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It is impossible to fully
understand how the deregulation of our financial system and the failure to
enforce existing regulations led to the financial crisis that began in 2007
without looking at the way in which financial deregulation affected the
markets for mortgages and in which financial derivatives increased leverage
within the economic system leading up to the Crash of 2008.
Before 1938, home mortgages were highly illiquid assets, the reason being it
is very difficult for a third party to judge the quality of a mortgage. When
a bank originates a mortgage it has a very good idea of the creditworthiness
of the borrower, the quality of the real estate that is the collateral for
the mortgage, and the characteristics of the neighborhood in which the real
estate is located. The further one gets from the bank that originated the
mortgage the less one knows about these things. As a result, the secondary
market for mortgages—that is, the market in which existing mortgages are
bought and sold—tended to be very local which made it difficult for people
in smaller communities to obtain mortgages for the purpose of purchasing
homes.
In 1938 the
Federal National Mortgage Association (Fannie
Mae) was created as a government agency to facilitate home ownership by
providing a secondary market for government insured mortgages. In 1968
Fannie Mae was privatized as a
Government Sponsored Enterprise (GSE), and in
1970 the
Federal Home Loan Mortgage Corporation
(Freddie Mac) was chartered as a GSE to provide a secondary market for
non-government insured mortgages, and Fannie Mae’s mission was changed to
provide a market for non-government insured mortgages as well. In the
meantime the
Government National Mortgage Association (Ginnie
Mae) was created as a government agency to replace Fannie Mae in the market
for federally insured mortgages. Ginnie Mae is a government owned
corporation within the
Department of Housing and Urban Development
(HUD), whereas Fannie Mae and Freddie Mac are private corporations that were
created by the government and then sold to the private sector.
The GSEs and Ginnie Mae worked closely with mortgage originators, mostly
banks and thrifts (i.e.,
savings banks
and
savings and loan associations), to maintain
and improve
underwriting standards (i.e., the standards by
which loans are made) and were very successful in providing a nationwide
secondary mortgage market by purchasing mortgages that met their
underwriting requirements from the mortgage originators. This, in turn,
greatly facilitated home ownership throughout the country.
Originally, the GSEs financed their operations by selling uncollateralized
bonds in the
capital market to obtain the funds necessary
to purchase mortgages from their originators, but in the 1970s the GSEs
began securitizing the mortgages they purchased by placing pools of
mortgages in trusts and issuing bonds collateralized by the revenues
generated from the pooled mortgages. The GSEs guaranteed the mortgages that
collateralized the bonds they issued, and these bonds are referred to as agency
Mortgage-Backed Securities or agency MBSs.
In the 1980s, private companies—mostly
investment banks,
depository institutions,
and
mortgage banks—began securitizing mortgages by
sponsoring SPVs and selling mortgages to the SPVs they sponsored. The bonds
issued by the SPVs of private companies are referred to as private-label
Mortgage-Backed Securities or private-label
MBSs. Private securitizers did not guarantee the mortgages they sold to
their SPVs, and, as a result, private securitizers had to offer
credit enhancements to minimize the interest
rates they would have to pay on the MBSs their SPVs issued.
One method of credit enhancement was to
over collateralize the MBSs they issued so
that the face value of the MBSs a private-label SPV issued was below the
face value of the mortgages held as collateral for their MBSs. A second
method was to provide an
excess spread on the rate of interest received
from the mortgages over the rate of interest paid on the MBSs so the amount
of money taken in from the mortgages that collateralized their MBSs exceeded
the amount the SPV was obligated to pay to bondholders. The most important
of these enhancements, however, was
subordination whereby the MBSs issued by the
privately sponsored SPVs were structured in a hierarchy of tranches
(a French word meaning slices) such that private-label MBSs in a lower
tranche were subordinate to those in a higher tranche.
