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28. July.2010 Sertaç Yay 20050682 The Financial Crisis of 2007: Roles of CDOs, CDSs and Subprime Mortgages HPEC.491 Honors Project in Economics Instructor: Prof. Sumru G. Altuğ

The Financial Crisis of 2007_ Roles of CDOs, CDSs and Subprime Mortgages

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In this paper, I would start with explaining and defining above mentionedmortgage backed securities that involved in the crisis which are Credit Default Swaps,Collateralized Debt Obligation and Subprime Mortgages that main financial productthat crisis had centered on. Secondly, I would briefly discuss and propose their roles inthe current crisis and relationship with each other.

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Page 1: The Financial Crisis of 2007_ Roles of CDOs, CDSs and Subprime Mortgages

28. July.2010

Sertaç Yay

20050682

The Financial Crisis of 2007: Roles of CDOs, CDSs and Subprime Mortgages

HPEC.491 Honors Project in Economics

Instructor: Prof. Sumru G. Altuğ

Page 2: The Financial Crisis of 2007_ Roles of CDOs, CDSs and Subprime Mortgages

1

Contents 1. Introduction ............................................................................................................................................... 2

2.1. What is Credit Default Swap? ................................................................................................................. 3

2.2. How did Credit Default Swap emerge? ................................................................................................... 4

2.3. Usage of Credit Default Swap in the Market .......................................................................................... 5

2.3.1. Speculation ....................................................................................................................................... 5

2.3.2. Hedging ............................................................................................................................................ 6

2.3.3. Arbitrage .......................................................................................................................................... 7

3.1. What is Collateralized Debt Obligation? ................................................................................................ 8

3.2. Types of CDOs ....................................................................................................................................... 9

3.2.1. Synthetic CDO ............................................................................................................................... 10

4. What is Subprime Mortgage? .................................................................................................................. 12

5. Financial Crisis of 2007 to the present ..................................................................................................... 13

5.1. Stage One: US Housing Bubble ........................................................................................................ 14

5.2. Stage Two: Growth in the Subprime Mortgage Market ..................................................................... 16

5.3. Stage Three: Where do CDS and CDO fit in this picture?............................................................... 17

5.3.1. Relations between CDS and CDO ............................................................................................. 17

5.3.2. Relation between CDS and Subprime Mortgage ........................................................................ 18

5.4. Stage Four: Burst of Housing Bubble ............................................................................................... 18

6. Conclusion ............................................................................................................................................... 21

Bibliography ................................................................................................................................................. 22

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1. Introduction

In 2008, a series of bank and insurance company failures triggered a financial

crisis that effectively halted global credit markets and required unprecedented

government intervention. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken

over by the government. Lehman Brothers declared bankruptcy on September 14th after

failing to find a buyer. Bank of America agreed to purchase Merrill Lynch (MER), and

American International Group (AIG) was saved by an $85 billion capital injection by the

federal government Shortly after, on September 25th, J P Morgan Chase (JPM) agreed to

purchase the assets of Washington Mutual (WM) in what was the biggest bank failure in

history In fact, by September 17, 2008, more public corporations had filed for

bankruptcy in the U.S. than in all of 2007. These failures caused a crisis of confidence

that made banks reluctant to lend money amongst them. (ANDREWS, MERCED, &

WALSH, 2008)

The collapse of a global housing bubble, which peaked in the U.S. in 2006, caused

the values of securities tied to real estate pricing to plummet thereafter, damaging

financial institutions globally. Commercial and residential properties saw their values

increase precipitously in a real estate boom that began in the 1990s and increased

uninterrupted for nearly a decade. Increases in housing prices coincided with a period

of government deregulation that not only allowed unqualified buyers to take out

mortgages but also helped blend the lines between traditional investment banks and

mortgage lenders. Questions regarding bank solvency, declines in credit availability,

and damaged investor confidence had an impact on global stock markets, where

securities suffered large losses during late 2008 and early 2009. Critics argued that credit

rating agencies and investors failed to accurately price the risk involved with mortgage-

related financial products such as CDOs, CDSs and Subprime Mortgages and that

governments did not adjust their regulatory practices to address 21st century financial

markets. Hence write downs after home owners failed to keep up their payments, found

several institutions at the brink of insolvency with many being forced to raise capital or

go bankrupt. (TheWhiteHouse, 2008)

In this paper, I would start with explaining and defining above mentioned

mortgage backed securities that involved in the crisis which are Credit Default Swaps,

Collateralized Debt Obligation and Subprime Mortgages that main financial product

that crisis had centered on. Secondly, I would briefly discuss and propose their roles in

the current crisis and relationship with each other.

