?? Collateralized Debt Obligation (CDO), Securitization & 2008 Global Financial Crisis

What is Securitization?

Securitization refers to the process of converting illiquid assets, such as loans or mortgages, into securities that can be traded on financial markets. The underlying assets are pooled together and sold to a special purpose vehicle (SPV), which then issues securities backed by the pool of assets. These securities are often sold to investors in the form of bonds or other debt instruments.

**Securitization is a financial process where a pool of assets, such as mortgages, car loans, or credit card debt, are combined and transformed into tradable securities. A Special Purpose Vehicle (SPV) is a separate legal entity created for a specific purpose or transaction, such as securitization or asset-backed financing.

The cash flows generated by the underlying assets, such as loan payments or mortgage payments, are used to pay interest and principal on the securities (Newly issued CDOs)

Why Securitize Loans?

1. More efficient allocation of Risk
2. Creates more Risk bearing capacity
3. Provides greater transparency
4. Support economic growth
5. Benefits of the sub-prime market

What is the Subprime market?

The subprime market refers to a segment of the lending market where borrowers with poor credit histories are offered loans at higher interest rates than prime borrowers. Subprime loans are typically made to borrowers with lower credit scores, higher debt-to-income ratios, or other risk factors that make them less likely to repay the loan. They have a higher chance of default.

But Successful Securitization Requires:

1. Diversification
2. Accurate risk measurement
3. Normal market conditions
4. Sophisticated Investor

Let's See How This Works?

The likelihood of the bond issuer paying back is estimated at 90%, while the probability of default is 10%. This calculation is based on the given information.

• If you combine these bonds into one large bond, the probability of receiving the full bond amount ($2000) is 81% (90% x 90%).
• The probability of not receiving any payment ($0) in case both bonds default is 1% (10% x 10%).
• The probability of receiving payment for one bond ($1000) is 18% (100% - 81% - 1%).

Now, let's say I created two new artificial bonds from that large bond (which, remember, was built with two bonds). These are called CDOs or Bonds on Bonds.

However, this time I did something different. I created two tranches of bonds, one senior and one junior. The senior bond has a higher priority in payment, while the junior bond will be paid after the senior bond, making it riskier.

Now think these bonds are independent of each other.

To recap, at the very beginning, the probability of each of the two individual bonds paying was 90%. However, after creating senior and junior structures, the probability of the senior bond getting paid has increased to 99% from 90%.

Here's how it works: Remember that the probability of the entire $2000 bond getting paid was 81%. This means that there is an 81% probability that both the senior and junior bonds will get paid.

In addition, there is an 18% probability that only $1000 will be paid out. In this case, only the senior bond will be paid, and the junior bond will not receive any payment because there will be nothing left after paying the senior bond.

So, Senior Tranche getting paid probability ( Independent 81% + 18% extra for its seniority = 99%, which was 90% at the begining)

And Junior bond has only an independent 81% getting paid probability which was 90% at the very first.

On the X-axis, we have the probability of default, and on the Y-axis, we have different bond grades, including different maturities.

Initially, we see four bars for an Aaa-rated bond. The smallest one represents the five-year Aaa-rated bond, which has the lowest probability of default.

Similarly, the Aaa-rated 10, 15, and 20-year bonds have a higher probability of default, as longer-duration bonds are riskier than shorter-duration bonds.

The Baa line separates investment-grade bonds from non-investment-grade bonds.

Bonds rated Baa and above are considered investment grade, whereas bonds rated Ba and below are non-investment grade.

If you observe the chart, you'll notice that initial bonds with a 10% default probability are highly risky and located near the non-investment grade area.

However, due to financial engineering, senior bonds have been turned into super-safe AAA-rated bonds. On the other hand, junior bonds fall below investment grade.

Assuming that both of those bonds are independent of each other, the newly created senior tranche has a 99% probability of getting paid, whereas the junior tranche has an 81% probability of getting paid.

Based on these probabilities, the expected price of the senior tranche is $990, while the expected price of the junior tranche is $810.

Now forget all of those. Imagine:

If the initial two bonds have become perfectly correlated, there is a 90% chance that both will be paid, which means both will be paid $1000 dollars each.

However, if one fails, the other will fail too, resulting in a 10% chance that both of those bonds will be paid nothing.

The calculation for this scenario would be as follows:

Senior and junior tranches will become the same. If one tranche gets paid, the other will get paid too. Similarly, if one tranche fails, the other will also fail.

The expected price of the Senior tranche is now $900 dollars, which was previously $990.

The expected price of the Junior tranche will also be $900, which was previously $810.

The money did not disappear; it just moved from the Senior tranche to the Junior tranche.

To This Basic Story Add:

1. Very low default rate (for artificially created senior segment of bonds)
2. The very low correlation of default (The portfolio we created at first with 2 bonds, assume no correlation between them)
3. Demand for senior bonds (pension funds buy those for low risk & a bit more return, remember initially the default rate was 10% for each bond which is too much for pension funds. so they couldn't afford that)
4. Demand for junior Bonds (Hedge funds. they do risky trade, it's in their nature)
5. Insurance on top of that ( Credit Default Swap)

Then, National Real-Estate Market Declines & Default correlation Rises

****(remember the initial two bonds, those were Mortgage-backed securities, These bonds originate from real estate, where people buy a house by taking a loan from the bank and providing the collateral of that house. They promise to pay the monthly payments for 20-30 years. However, a few months later, they failed to keep up with the payments)

Then the whole real estate market collapsed, there were millions of those bonds were issued. Those bonds were highly correlated.

Replace those initial two bonds with millions, and now imagine what a catastrophe that was.

The senior tranche's price falls, and Junior tranches gain in price.

Pension funds lose billions, and hedge funds gained that amount.

The contagion of the collapse spread from the housing sector to other sectors, as housing is the second most essential need for humans. So, the crisis was deep-rooted

Finally A story "Confessions of a Risk Manager" In The Economist, August 7, 2008:

Like most banks, we owned a portfolio of different tranches of collateralized-debt obligations (CDOs), which are packages of asset-backed securities. Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs, and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.

In May 2005 we held AAA tranches, expecting them to rise in value, and sold non-investment-grade tranches, expecting them to go down. From a risk-management point of view, this was perfect: have a long position in the low-risk asset and a short one in the higher-risk one. But the reverse happened of what we had expected: AAA tranches went down in price and non-investment-grade tranches went up, resulting in losses as we marked the positions to market.?

This was entirely counter-intuitive. Explanations of why this had happened were confusing and focused on complicated cross-correlations between tranches. In essence it turned out that there had been a short squeeze in non-investment-grade tranches, driving their prices up, and a general selling of all more senior structured tranches, even the very best AAA ones.