The way subordination works is that the MBSs issued by the SPV are broken
down into
senior
tranches which have first claim to the income
received from the mortgages held by the SPV,
junior tranches (also called
mezzanine tranches) which have a claim to this
income only after the MBSs in the senior tranches have been paid, and
equity tranches (also called
residual tranches) which are paid only after
the MBSs in the senior and junior tranches have been paid. This structure
gives the MBSs in the senior and junior tranches protection against default
on the mortgages held by the SPV in that the defaults on the underlying
mortgages must be greater than the income owed to the equity tranches before
the income and principal payments available to service senior and junior
tranches will be affected. It gives even more protection to the MBSs in the
senior trances in that the defaults on the underlying mortgages must be
greater than the income owed to both the equity and junior tranches before
the income available to service the senior tranches will be affected.
The way in which MBSs are structured is illustrated in
Figure 8.1
which shows the structure of the
CMLTI 206-NC2 offering sponsored by Citigroup
in 2006.
Figure 8.1: Structure of the CMLTI 2006-NC2 MBS Offering.
Source:
Financial Crisis Inquire Report,
Security Exchange Commission.
This offering was backed by 4,499 mortgages with a principal value of $947
million, and was described as a “typical deal” in the
final report of the
Financial Crisis Inquire Commission. As is
shown in this figure, 78% of the MBSs in this offering were
investment grade securities in the
Senior
Investment Grade tranche that were rated
AAA by the
rating agency
Standard & Poor’s. Another 18% were in the
Junior Investment Grade tranches that were rated BBB or above,
but less than AAA, which brought the total of the investment grade
securities in this offering to 96%. The 2.4% of the offering in the Junior Non-Investment Grade tranches that received a BB rating or below
held a
junk bond status, and the Equity tranches made
up 1.4% of the offering.[44]
By structuring their
offerings in this way, the sponsors of private-label
Mortgage-Backed Securities were able to compete with the GSEs even
though the sponsors of the private-label MBSs did not guarantee the
mortgages that backed their MBSs. As a result, private-label MBSs began to
increase their share of the
Mortgage-Backed Securities market dramatically in the 2000s, but there
was a catch: Virtually all of the demand was for the highest rated
securities in the offerings, and there was relatively little demand for
those that were lower rated. (FCIC
Smith) This led to a problem.
For securitization to work,
all of the tranches in an offering must be sold. Otherwise there’s not
enough money to purchase the collateral needed to make the offering viable.
When the lower rated securities can’t be sold elsewhere, the sponsor of the
offering is forced to purchase them. This limits the ability of the
sponsoring institution to sponsor new offerings since its purchases from its
previous offerings must be financed. The ability to finance these purchases
is limited by capital requirements in the case of a regulated institution
such as an investment bank or depository institution,
or by margin requirements in the case of an unregulated institution such as
a hedge fund. When the sponsoring institutions reach their funding limits,
they can no longer sponsor new MBS offerings. To solve this problem the
sponsors of
Mortgage-Backed Securities turned to alchemy. (Dowd)
Collateralized Debt Obligations (CDOs) are created in the same way
Mortgage-Backed Securities are created and are divided into subordinate
tranches with the equity and junior tranches being paid only after the
senior tranches are paid, and the equity tranches being paid only after the
senior and junior tranches are paid just as MBSs are structured. In
addition, CDO offerings were rated similarly by the rating agencies with 95%
or so of the offering rated investment grade (BBB or higher) and as much as
80% of the offering investment-grade tranches (the Senior Investment
Grade tranches) receiving a triple-A rating.