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2.1. What is Credit Default Swap? CDS are the fastest-growing major type of financial derivatives, and have played

a critical role in the unfolding financial crisis. By seemingly providing "insurance" on

risky mortgage bonds, they enabled and encouraged uncontrolled behavior during the

housing bubble. (Varchaver,Nicholas;Benner,Katie, 13 Oct 2008) At its most

fundamental level, the CDS is analogous to an insurance contract, though it differs in

ways that are important in understanding how they are used. An insurance contract

might insure a homeowner by providing a payment in the event of a house fire. The

homeowner pays premiums at set dates, and if a fire occurs, the premiums stop and the

insurance company pays the homeowner the claim, which depends on the amount of

damage done to the house. In the same way, a CDS "insures" the holder of the contract

against a corporate default. In exchange, the writer of the CDS contract receives

"premium" payments. However, the analogy with insurance extends only so far. One

major difference between the two contracts is that the CDS can be bought by a person

who does not actually hold the underlying asset (a bond). (Imagine trying to buy

insurance for a house that one does not own!) Consequently, the total value of CDS

contracts can exceed the amount of outstanding debt being insured. (Cherny, Kent;

Craig, R. Ben, July 2009)

For looking more concrete definitions, it is a swap in which the buyer makes a

series of payments and, in exchange, receives a guarantee against default from the seller

on a designated debt security. That is, the buyer transfers the risk that a debt security,

such as a bond, will default to the seller, and the seller receives a series of fees for

assuming this risk. (Credit Default Swap, 2010) A CDS is a contract involving two

parties that trade credit risk: a credit protection buyer and a credit protection seller.

Each party to a CDS trade is counterparty to the other. A CDS always references one or

more debt obligations as it mentioned above, such as a loan made by a bank or the

bonds of a public company. Under the terms of a CDS contract, a protection buyer must

make periodic

payments to the

protection seller,

and will typically do

so on a quarterly basis for a period of five years. The protection buyer will generally pay

a fee proportionate to the credit risk of the debt obligation referenced by the CDS. In

return, the protection seller must pay the protection buyer if a credit event takes place.

What is credit event? A credit event is a negative development relating to the specified

reference debt obligation, such as a failure to pay under the obligation or the bankruptcy

of the entity that issued the reference obligation. If a credit event occurs, a CDS requires

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the protection seller to pay the protection buyer the diminished value of the reference

debt obligation. In this sense, a CDS is a type of insurance for credit risk that can help

banks and other companies better manage their credit risks. (SHADAB, 2009)

2.2. How did Credit Default Swap emerge?

JPMorgan, commercial and investment banking institution, actually was its

father. So, why did JPMorgan need or create such a vital derivative? In order to

understand the creation of CDS we should look at the near history. By the mid-'90s,

JPMorgan's books were loaded with tens of billions of dollars in loans to corporations

and foreign governments, and by federal law it had to keep huge amounts of capital in

reserve in case any of them went bad. JPMorgan bankers were trying to get their heads

around a question as old as banking itself: how do you mitigate your risk when you

loan money to someone? (Philips, 2008)

One of the brands of motor fuel, Exxon, client of the JPMorgan also, needed to

open a line of credit to cover potential damages of five billion dollars resulting from the

1989 Exxon Valdez oil spill (hundreds of thousands of barrels of crude oil in Alaska). J.

P. Morgan was unwilling to turn down Exxon, which was an old client, but the deal

would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-

called Basel rules, named for the town in Switzerland where they were formulated,

required that the banks hold eight per cent of their capital in reserve against the risk of

outstanding loans. That limited the amount of lending bankers could do, the amount of

risk they could take on, and therefore the amount of profit they could make. But, if the

risk of the loans could be sold, it logically followed that the loans were now risk-free;

and, if that were the case, what would have been the reserve cash could now be freely

loaned out. (JP Morgan invented credit-default swaps to give Exxon credit line for

Valdez liability, 2010) What the bankers hit on was a sort of insurance policy: a third

party would assume the risk of the debt going sour, and in exchange would receive

regular payments from the bank, similar to insurance premiums. (Philips, 2008) In late

1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of

selling the credit risk to the European Bank of Reconstruction and Development. So, if

Exxon defaulted, the E.B.R.D. would be on the hook for it—and, in return for taking on

the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P.

Morgan would get to honor its client relationship but also to keep its credit lines intact

for interesting activities. (JP Morgan invented credit-default swaps to give Exxon credit

line for Valdez liability, 2010) JPMorgan would get to remove the risk from its books

and free up the reserves. The scheme was called a "credit default swap," and it was a

twist on something bankers had been doing for a while to hedge against fluctuations in

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interest rates and commodity prices. While the concept had been floating around the

markets for a couple of years, JPMorgan was the first bank to make a big bet on credit

default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and

science grads from schools like MIT and Cambridge to create a market for the complex

instruments. Within a few years, the credit default swap (CDS) became the hot financial

instrument, the safest way to parse out risk while maintaining a steady return. (Philips,

2008)

2.3. Usage of Credit Default Swap in the Market

Although Credit Default Swap can be seen new to the market, they are growing

rapidly. At the end of 2001, there was $920 billion in credit default swaps outstanding.

