An Overview of the 2008 Financial Crisis (the perspective of an electrical engineer on Wall Street) 1 Samir Padalkar PhD,

Roadmap Real Estate Bubble Security Definitions CDO Issues Rating Agencies, FNMA, FHLMC, AIG Federal Reserve 2000 Internet Bubble Comparison Where are we today

Case Shiller Property Values Index (source Wikipedia) Fed Funds Rate (source Federal Reserve)

mortgage $200k 6% 30 years mortgage $250K 6.5% 30 years MBS 6 % weighted avg coupon, 30 year weighted average maturity MORTGAGE BACKED SECURITY (MBS) 4 Several individual mortgages are packaged into one security MBS has a Weighted Avg. Coupon & Weighted Avg. Maturity Mortgages made to Prime customers ended up being securitized By FNMA & FHLMC Mortgages made to Subprime customers ended up being securitized by Private Banks

MBS 6% 30 years MBS 6.5% 30 years Senior AAA 70% COLLATERALIZED DEBT OBLIGATION – CASH CDO Mezzanine BBB 25% Equity 5% 5 Several MBS Bonds are packaged into a CDO CDO has several Tranches Lowest Rated Equity Tranche suffers with first defaults, but has highest yield Mezzanine Tranche suffers next, still Investment grade, but has lower yield Senior Tranche is AAA rated since at least 30 % defaults before it is affected, lowest yield Moody's, S&P, Fitch assigned Ratings to Tranches

MBS 6% 30 years MBS 6.5% 30 years Senior AAA 70% COLLATERALIZED DEBT OBLIGATION – CASH CDO Mezzanine BBB 25% Equity 5% 6 Cash CDO is made up using MBS bonds In most cases, MBS Bonds contained subprime mortgages Subprime --- FICO score < 640

CDS BUYER CDS SELLER Reference MBS Premium Face Value upon default CREDIT DEFAULT SWAP 7 CDS is insurance on an underlying reference bond CDS buyer pays a premium to the CDS Seller CDS Seller pays Reference Bond Face Value minus recovery To CDS Seller AIG sold CDS on several Subprime MBS & CDO

CDS 6% 30 years CDS 6.5% 30 years Senior AAA 70% COLLATERALIZED DEBT OBLIGATION – SYNTHETIC CDO Mezzanine BBB 25% Equity 5% 8 Simpler to create than Cash CDO, since actual MBS bonds Are not required Mortgage Bubble even more inflated by such securities

Senior 70% Mezz 25% Equity 5% Senior 70% Equity5% Senior 70% Equity 5% Senior 70% Equity 5% Senior 70% Mezz 25% Equity 5% Mezz 25% CDO SQUARED 9 Mezzanine Tranche difficult to sell, so 4 such tranches make up a CDO^2

Senior 70% Equity 5% Senior 70% Equity5% Senior 70% Equity 5% Senior 70% Equity 5% Senior 70% Mezz 25% Equity 5% Mezz 25% CDO SQUARED– 10 % DEFAULT Mezz 25 % % default results in 20 % default in CDO^2, Equity wiped out, Mezzanine suffers 15 % wipe-out out of 25 % Mezz 25%

Senior 70% 2% Equity 5% Senior 70% Equity5% Senior 70% Equity 5% Senior 70% Equity 5% Senior 70% Mezz 25% Equity 5% Mezz 25% CDO SQUARED– 13 % DEFAULT Mezz 25% 8% % defaults results in defaults in AAA Senior Tranche of CDO^2

Other CDO Failures Correlation between individual loans assumed to be low, say.2 to.3 In reality, when the Real Estate Bubble burst, correlations in individual subprime loans jumped almost close to 1 Especially if CDO contained a high % of loans from Florida, California, Nevada, Arizona Many Subprime borrowers had an ARM, so in the initial years they could pay the lower interest rate. When the ARM reset to a higher rate, subprime people began defaulting. Defaults in Cash CDO’s got magnified in Synthetic CDO’s

CDO Pricing Gaussian Copula Monte Carlo Simulation

The copula function was used to price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared. "Everyone was pinning their hopes on house prices continuing to rise," says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. "When they stopped rising, pretty much everyone was caught on the wrong side, because the sensitivity to house prices was huge. And there was just no getting around it. Why didn't rating agencies build in some cushion for this sensitivity to a house-price- depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO."Kai Gilkes

