis.As the CDO market collapsed, much of the derivatives market tumbled

along with it. Hedge funds folded. Credit-ratings agencies, which had

failed to warn Wall Street of the dangers, saw their reputations severely

damaged. Banks and brokerage houses were left scrambling to increase

their capital.

Then, in March 2008, slightly more than a year after the first indicators

of trouble in the CDO market, the unthinkable happened. Bear Stearns,

one of Wall Street's biggest and most prestigious firms, collapsed.Eventually, the fallout spread to the point that bond insurance

companies had their credit ratings lowered (creating another crisis in the

bond market); state regulators forced a change in how debt is rated, and

some of the bigger players in the debt markets reduced their stakes in the

business or exited the game entirely.

When the financial crisis peaked in 2008 crippling the banking sector,banks found themselves with a trillion dollars tied up in now worthless

assets. Of this, around half, that's $500 billion, was tied up in CDOs.With many banks sitting on huge losses, the interbank lending marketdried up, as no bank wanted to lend to another bank that was potentiallygoing bust. CitiGroup lost $34 billion on mortgage CDOs, Merrill Lynchlost $26 billion. The insurer AIG was crippled due to selling $500 billion

worth of Credit Default Swaps to in effect insure against defaults onCDOs, and payments of which it could not meet.

By the middle of 2008, it was clear that no one was safe. As the dust

settled, auditors began to assess the damage. And it became clear that


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everyone -- even those who had never invested in anything -- would wind

up paying the price.

The Role of CDOs in Subprime Crisis

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