By the end of 2007, that number had skyrocketed to more than $62 trillion. (How

Credit Default Swaps Brought Down the World Economy, 2009) There are three main

usages of CDS in today’s world and we can title them as speculation, hedging, and

arbitrage

2.3.1. Speculation

The buyer of credit risk protection does not necessarily need to be exposed to the

underlying risk when entering into a CDS contract. CDS may also be used for pure

trading purposes, where traders try to exploit possible mispricing between different

asset classes or take open positions if they believe the market will evolve in a certain

direction. Similarly, sellers of credit protection are able to gain access to the credit

market via an arm’s length financial transaction. By using CDSs, they do not have to

prefund their exposure (except for the posting of collateral) and do not bear interest rate

risk generally associated with the purchase of bonds or the extension of loans. Through

trading, the CDS market generally becomes more liquid, improving not only the chances

of protection buyers and sellers finding a contract partner, but also enhancing pricing

efficiency. Due to their favorable characteristics, CDS spreads have gained widespread

acceptance as an important indicator of distress. Other examples include the prices

charged for government guarantees for debt issues of banks hit by the financial crisis or

the rates demanded for corporate credit lines, both of which have been directly linked to

CDS spreads. Likewise, rating agencies use information derived from CDS prices to

calculate “market implied ratings”. Thus in practice, CDS spreads serve as an important

source of information for private banks, central banks, supervisors and international

organizations alike. (DeutscheBankResearch, 2009).

Credit default swaps allow investors to speculate on changes in CDS spreads. An

investor might believe that an entity's CDS spreads are too high or too low, relative to

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the entity's bond yields, and attempt to profit from that view by entering into a trade

that combines a CDS with a cash bond and an interest-rate swap. Also an investor

might speculate on an entity's credit quality, since generally CDS spreads will increase

as credit-worthiness declines and decline as credit-worthiness increases. The investor

might therefore buy CDS protection on a company to speculate that it is about to

default. Alternatively, the investor might sell protection if it thinks that the company's

creditworthiness might improve. (Pinsent)The investor selling the CDS is viewed as

being “long” on the CDS and the credit, as if the investor owned the bond. In contrast,

the investor who bought protection is named “short” on the CDS and the underlying

credit. Credit default swaps opened up important new avenues to speculators. Investors

could go long on a bond without any upfront cost of buying a bond; all the investor

need do was promise to pay in the event of default. Shorting a bond faced difficult

practical problems, such that shorting was often not feasible; CDS made shorting credit

possible and popular. Because the speculator in either case does not own the bond, its

position is said to be a synthetic long or short position.

For example, a hedge fund believes that SY Corp will soon default on its debt.

Therefore, it buys $10 million worth of CDS protection for two years from X-Bank, with

SY Corp as the reference entity, at a spread of 500 basis points (=5%) per annum. If SY

Corp does indeed default after, say, one year, then the hedge fund will have paid

$500,000 to X-Bank, but will then receive $10 million, thereby making a profit. X-Bank,

and its investors, will incur a $9.5 million loss However, if SY Corp does not default,

then the CDS contract will continue for two years, and the hedge fund will have ended

up paying $1 million, thereby making a loss. X-Bank, by selling protection, has made

$1 million. On the other side suppose after one year, the market now considers SY Corp

more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The

hedge fund may choose to sell $10 million worth of protection for one year to X-Bank at

this higher rate. Therefore over the two years the hedge fund will pay the bank 2 * 5% *

$10 million = $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a

total profit of $500,000. (Mengle, 2007)

2.3.2. Hedging

First of all, “hedging” is any action such as transaction and investment to reduce

the risk of price fluctuations for an asset or investment. Normally, a hedge consists of

taking an offsetting position in a related security, such as a futures contract. (Financial

Dictionary, 2010)There are many specific financial vehicles to reduce risk of adverse

price movements in a security, including insurance policies, forward contracts, swaps,

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options, many types of over-the-counter and derivative products. However, Credit

default swaps are often used to manage the risk of default which arises from holding

debt. (Choudhury, 2006) CDSs are derivative instruments because their financial value

is derived from the value of an underlying financial asset, usually a bond. The ability to

trade derivatives allows the various risks of an asset to be transferred to counterparties

willing to bear them without the underlying asset being involved in the trade—or even

being held by either the buyer or the seller. CDS contracts represent the exchange of a

specific risk—corporate or sovereign default—between two investors making opposite

bets, the CDS seller who bets the borrower will not default, and the CDS buyer who bets

it will. This exchange of risk leads, naturally, to investment hedging, an important use of

CDSs. (Cherny, Kent; Craig, R. Ben, July 2009)

For example, suppose an investment fund owned mortgage bonds from

riskymortgage.com.tr. It might be worried about losing all its investment. Therefore, to

hedge against the risk of default, they could purchase a credit default swap from SY-

Bank. If riskymortgage.com.tr defaulted, they will lose their investment, but receive a

payoff from SY to compensate. If they don’t default, they have paid a premium to SY

but have had security. (Credit Default Swaps Explained, 2008)

2.3.3. Arbitrage

Arbitrage refers to the buying of one item and the selling of the same item for a

higher price, therefore making a profit on the difference or in our case refers to the

simultaneous purchase and sale of an asset in order to profit from a difference in the

price. It is a trade that profits by exploiting price differences of identical or similar

financial instruments, on different markets or in different forms. Arbitrage exists as a

result of market inefficiencies; it provides a mechanism to ensure prices do not deviate

substantially from fair value for long periods of time. (Financial Dictionary, 2010)

Arbitrage is used to utilize CDS transactions. It relies on the fact that company’s

stock price and its CDS spread should exhibit negative correlation. Hence, if the position

for a company improves then its share price should go up and its CDS spread should

tighten, since it is less likely to default on its debt. However if its position worsens then

its CDS spread should expand and its stock price should fall. Techniques reliant on this

are known as capital structure arbitrage because they exploit market inefficiencies

between different parts of the same company's capital structure; i.e. mis-pricings

between a company's debt and equity. (Chatiras,Manolis;Mukherjee, Barsendu,

February 2004)

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3.1. What is Collateralized Debt Obligation?