The fundamental difference
between
Collateralized Debt Obligations and
Mortgage-Backed Securities is in the nature of the collateral. While
MBSs are backed only by mortgages, CDOs use a variety of debt obligations
for collateral—bonds, loans, and other
Asset-backed Securities (ABSs)—rather than a single kind of financial
instrument. (FCIC)
Until the 2000s, CDOs were
a relatively obscure financial product confined to a relatively small
market, but in the early 2000s the CDO market simply exploded. From 2003 to
2006 it increased more than seven fold as it went from $30 billion to $225
billion in just three years. In the process, CDOs transformed the mortgage
market by increasing the demand for MBSs in the lower rated tranches. In
2004, CDOs were the dominate buyer of BBB-rated MBSs, and in 2005 they
purchased virtually all of the BBB tranches of these securities. Between
2003 and 2007 over $4 trillion
Mortgage-Backed Securities were created and some $700 billion of CDOs
that contained lower rated tranches of MBSs as collateral were created as
well. (FCIC)
The alchemy involved in
this process should be apparent. By taking the lower rated MBSs and using
them as collateral for CDOs, the sponsors of the SPVs that offered these
CDOs for sale were able to convert as much as 80% of the BBB or BB rated
MBSs held as collateral in their SPVs into triple-A rated securities in the
form of AAA rated CDOs. They were, indeed, able to make a silk purse out of
a sow’s ear—or so it seemed—and the alchemy didn’t end there. CDOs were
often structured with the lower rated tranches of other CDOs as part of
their collateral. CDOs with 80% or more of their collateral in the form of
lower rated tranches of other CDOs were referred to as CDOs squared, and by
this sleight of hand the sponsors of the SPVs were able to convert more than
60% of the lower rated CDO tranches held in their portfolio of collateral
into triple-A rated CDOs squared. (FCIC)
Collateralized Debt Obligations fueled the
mortgage market as it expanded in the mid 2000s in that CDOs allowed the
sponsors of MBSs to keep the lower rated tranches of the MBSs that they
couldn’t sell otherwise off their books. This freed up capital and, thus,
allowed them to expand the creation of MBSs beyond what they would have been
able to if the CDO market had not existed.
Leverage is a term used to describe methods by which investors can enhance
their return on their equity. The most common form of leverage is the kind
discussed in Chapter 5 and Chapter 7, namely, borrowing money to increase
the amount to invest. This kind of leverage is referred to as
balance sheet or
debt leverage where
the amount of leverage is measured by the debt to equity ratio—that is, by
the value of the amount borrowed by the investor divided by the value of the
equity (net worth) of the investor. There is another kind of leverage that
can be used to increase the return on equity, namely, that which is obtained
through the use of
derivatives. Derivatives are contracts that
derive their value from some underlying asset or collection of assets. They
are used either to provide a
hedge against a potential loss or to
speculate on future events.
Perhaps, the simplest derivative to understand is an
option contract. An option is a financial
instrument that gives the holder of the option the right, but not an
obligation, to either buy or sell (depending on the kind of option), an
asset at a specified price during a specified period of time. An option to
buy an asset is a
call option. An option to sell an asset is a
put option. While an option does not obligate
the holder of the option in any way, if the holder of the option chooses to
exercise the option during the specified time period the
writer of the option is obligated to sell, in
the case of a
call option, or to buy, in the case of a
put option, the asset being optioned at the
specified price.
For example, if you purchase a 30-day option to buy 100 shares of IBM stock
at $100/share—a 30-day call option for 100 shares of IBM stock at
$100/share—this gives you the right to buy 100 shares of IBM stock for
$100/share at any time during the next 30 days. At the same time, it
obligates the writer of the option to sell 100 shares of IBM stock to
you at $100/share at any time you choose during the next 30 days.
If you purchase a 30-day option to sell 100 shares of IBM stock for
$100/share at any time during the next 30 days—a 30-day put option
for 100 shares of IBM stock at $100/share—this gives you the right to sell
100 shares of IBM stock at $100/share at any time during the next 30 days.
At the same time, it obligates the writer of the option to buy 100 shares of
IBM stock from you at $100/share at any time you choose during the next 30
days.
If you own 100 shares of IBM stock that is worth $100/share today you can
use an option as a hedge against the risk of the value of your stock falling
over the next six months by purchasing a 6-month put option that gives you
the right to sell 100 shares of IBM stock at $100/share at any time during
the next six months. Having purchased such an option, if the price of IBM
stock should fall to, say, $50/share you would be protected from that loss.
Your $5,000 loss in the value of your stock would be offset by the $5,000
gain in the value of your option that gives you the right to sell your 100
shares of IBM stock for $100/share. Your only loss would be the price you
had to pay for the option.
