Collatrized Debt Obligations

• High grade structured strategy master fund (“High-Grade”) run by Ralph Cioffi
• Raised capital from investors and used it to buy Collatrized Debt Obligations (CDOs)which were bagged by AAA rated subprime mortgage-backed securities (MBSs).
• Through the use of leverage the fund bought more CDOs because CDOs paid interest rates higher than that the cost of borrowing
• The fund purchased credit default swaps (CDSs) as insurance against movements in the credit market because the use of leverage increased the fund’s overall risk. CDSs were expected to pay off when credit concerns caused bond’s value to fall, effectively hedging some of the risk of failing collateral values.
• In the aftermath of September 11, 2001, the US Federal Reserve had moved aggressively to cut interest rates to stave off a recession. This low interest rate environment spurred increase in mortgage refinancing, new mortgages and substantial increase in house prices.
• With house prices increasing, mortgage backed securities seemingly offered both safety and yield.
• High-Grade fund’s cumulative yield was 50% through January 2007.
• In August 2006, Cioffi opened a second fund called the High-Grade Structured Credit Strategies Enhanced Master Fund (“Enhanced”)
• The fund would invest even higher proportion of its asset in low-risk securities. The increased profits would result frim grater use of leverage.

Roots of the Problem

• Banks started grating mortgages ad loans, repackaged them and sold them to other financial investors.
• Investment banks started investing their shareholder’s funds in securities or other activities.

Securitization

• Banks first pooled the assets to create portfolios of mortgages, loans, corporative bond, or other assets. These assets were transferred to a special purpose vehicle (SPV), who collected the principal and interest from the underlying assets and convey them to the holders of the structured products or asset backed securities (ABSs)
• The pooling of the assets helped to diversify risk and tranching allowed securities to tailored to meet the preference of different investors.
• The tranches were sold to pension funds, hedge funds, structured investment vehicles (SIVs) and other investors.
• CDO consisted of several tranches of an underlying portfolio of debt, such as corporate binds or mortgages
• Main advantage of securitization was risk spread.
• The main disadvantage was of securitization was that the transfer of credit risk distanced the borrowers from the lenders.
• Bank’s incentive to carefully approve loan applications and their incentive to monitor the loans was weakened considerably because the substantial portion of credit risk was soon passed on to other financial institutions.
• Subprime mortgage accounted for about 15% of all mortgages in 2001-2007. The outstanding value of US subprime mortgages was estimated at $1.3 trillion as of March, 2007.

Role of Rating Agents

• CDO tranches were always sliced in such a way to just result in an AAA rating.
• The rating agencies rated the structure of the CDO, but did not investigated the underlying credit quality of the assets that made up the CDO.
• The credit agencies stress-tested the structure of CDO that were based in part on past default history and lending prices.
• Real estate markets were thought to be largely uncorrelated across the country
• To the extent that lending standards had become less stringent over time, the models would fail to anticipate the increase in default rates that might arise as a consequence of this.
• Investment-grade CDOs typically returned 25% more than the average yield on a similarly rated corporate bond.
• The higher return on CDOs ultimately derived from the riskier assets that were structured to give higher ratings.
• The difference in the default rates on instruments of the same rating clearly demonstrated that the ratings on CDOs were not comparable to corporate bonds; yet few in the market appeared to appreciate the difference.

Mismatch in Maturity Structure

• Because investors generally preferred assets with short-term maturities, banks created off-balance sheet vehicles that shortened the maturity of long term structured products in the form of structured investment vehicles (SIVs).
• The aim of SIVs was to generate a spread between the yield on the asset portfolio and the cost of funding by managing credit, market, and liquidity risks.
• SIVs invested in illiquid long-maturity assets and financed them with asset backed commercial paper (ABCP) or medium-term notes (MTN).
• Along with the growth in SIVs, investment banks financed a larger portion of their balance sheets with short term collateralized lending in the form of repurchase agreements.
• The trend to invest in long-term assets and borrow short-term increasingly exposed financial institutions to liquidity risk, because the ABCP or repo market might suddenly dry up.

Growth of Credit Default Swaps

• A CDS was a contract between two counterparties, whereby the buyer made periodic payments to the seller in exchange for the right to a payoff in case of default.
• It was an insurance that could be used by a debt holder to hedge or to protect against default.
• Could be used to manage credit risk without necessitating the sale of the underlying bonds.
• In many instances, the amount of CDSs outstanding for an individual company greatly exceeded the bonds or underlying collateral value.
• As CDSs were bought and sold, it became difficult for the original purchaser of the insurance to locate the party responsible to pay the insurance and therefore judge the creditworthiness of the counterparty.
• The total notional amount of CDSs outstanding was more than $45 trillion by mid 2007 and rose to $62.2 trillion by year end

The Music Stops

• Things started to go wrong for Ralph Cioffi and the Bear funds in early 2007. The funds had purchased large amount of CDOs in late 2006 and January 2007.
• The same time, the finds were shorting the ABX index, which was tied to subprime loans
• As the news about subprime mortgage worsened, CDO assets dropped in price.
• CDO bonds were falling in value and its ABX positions were no longer making money.