In order to understand what Collateralized Debt Obligation is, let’s try to

understand what collateral means. In finance, collateral refers to assets pledged as

security for a loan. In the event that a borrower defaults on the terms of a loan, the

collateral may be sold, with the proceeds used to satisfy any remaining obligations.

Actually, high-quality collateral reduces risk to the lender and results in a lower rate of

interest on the loan. (Scott, 2003) So, we can predict that concrete definition of CDOs will

lead us an asset-backed security (ABS).

One of the most significant developments in international credit markets in recent

years has been the trade in Collateralized Debt Obligations (CDO), which has enabled

financial institutions to repackage the credit risk of an asset portfolio into tranches to be

transferred to investors. The first CDO was issued in 1987 by bankers at now-defunct

Drexel Burnham Lambert Inc. for Imperial Savings Association. A decade later, CDOs

emerged as the fastest growing sector of the asset-backed synthetic securities market. A

major factor in the growth of CDOs was the 2001 introduction by David X. Li of

Gaussian copula models, which allowed for the rapid pricing of CDOs. According to the

Securities Industry and Financial Markets Association, aggregate global CDO issuance

totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$

486 billion in 2007. Research firm Celent estimates the size of the CDO global market to

close to $2 trillion by the end of 2006. (Rösch & Scheule, 2008)CDO's, or Collateralized

Debt Obligations, are sophisticated financial tools repackaging individual loans into a

product that can be sold on the secondary market. These packages consist of auto loans,

credit card debt, or corporate debt. They are called collateralized because they have

some type of collateral behind them. If the package consists of corporate debt, CDO's are

called asset-backed commercial paper. They are called mortgage-backed securities if the

loans are mortgages. CDO's were created to provide more liquidity in the economy. It

allows banks and corporations to sell off debt, which allows more capital to invest or

loan. (Amadeo, 2010)

Collateralized debt obligations are securitized interests in pools of generally non-

mortgage assets. Assets called collateral usually comprise loans or debt instruments. A

CDO may be called a collateralized loan obligation (CLO) or collateralized bond

obligation (CBO) if it holds only loans or bonds, respectively. Investors bear the credit

risk of the collateral. Multiple tranches of securities are issued by the CDO, offering

investors various maturity and credit risk characteristics. Tranches are categorized as

senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If

there are defaults or the CDO's collateral otherwise underperforms, scheduled

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payments to senior tranches take priority over those of mezzanine tranches, and

scheduled payments to mezzanine tranches take priority over those to

subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with

the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB.

The ratings reflect both the credit quality of underlying collateral as well as how much

protection a given tranch is afforded by tranches that are subordinate to it.

(Collateralized Debt Obligation, 2010)

3.2. Types of CDOs

CDOs can be classified using three criteria: motivation, asset type, and form of

risk transfer as you can see above. From the motivations’ perspective, CDOs can be

categorized into two main categories, balance sheet or arbitrage transactions. A balance

sheet transaction is intended to remove loans or in some cases bonds, from the balance

sheet of financial institution. The purpose is to free up regulatory capital, to improve

liquidity and generate a higher return on the assets through redeployment of capital.

The main sponsors of balance sheet transactions are banks and insurance companies. A

further classification of the balance sheet transactions is the division into cash flow and

synthetic structures. (Das, 2001) The classic example of balance sheet transactions is a

bank that has originated loans over months or years and now wants to remove them

from its balance sheet. Unless the bank is very poorly rated, CDO debt would not be

cheaper than the bank’s own source of funds. But selling the loans to a CDO removes

them from the bank’s balance sheet and therefore lowers the bank’s regulatory capital

requirements. This is true even if market practice requires the bank to buy some of the

equity of the newly created CDO (Lucas & Laurie S. Goodman, 2007)

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An arbitrage transaction is setup to make money from the credit-spread

difference between the yield of the collateral and the yield of the issued CDO notes.

Arbitrage CDOs can be broken into three categories. If the primary source is the interest

and maturing principal from the collateral assets, then the transaction is referred to as a

cash flow transaction. If the proceeds depend heavily on the total return generated from

active management of the collateral assets, then the transaction is referred to as a market

value transaction. The third category is an arbitrage synthetic CDO structure. The

arbitrage CDO market has emerged as one of the most important structured product

markets. The reasons were wider swap spreads and therefore higher arbitrage

opportunities as well as the slowdown of the activity in the high yield bond market due

to rating downgrades and corporate defaults. (Deacon, 2004) Simply, the aim of

Arbitrage CDOs is to capture the arbitrage opportunity that exists in the credit-spread

differential, between the high yield collateral and the highly rated notes. The idea is to

create collateral with a funding cost lower than the returns expected from the notes

issued. Most arbitrage deals are private ones, where size is not large and the number of

assets included in the deal is very limited compared to the cash flow type. (Picone, 2008)