You can also use options to speculate on the price of IBM stock even if you
don’t own the stock. Suppose you believe that IBM stock is going to double
in value over the next six months. You can take advantage of this
expectation either by purchasing IBM stock directly or by purchasing a
6-month call option for IBM stock. If the price of IBM stock is $100/share
it will cost you $10,000 to purchase 100 shares of stock. If you purchase
the stock and are right about the price of IBM doubling over the next six
months, the price of your stock will increase to $200/share. Your 100 shares
of IBM stock will then be worth $20,000, and you will make a $10,000 profit.
Alternatively, if the price of a 6-month call option to buy IBM stock for
$100/share is $10/share, that same $10,000 you have to invest could be used
to purchase an option that would give you the right to buy 1,000 shares of
IBM stock for $100/share. If the price of IBM stock were to double, the
value of your option would increase from the $10,000 that you paid for it to
$100,000 since your option gives you the right to buy $200,000 worth of IBM
stock for just $100,000. As a result, you would be able to make a $90,000
profit ($200,000 - $100,000 -$10,000) by investing your $10,000 in the
option as opposed to a $10,000 profit by investing in the stock. Thus,
purchasing the option allows you to leverage your $10,000 investment by
increasing your profit 9 times what you would be able to make by buying the
stock directly.
Just as debt leverage increases your risk of loss as it increases your
potential profit, the same is true for derivative leverage. Even though your
potential loss is limited to $10,000 whichever investment you chose to make
in the above example, if you chose to invest in an option you will lose the
entire $10,000 if the price of IBM stock fails to increase above $100. You
will not lose your entire $10,000 investment if you chose to purchase IBM
stock directly unless the price of IBM stock goes to zero.
Historically, derivatives in the form of
futures contracts—an agreement to buy or sell
something at a specific date and price in the future—have been around for
over a hundred and fifty years where the difference between a futures
contract and an option contract is that both parties are obligated to
perform on a futures contract. The buyer agrees to buy, and the seller
agrees to sell. Neither the buyer nor the seller has the option of not
buying or not selling.
Just as with options contracts, futures contracts can be used to hedge
against a potential loss or to speculate on changes in prices. To see how a
futures contract can be used to hedge against a potential loss, consider the
plight of a farmer who knows approximately what it will cost to plant a
particular crop in the spring and how much product he will have available to
sell when it is harvested in the fall, but has no way of knowing what the
price of that crop will be when he brings it to market. If he plants the
wrong crop he will lose money if the price at harvest time is below his
costs of production. One way he can hedge against this possibility is by
entering into a contract in the spring with a miller to sell his crop in the
fall at an agreed upon price. By entering into this kind of contract both
the farmer and the miller are able to protect themselves against adverse
changes in prices when crops are brought to market in the fall.
As was noted, futures contracts can also be used to speculate on changes in
prices. If the price of wheat is $2/bu. in May and you think it will be $4/bu.
in the September you can take advantage of this situation by buying wheat
today, storing it until September, and then selling it at whatever the price
turns out to be. If your expectation is correct and the price in September
is $4/bu. you will be able to make a profit of $2/bu. on each bushel of
wheat you purchased and stored, less the cost of storing the wheat from June
to September. If it costs you $1/bu. to store the wheat your net profit will
be $1/bu.
Now suppose that you can enter into a futures contract to purchase wheat at
$3/bu. in September, a price that is equal to the price of wheat today plus
the cost of storing wheat that exists today until September. If you enter
into this contract and your expectation is correct and the price in
September is $4/bu. you will make the same profit of $1/bu. when you
purchase the wheat in September at $3/bu. and resell it at $4/bu., less, of
course, the cost of the commission to the broker who arranged the contract.
There are, however, a number of important differences.
To begin with, when you purchase a futures contract you don't have to
actually buy any wheat in order to make a profit. As the price of wheat
approaches $4/bu. in September, the value of your contract will approach $1/bu.
since that is the profit you can make on it when it comes due. As a result,
when your contract comes due in September you will be able to sell your
contract to someone who actually wants to buy wheat or to someone who has
contracted to sell wheat and wants to close out his or her contract to sell
by buying an offsetting contract to buy without having to actually come up
with the wheat needed to fulfill his or her contract to sell. This makes
speculating through futures contracts much less time consuming and less of a
bother than actually purchasing and storing the commodity involved.
