Bond Insurance Guarantees bond principal in case of a credit event. Effectively “swaps” the rating of the bond for that of the insurer. Purchased by bond issuers at time of issue to help sell bond (often done with munis). bond holders interested in protecting themselves from bond default. bond holders interested in upgrading the quality of the bonds they have on their books. Financial soundness of the insurance only as good as the insurance company.

Credit Default Swaps (CDS) CDS typically quoted in terms of $10 million for 5 years. Ex: Price to insure $10 million of XYZ bonds for 5 years is 150 basis points per annum. But like free money if no credit event. Many CDS buyers didn’t own reference obligation. More like a bet than insurance. Several things went wrong: Since don’t have to own reference obligation, notional amount of outstanding CDSs can exceed reference obligation’s total face value. CDS coverage grew rapidly on mortgage-backed securities. Made them look, whatever their quality, good on the books of financial institutions. When reference obligations went bad in large numbers, CDS writers (like AIG) unable to pay. As a result of Commodity Futures Modernization Act, there were no regulations about having to put any money aside.

Credit Event CDS writers have to pay when credit event occurs on reference obligation. bankruptcy default failure to pay repudiation/moratorium restructuring

Securitization (pp. 261-263) Prior to financial crisis, housing prices sometimes dropped regionally, but never all at once across the country. Securitization – conversion of illiquid assets (like, auto loans, student loans, mortgages) into securities that can be much more readily sold among investors in the capital market. borrower lender investors Wall St firm SPV rating agencies Following slides describe how the securitization process got off the rails and caused the financial crisis.

Typical Situation Wall St firm buys $1 billion of mortgages from various lenders. Organizes a trust, often called special purpose vehicle (SPV). SPV sells mortgage bonds to investors in tranches for money to pay back Wall St firm.  SPV 80%, Senior tranche at 4%, AAA 5%, Equity at 10%, unrated 15%, Mezzanine at 8%, BB 6.5% mortgages Of monthly mortgage payments: repayments of principal go (a) to Senior tranche holders first until paid off, (b) then to Mezzanine tranche holders until paid off; (c) then to Equity tranche holders. Interest goes to make coupon payments on the tranche securities not yet paid off. Anything extra is held by the SPV, to eventually go to the equity tranche holders. It is the monthly cycle that causes MBSs to make payments monthly. Because of interest rate spread, for years, had been very lucrative for Wall St firms.

Mortgage Bonds vs. CDOs Equity tranche securities often kept by the Wall St firms because so profitable.   Investors (municipalities from all around the world, pension funds, individuals) were ravenous for Senior tranche (i.e, AAA) securities. BBs not so much. Investors generally relied on AAA rating, rather than trying to understand what was in the pools. Investors thought: AAA, 1 out of 200 chance of failure. What is there to investigate? Where else can I get such a good rate on a AAA? After about 2000, Wall St moved to create as many 2nd and 3rd pools as they could. Securities issued by a 1st pool called mortgage bonds. Securities issued by 2nd and subsequent pools called CDOs.

Tranche Securities of 2nd Pools 2nd pools formed out of Mezzanine securities from various 1st pools. 2nd pools then sold tranche securities (here called CDOs) to pay for them. Thus, at the CDO level, AAA securities could be manufactured out of BB. But the rating agencies dropped the ball in rating too much of all the pools AAA. Senior (80%) Equity (5%) Mezz (15%) SPV investors Wall St firm Senior (70%) Equity (10%) Mezz (20%) CDO rating agencies Note: investors in CDO tranche securities are investing in securities whose payment depends upon other securities that depend on mortgages. CDOs more lucrative than SPVs, but supply is a problem. Takes several SPVs to produce enough mezzanine securities to form a CDO.

Need for More and More Mortgages To make more and more profit machines, need more and more mortgages. Since most mortgages from prime borrowers already in a pool, where to get more mortgages? From borrowers that were subprime. 12/1

3rd Pools (known as a CDOs-squared) Se(.80) Eq(.05) Me(.15) SPV investors Wall St firm Se(.7) Eq(.1) Me(.2) CDO Se(.6) Eq(.1) Me(.3) CDO2 rating agencies As SPV-pools became stuffed with subprime, and people couldn’t make payments after teaser period, collapse of CDO and CDO2 tranche securities just a matter of time. The few who saw this coming, bought CDSs on the whatever tranche securities they could (from AIG and others who were complacent from previous profits), and became rich when tranche securities collapsed.