3.2.1. Synthetic CDO

The development of the credit derivatives market, particularly the credit default

swap (CDS) market, fostered the development of the synthetic CDO. A synthetic CDO

does not actually own the portfolio of assets on which it bears credit risk. Instead, it

gains credit exposure by selling protection via CDSs. In turn, the synthetic CDO buys

protection from investors via the tranches it issues. These tranches are responsible for

credit losses in the reference portfolio that rise above a particular attachment point; Each

tranche’s liability ends at a particular detachment or exhaustion point. The first

synthetic CDOs were initiated by U.S. and European banks in 1997 for balance sheet

purposes. The motivation was to achieve regulatory capital relief without forcing the

banks to sell loans they had originated. Instead, synthetic balance sheet CDOs allowed

sponsoring banks to purchase credit protection on loans they continued to own, which

reduced their credit risk and required capital. A synthetic CDO’s ability to delink the

credit risk of an asset from its ownership affords banks substantial flexibility in balance

sheet management.

As explained earlier, there are balance sheet CDOs and arbitrage CDOs. The same is

true for the synthetic variety. Synthetic arbitrage CDOs come in the following forms:

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• Full capital structure CDOs, which are the oldest, include a full complement of

tranches from super senior to equity. These CDOs have either static reference

portfolios or a manager who actively trades the underlying portfolio of CDSs.

• Single tranche CDOs are newer, and are made possible by dealers’ faith in their

ability to hedge the risk of a CDO tranche through single name CDS. Single

tranche CDOs often allow CDO investors to substitute credits and amend other

terms over the course of the CDOs’ life. (Lucas & Laurie S. Goodman, 2007)

Hence, a synthetic CDO is a portfolio of credit default swap. The problem with

buying a CDS is that it usually references only one security, and the credit risk to be

transferred in the swap may be very, very large. In contrast, a synthetic CDO references

a portfolio of securities and is itself securitized into notes in various tranches, with

progressively higher levels of risk. In turn, synthetic CDOs give buyers the flexibility to

take on only as much credit risk as they wish to assume. The buyer of the synthetic CDO

gets premiums for the component CDS and is taking the "long" position, meaning they

are betting the referenced securities (such as mortgage bonds or regular CDO's) will

perform. The seller of the synthetic CDO is paying premiums and is taking the "short"

position, meaning they are betting the referenced securities will default. The seller

receives a large payout if the referenced securities default, which is paid to them by the

buyer.

The term synthetic CDO arises because the cash flows from the premiums (via

the component CDS in the portfolio) are analogous to the cash flows arising from

mortgage or other obligations that are aggregated and paid to regular CDO buyers. In

other words, taking the long position on a synthetic CDO (i.e., receiving regular

premium payments) is like taking the long position on a normal CDO (i.e., receiving

regular interest payments on mortgage bonds or credit card bonds contained within the

CDO).

Let’s try to understand with an example. Suppose Party A wants to bet that at

least some mortgage bonds and CDO's will default from among a specified population

of such securities, taking the short position. Party B can bundle CDS related to these

securities into a synthetic CDO contract. Party C agrees to take the long position,

agreeing to pay Party A if certain defaults or other credit events occur within that

population. Party A pays Party C premiums for this protection. Party B, typically an

investment bank, would take a fee for arranging the deal. (Conerly, 2010)

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A synthetic CDO has a lot of advantages over a cash flow CDO. The main

advantage is the funding advantage, i.e. that the super senior bond does not need to be

funded and that CDS are often cheaper than the underlying cash bond(cheaper

collateral assets).Another economic advantage is the efficient deal execution with no

ramp-up risk. A transaction can be issued and priced in a very short time horizon.

Synthetic CDOs have bullet maturities where the entire principal sum falls due on

maturity date. The maturity is therefore determined by the maturity of the underlying

CDS. The last advantage is the fact that there is also no interest rate and currency risk on

a synthetic CDO, because the CDS addresses only the credit risk on the instrument.

(Basel II- A new Bank Architecture , 2003)

4. What is Subprime Mortgage?

Actually, Subprime Mortgage is a type of Subprime Loan. In order to understand

what Subprime Mortgage is let’s try to understand what Subprime Loan is. The Federal

Deposit Insurance Corporation (FDIC) has defined subprime borrowers and loans: "The

term subprime refers to the credit characteristics of individual borrowers. Subprime

borrowers typically have weakened credit histories that include payment delinquencies

and possibly more severe problems such as charge-offs, judgments, and bankruptcies.

They may also display reduced repayment capacity as measured by credit scores, debt-

to-income ratios, or other criteria that may encompass borrowers with incomplete credit

histories. Subprime loans are loans to borrowers displaying one or more of these

characteristics at the time of origination or purchase. Such loans have a higher risk of

default than loans to prime borrowers.” (Subprime Lending, 2010)Hence, we can

conclude that Subprime Mortgage is a type of mortgage that is normally made out to

borrowers with lower credit ratings. As a result of the borrower's lowered credit rating,

a conventional mortgage is not offered because the lender views the borrower as having

a larger-than-average risk of defaulting on the loan. Lending institu-

tions often charge interest on subprime mortgages at a rate that is higher than a

conventional mortgage in order to compensate themselves for carrying more risk.