GLOBAL CDO issuance USD ( millions ) SIFMA YearArbitrageBalance SheetTotal , , , , , , , , , , , , , , , , , , , ,231.04,451.18, ,610.86, ,

Federal Reserve Response Almost 0 Fed Funds Rate Massive Quantitative Easing Balance Sheet Jan 2008 = 943 Billion Balance Sheet Jan 2009 = 2298 Billion (2.3 Trillion) Balance Sheet Jan 2012 = 2964 Billion (nearly 3 Trillion)

Reserve Bank credit, related items, and Averages of daily figures Change from week ended reserve balances of depository institutionsWeek ended at Federal Reserve Banks Jan 2, 2008Dec 26, 2007Jan 3, 2007 Reserve Bank credit 891,743+18,231+32,341 Securities held outright 740,611-13,994-38,305 U.S. Treasury 1 740,611-13,994-38,305 Bills 2 227,841-14,015-49,178 Notes and bonds, nominal 2 470,9840+3,120 Notes and bonds, inflation-indexed 2 36,9110+6,806 Inflation compensation 3 4, Federal agency Repurchase agreements 4 39, ,107 Term auction credit 40,000+20,000+40,000 Other loans to depository institutions 5, ,554 Primary credit 5, ,590 Secondary credit 000 Seasonal credit Float -1, Other Federal Reserve assets 66,612+11,167+27,007 Gold stock 11,04100 Special drawing rights certificate account 2,20000 Treasury currency outstanding 5 38, Total factors supplying reserve funds 943,805+18,245+32,957 Federal Reserve Balance Sheet, Jan 3, 2008, 17

Reserve Bank credit, related items, and reserve balances (millions of dollars) of depository institutions at Federal reserve banks Averages of daily figures Change from week ended Week ended Dec 31, 2008Dec 24, 2008Jan 2, 2008 Reserve Bank credit 2,246,527+39,255+1,354,752 Securities held outright 496, ,384 U.S. Treasury 1 475, ,650 Repurchase agreements 4 80, ,250 Term auction credit 450,219+29, ,219 Other loans 187,770-9, ,983 Net portfolio holdings of Commercial Paper Funding Facility LLC 7 332,410+6, ,410 Net portfolio holdings of LLCs funded through the money market investor funding facility Net portfolio holdings of Maiden Lane LLC 9 26, ,974 Net portfolio holdings of Maiden Lane II LLC 10 20, ,059 Net portfolio holdings of Maiden Lane III LLC 11 27, ,990 Float Other Federal Reserve assets 625,741+11, ,086 Gold stock 11,04100 Special drawing rights certificate account 2,20000 Treasury currency outstanding 12 38, Total factors supplying reserve funds 2,298,625+39,269+1,354,928 Federal Reserve Balance Sheet, Jan 2, 2009, 18

Reserve Bank credit, related items, and Averages of daily figures reserve balances of depository institutions atWeek endedChange from week ended Federal Reserve Banks (millions of Dollars)Jan 18, 2012Jan 11, 2012Jan 19, 2011 Reserve Bank credit 2,903,761+20, ,459 Securities held outright 1 2,602,187+7, ,648 U.S. Treasury securities 1,647,279-5, ,660 Federal agency debt securities 2 102,030-1,281-44,174 Mortgage-backed securities 4 852,878+14, ,839 Repurchase agreements Loans 8, ,030 Net portfolio holdings of Maiden Lane LLC 8 7, ,289 Net portfolio holdings of Maiden Lane II LLC 9 9, ,800 Net portfolio holdings of Maiden Lane III LLC 10 17, ,747 Net portfolio holdings of TALF LLC Float Central bank liquidity swaps ,266+10, ,196 Other Federal Reserve assets ,700+2,799+40,218 Gold stock 11,04100 Special drawing rights certificate account 5,20000 Treasury currency outstanding 14 44, Total factors supplying reserve funds 2,964,278+20, ,090 Federal Reserve Balance Sheet, Jan 19, 2012, 19

Internet Bubble Vs. Housing Bubble Equity (Internet) Vs. Debt-Derivative (Housing) Derivatives expanded the Housing Bubble much more. Housing Bubble used more complicated Math to justify pricing Most of the Housing Bubble Derivatives remained on the books of a few Financial Institutions. Housing Bubble used CDS Insurance to further add to risk. AIG is an example of a company that significantly underpriced Housing risk, and had to be bailed out ($ 50+ billion)