(Financial Dictionary, 2010)Subprime lending is a relatively new and rapidly growing

segment of the mortgage market that expands the pool of credit to borrowers who, for a

variety of reasons, would otherwise be denied credit. For instance, those potential

borrowers who would fail credit history requirements in the standard (prime) mortgage

market have greater access to credit in the subprime market. Two of the major benefits

of this type of lending, then, are the increased numbers of homeowners and the

opportunity for these homeowners to create wealth. (Chomsisengphet & Pennington-

Cross, 2006)

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There are several different kinds of subprime mortgage structures available. The

most common is the adjustable rate mortgage (ARM). A type of mortgage in which the

interest rate paid on the outstanding balance varies according to a specific benchmark.

The initial interest rate is normally fixed for a period of time after which it is reset

periodically, often every month. The interest rate paid by the borrower will be based on

a benchmark plus an additional spread, called an ARM margin. An adjustable rate

mortgage is also known as a "variable-rate mortgage" or a "floating-rate mortgage".

(Financial Dictionary, 2010)

Unlike fixed rate mortgages that have an interest rate that remains the same for

the life of the loan, the interest rate on an ARM will change periodically. The initial

interest rate of an ARM is lower than that of a fixed rate mortgage, consequently, an

ARM may be a good option to consider if you plan to own your home for only a few

years; you expect an increase in future earnings; or, the prevailing interest rate for a

fixed rate mortgage is too high.

An ARM has four components: (1) an index, (2) a margin, (3) an interest rate cap

structure, and (4) an initial interest rate period. When the initial interest rate period has

expired, the new interest rate is calculated by adding a margin to the index. Your lender

will disclose the margin at time of loan application. As the index figure moves up or

down, your interest rate will be adjusted accordingly. Among the most common indices

are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds

Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their

own cost of funds as an index, rather than using other indices. This is done to ensure a

steady margin for the lender, whose own cost of funding will usually be related to the

index. Increases or decreases in the interest rate will be limited by the interest rate cap

structure of your loan. (The Federal Reserve Board, 2010)

5. Financial Crisis of 2007 to the present

The financial crisis of 2007 to the present is a crisis triggered by a liquidity

shortfall in the United States banking system caused by the overvaluation of assets It has

resulted in the collapse of large financial institutions, the bailout of banks by national

governments and downturns in stock markets around the world. In many areas, the

housing market has also suffered, resulting in numerous evictions, foreclosures and

prolonged vacancies. It is considered by many economists to be the worst financial crisis

since the Great Depression of the 1930s. (Mah & Lim, 2008)

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5.1. Stage One: US Housing Bubble

Above figure shows the behavior of housing prices in the United States from

January 2000 through March 2009. While these two indexes of housing prices show

different increases and decreases due to differences in coverage and methodology, the

overall picture is the same: increases in housing prices until Summer 2006 or Spring

2007 followed by decreases. This fall in housing prices occurred in the context of rising

and then falling housing prices in many other parts of the world.

The United States housing bubble is an economic bubble affecting many parts of

the United States housing market; in several states housing prices peaked in early 2005,

started to decline in 2006, and may not yet have hit bottom. On December 30, 2008 the

Case-Shiller home price index reported its largest price drop in its history. Increased

foreclosure rates in 2006–2007 among U.S. homeowners led to a crisis in August 2008 for

the subprime, collateralized debt obligation (CDO), mortgage, credit, hedge fund, and

foreign bank markets. (Tkac & Dwyer, 2009)In 2008 alone, the United States government

allocated over $900 billion to special loans and rescues related to the US housing bubble,

(Reuters, 2008)

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So, what were reasons behind the housing bubble? The answer is easy. 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. Once you've

established that an above-average rise in housing prices is primarily driven by an

increase in demand, you might ask 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. (Wheaton & Nechayev, 2009)Third and finally

the important one for our issue, a low general level of interest rates, particularly short-

term interest rates, innovative mortgage products with low initial monthly payments

and easy access to credit that makes homes more affordable. Hence, all of these variables

can combine to cause a housing bubble. (Smith & Smith, 2006) However, first two

reasons were not actually there rather than third reason according to Baker. He says:

“The increase in house prices is not being driven by fundamental factors in the housing

market, such as income and population growth.” And “The market in Mortgage backed

security exceeds $6 trillion in 2005” (BAKER, 2005)

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5.2. Stage Two: Growth in the Subprime Mortgage Market

Subprime lending is a relatively new

and rapidly growing segment of the mortgage

market that expands the pool of credit to

borrowers who, for a variety of reasons, would

otherwise be denied credit. For instance, those

potential borrowers who would fail credit

history requirements in the standard (prime)

mortgage market have greater access to credit

in the subprime market as I mentioned before.