Current Situation Global Notional Value of OTC Derivatives = 707 Trillion $ Global Notional Value of Exchange Traded Derivatives = 80 Trillion $ Global GDP = approximately 60 Trillion $ Global Bond Market Size = Trillion $ Global Equity Market Size = 45 – 55 Trillion $

Table 23A: Derivative financial instruments traded on organized exchanges By instrument and location Notional principal in billions of US dollars Amounts outstanding Turnover Instrument / locationDec 2009Dec 2010Jun 2011Sep Futures All markets21, , , ,313.41,126,519.21,380,538.9 Interest rate20, , , ,999.21,016,361.61,235,907.4 Currency , ,771.2 Equity index966.11,128.41,197.01, , ,860.3 North America10, , , , , ,195.9 Interest rate10, , , , , ,193.5 Currency , ,649.0 Equity index , ,353.4 Europe8,053.66,345.38,933.57, , ,297.9 Interest rate7,608.75,816.68,373.47, , ,836.1 Currency Equity index , ,206.5 Options All markets51, , , , , ,661.8 Interest rate46, , , , , ,872.0 Currency ,980.33,048.5 Equity index4,803.54,560.35,218.95, , ,741.3 North America23, , , , , ,543.9 Interest rate21, , , , , ,342.9 Currency ,600.9 Equity index1,991.92,210.92,651.82, , ,600.2 Europe26, , , , , ,485.3 Interest rate23, , , , , ,930.0 Currency Equity index2,417.21,926.12,093.82, , ,550.2 Source- BIS 22

Notional amounts outstandingGross market values Risk Category / InstrumentJun 2009Dec 2009Jun 2010Dec 2010Jun 2011Jun 2009Dec 2009Jun 2010Dec 2010Jun 2011 Total contracts 594,553603,900582,685601,046707,56925,29821,54224,69721,29619,518 Foreign exchange contracts48,73249,18153,15357,79664,6982,4702,0702,5442,4822,336 Forwards and forex swaps23,10523,12925,62428,43331, Currency swaps15,07216,50916,36019,27122,2281,2111,0431,2011,2351,227 Options10,5559,54311,17010,09211, Interest rate contracts437,228449,875451,831465,260553,88015,47814,02017,53314,74613,244 Forward rate agreements46,81251,77956,24251,58755, Interest rate swaps341,903349,288347,508364,377441,61513,93412,57615,95113,13911,864 Options48,51348,80848,08149,29556,4231,4141,3641,5011,4011,319 Equity-linked contracts6,5845,9376,2605,6356, Forwards and swaps1,6781,6521,7541,8282, Options4,9064,2854,5063,8074, Commodity contracts3,6192,9442,8522,9223, Gold Other commodities3,1942,5212,4342,5252, Forwards and swaps1,7151,6751,5511,7811,846 Options1, Credit default swaps36,09832,69330,26129,89832,4092,9731,8011,6661,3511,345 Single-name instruments24,16521,91718,49418,14518,1051,9501, Multi-name instruments11,93310,77611,76711,75314,3051, of which index products–...7,5007,47612,473 Unallocated62,29163,27038,32939,53646,5432,8162,3981,7891,5431,414 Memorandum Item: Gross Credit Exposure3,7443,5213,5813,4802,971 Amounts outstanding of over-the-counter (OTC) derivatives By risk category and instrument In billions of US dollars. Source BIS 23

Concentration of Derivative Contracts ($ Billions) Type Top 5 Banks $ All Other banks $Total $Top 5 Banks % Futures & Fwrds35,7973,99439,79114 Swaps150,5025,630156,13261 Options35,1571,21136,36814 Credit Derivatives15, ,6616 TOTAL236,97710,974247,95296 Source : Comptroller of the Currency, Washington DC, 3Q 2011

Net Current Credit Exposure $ in billions3Q112Q11Change% Gross Positive Fair Value (GPFV)6,0213,9422,07853% Netting Benefits5,5173,5791,93854% Netted Current Credit Exposure (NCCE) % Potential Future Exposure (PFE) % Total Credit Exposure (TCE)1,2991, % Netting Benefit %91.60%90.80%0.90%1% Source : Comptroller of the Currency, Washington DC, 3Q 2011