Because of its complicated nature, subprime

lending is simultaneously viewed as having

great promise and great peril. The promise of

subprime lending is that it can provide the

opportunity for homeownership to those who

were either subject to discrimination or could

not qualify for a mortgage in the past. in fact, a loan subprime is the existence of a

premium above the prevailing prime market rate that a borrower must pay. In addition,

this premium varies over time, which is based on the expected risks of borrower failure

as a homeowner and default on the mortgage. (Chomsisengphet & Pennington-Cross,

2006)

In order to catch the high trend of housing, people of US started to get loans by

using advantages of subprime mortgage. Subprime mortgages simply mean lending to

house borrowers with weak credit. Lenders did so by providing teasers like minimal or

zero down payment, and low introductory adjustable rate mortgages, as well as

negligent documentation and credit checks. Between 2004 and 2006, $1.5 trillion (15% of

the total U.S. housing loans) of subprime mortgages were booked. Total subprime loans

form 25% of the housing mortgage market; these subprime loans were fine as long as the

housing market continued to boom and interest rates did not rise. When these

conditions disappeared, the first to default were subprime borrowers. (Mah & Lim,

2008)

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5.3. Stage Three: Where do CDS and CDO fit in this picture?

5.3.1. Relations between CDS and CDO

David Li's formula, known as a Gaussian

copula function was adapted by everybody from

bond investors and Wall Street banks to ratings

agencies and regulators. And it became so deeply

entrenched—and was making people so much

money—that warnings about its limitations were

largely ignored. In 2000, while working at

JPMorgan Chase, Li came up with an ingenious

way to model default correlation without even

looking at historical default data. Instead, he used

market data about the prices of instruments known

as credit default swaps. When the price of a credit

default swap goes up, that indicates that default

risk has risen. Li's breakthrough was that instead of

waiting to assemble enough historical data about

actual defaults, which are rare in the real world, he

used historical prices from the CDS market. Armed

with Li's formula, Wall Street's mathematicians saw

new possibilities. The first thing they did was start creating a huge number of brand-

new triple-A securities. Using Li's copula approach meant that ratings agencies no

longer needed to puzzle over the underlying securities. All they needed was that

correlation number, and out would come a rating telling them how safe or risky the

tranche was. As a result, just about anything could be bundled and turned into a triple-

A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked.

The consequent pools were often known as collateralized debt obligations, or CDOs.

You could tranche that pool and create a triple-A security even if none of the

components were themselves triple-A. The CDS and CDO markets grew together,

feeding on each other. At the end of 2001, there was $920 billion in credit default swaps

outstanding. By the end of 2007, that number had skyrocketed to more than $62

trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by

2006. (How Credit Default Swaps Brought Down the World Economy, 2009)

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5.3.2. Relation between CDS and Subprime Mortgage

As I mentioned before, a credit default swap is, essentially, an insurance contract

between a protection buyer and a protection seller covering a corporation’s, or

sovereigns (the “referenced entity”), specific bond or loan. A protection buyer pays an

upfront amount and yearly premiums to the protection seller to cover any loss on the

face amount of the referenced bond or loan. CDSs are subject only to the collateral and

margin agreed to by contract. They are traded over-the-counter. They are subject to re-

sale to another party willing to enter into another contract. Most frighteningly, credit

default swaps are subject to “counterparty risk.” If the party providing the insu-

rance protection – once it has collected its upfront payment and premiums – doesn’t

have the money to pay the insured buyer in the case of a default event affecting the

referenced bond or loan or if the “insurer” goes bankrupt the buyer is not covered –

period. The premium payments are gone, as is the insurance against default. Credit

default swaps are not standardized instruments. In fact, they technically aren’t true

securities in the classic sense of the word in that they’re not transparent, aren’t traded on

any exchange, aren’t subject to present securities laws, and aren’t regulated. They are,

however, at risk – all $62 trillion (ISDA) of them. (Moars, 2009)

What happened, however, is that risk speculators who wanted exposure to

certain asset classes, various bonds and loans, or security pools such as residential and

commercial mortgage-backed securities (subprime mortgage-backed securities), but

didn’t actually own the underlying credits, now had a means by which to speculate on

them. The bad news is that there are even worse bets out there. There are credit default

swaps written on subprime mortgage securities. It’s bad enough that these subprime

mortgage pools that banks, investment banks, insurance companies, hedge funds and

others bought were over-rated and ended up falling sharply in value as foreclosures

mounted on the underlying mortgages in the pools. (Baker, 2008)

5.4. Stage Four: Burst of Housing Bubble

By the end of 2007, real house prices had fallen by more than 15 percent from

peak.4 House prices in many of the most over-valued markets, primarily along the two

coasts, had fallen by more than 20 percent. Furthermore, the rate of price decline was

accelerating, with prices in these cities falling at more than a 30 percent in annual rate at

the beginning of 2008.5 The rate of price decline in the Shiller indexes imply that real

house prices will be down by more than 30 percent from their 2007 peaks by the end of

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2008. This would mean a loss of more than $7 trillion in housing bubble wealth

(approximately $100,000 per homeowner). The lost wealth is almost equal to 50 percent

of GDP. There is no way that an economy can see a loss of wealth of this magnitude

without experiencing very serious financial stress. (Baker, 2008)

First, by the decrease in the prices of house in the market, lenders of subprime

mortgages had increased interest rate on the credit since they are ARMs mainly.

Borrowers who could not make the higher payments once the initial grace period ended

would try to refinance their mortgages. Refinancing became more difficult, once house

prices began to decline in many parts of the USA. Borrowers who found themselves

unable to escape higher monthly payments by refinancing began to default. As more

borrowers stop paying their mortgage payments (this is an on-going crisis), foreclosures

and the supply of homes for sale increases. This places downward pressure on housing

prices, which further lowers homeowners' equity. (Mah & Lim, 2008)

Second and the crucial part is how CDSs and CDOs were involved in the crisis.

As I mentioned before, firstly, CDS were used as insurance for ARMs and secondly,

CDOs included pool of Subprime Mortgages and even CDSs of these Subprime

Mortgages. After decline in mortgage payments, hence, the values of theses mortgage

backed securities declined. (Baker, 2008)

CDS are lightly regulated. As of 2008, there was no central clearing house to

honor CDS in the event a party to a CDS proved unable to perform his obligations under

the CDS contract. Required disclosure of CDS-related obligations has been criticized as

insufficient. By the decline in mortgage backed securities that were “insured” by CDS,

insurance companies such as American International Group (AIG), MBIA, and Ambac

faced ratings downgrades because widespread mortgage defaults increased their

potential exposure to CDS losses. These firms had to obtain additional funds (capital) to

offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its

seeking and obtaining a Federal government bailout. (Harrington & Moses, 2008)

On the CDO side, the situation was not so different. The securitization of

mortgages was only the first step in the financial engineering of residential mortgage-

backed securities (RMBSs). RMBSs then were packaged into collateralized debt

obligations (CDOs). CDOs are far from homogeneous securities, both in terms of the

underlying RMBSs and the contractual structure of the CDO itself. The result was the

proliferation of highly individualized CDO securities spread out among a global market

of investors. The heterogeneity of CDOs then led directly to opacity in security

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valuation. The value of a particular CDO security can be modeled in a variety of ways,

but all models rely on knowledge of the implications of the entire CDO’s structure plus

knowledge or assumptions about the characteristics of the underlying RMBSs and their

underlying mortgages. Since CDOs are not standardized and trade in the OTC market,

the exposure of any counterparty to CDOs in general was largely unobservable (except

by general ‘‘common knowledge’’). This opacity combined with the difficulty in

assessing the value and risk of any particular CDO holdings increases the level of

counterparty risk in these transactions. (Tkac & Dwyer, 2009)

Hence, decline in subprime mortgage market resulted in decline CDO market

and this effected big investment banks which were holding huge share of CDOs pooled

by mortgages such as Lehman Brothers Inc. Lehman Brothers had a 35 to 1 debt to

equity ratio, that is, it only owned $1 out of every $36 in its bank account — the other

$35 were borrowed from somewhere. This meant that a loss of just 3% of the money on

its balance sheet would have meant the loss of all the money it owned. After suffering

heavy losses (more than 3% of the money in its balance) from CDO, borrowers began to

lose confidence and called back the loans. As Lehman had always relied on short-term

loans, its lenders were able to pull their cash back quickly. Now the bank was in trouble.

It borrowed much more than it was able to return and soon found itself unable to pay

back. On 15th September 2008, the world's fourth biggest investment bank declared its

bankruptcy. (Horatio, 2009)When Lehman Brothers declared bankruptcy, it triggered

the transfer of large sums in the CDS market to insure buyers of Lehman credit default

risk protection against all losses from that event. The sellers of these contracts received

the Lehman debt and in return they were obligated to pay the contract buyers (the

insured parties) enough money to make the buyers “whole” i.e. to give them their full

investment in the bonds back as if they had never bought the Lehman bonds.

Outstanding Lehman Brothers’ CDS have an estimated value of $400 billion. No one

knows just how many CDS have been traded or whose balance sheet they are on

because the market for these swaps is unregulated. The International Swaps and

Derivatives Association in 2008 estimated the market at $54.6 trillion. But since there is

no central clearinghouse, trade volume can’t be tracked and publicly posted. (Lengle,

2008) CNBC had announced on 10 October 2008 that according to Erin Burnett,

“Indications are that people who sold protection on Lehman Brothers going bankrupt

may lose 91.25%”. So not only CDOs dealers such as Lehman Brothers failed as a

consequence of US Housing Bubble but “insurance” companies that had CDSs on CDOs

of Lehman Brothers such as American International Group Inc dragged into the crisis.

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6. Conclusion

From 2007 to present, the world has seen worst financial crisis since the Great

Depression. Causes of the crisis had been discussed by many economists, businessmen,

and journalist all around the world and lots of varying causes, triggers, indicators had

been proposed. However, on the common path they had this pattern: By decline in the

price of house as an end of US Housing Bubble, both the mortgage market and

mortgage backed security markets that include growing new hot products of financial

markets: Credit default swaps, Collateralized debt obligations and their babies Synthetic

CDO markets started decline and eventually crashed. CDOs and CDS grew together by

feeding each other in the first phase of Housing Bubble but in the second phase they

crashed also together and led big companies such as Lehman Brothers and AIG go

bankruptcy. Although people in the investment world did lots of money by using new

hot derivatives, miscalculations or biased-calculations, unregulated market, opacity of

the market, and enjoying risk that brings higher return led them to end up with liquidity

problems hence the bankruptcy. As a conclusion, since numbers were huge in the

chained losses of investment market and needed big bailouts from the government of

U.S.A which has enormous power in global economy, this credit crunch fed the financial

crisis which had triggered the global economic crisis of 2007 –present.

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