Second, it you wish to purchase, say, 10,000 bushels of wheat to speculate
on the price of wheat you will have to come up with $20,000 to purchase the
wheat and an additional $10,000 to store the wheat until September for a
total of $30,000. If the price of wheat is $2/bu. in May and you can
purchase a futures contract to purchase 10,000 bushels of wheat at $3/bu.
(or less) in September (the price in May plus the cost of storing the wheat
until September) there is no reason for you to actually purchase the wheat
since you will make at least as much profit or more if you purchase the
futures contract that commits you to purchase the wheat in September for $3/bu.
as you will if you purchase the wheat at $2/bu. in May and store it until
September.
In addition, you will have to come up with much less cash to purchase the
futures contract than you will have to come up with to purchase the wheat.
When you purchase a futures contract you only have to come up with the
commission paid to the broker and enough collateral to convince the
counterparty to your contract that you will, in fact, be able to live up to
your end of the contract. The collateral posted on a futures contract is
referred to as the margin, and it can be as little as 10% or even as
low as 5% of the value of the wheat covered by the contract. That means that
instead of having to come up with $30,000 to purchase and store 10,000
bushels of wheat you can place the same bet on the price of wheat in
September by coming up with only $3,000 (ignoring the broker's commission
which I will do from now on to simplify the exposition) if the margin is 10%
or only $1,500 if the margin is 5%.
Just as with option contracts, futures contracts allow you to leverage your
equity. If you have $30,000 to invest in this speculative endeavor you have
the option of using that $30,000 to purchase 10,000 bushels of wheat and
storing it, or at a 10% margin you can use your $30,000 as collateral for 10
futures contracts that commit you to purchase 10,000 bushels of wheat each.
If you are right and the price of wheat is $4/bu. in September you will make
a $10,000 profit on the 10,000 bushels of wheat you purchased with your
$30,000 if you chose the first option, and you will make a $100,000 profit
on the 100,000 bushels of wheat you have committed yourself to purchase with
your $30,000 if you chose the second option. In other words, you can
leverage your investment tenfold by purchasing the futures contracts at a
10% margin. If the margin is 5% you can leverage your investment twentyfold
by purchasing 20 contracts that commit you to purchase 200,000 bushels of
wheat.
Futures contracts not only leverage your equity, they leverage your risk as
well. If you purchase the wheat in the above example, and the price falls to
$1/bu. instead of increasing to $4/bu. as you had expected, you will lose
the $10,000 you spent on storage and an additional $10,000 when you are
stuck with 10,000 bushels of wheat you bought at $2/bu. that can now only be
sold at $1/bu. This 67% loss on your investment may sound grim, but if you
had instead purchased 10 futures contracts on a 10% margin that committed
you to purchase 100,000 bushels of wheat at $3/bu. and you can only sell
that wheat for $1/bu. on its due date you are out $200,000. That's a 667%
loss on your investment. If you had purchased 20 contracts on a 5% margin
your loss would be $400,000 on your $30,000 investment. That's more than 13
times the amount you had planned to invest in the first place!
This brings us to a very important point: When derivatives are used to hedge
against a risk of potential loss the risk that is hedged is transferred from
one party of the derivative contract to the other. There is no increase in
risk in the system as a whole, and there even may be a reduction in risk in
the system as a whole if the risk is transferred from an individual or
institution that is less able to cope with the potential loss to an
individual or institution that is better able to cope with the potential
loss. As a result, using derivatives to hedge against a potential loss can
have the effect of increasing the stability of the economic system as a
whole. This is not the case when derivatives are used for pure speculation.
When derivatives are used for pure speculation where neither party is
hedging against a risk of potential loss, both parties to the contract
assume risk that they otherwise would not have assumed. There is no transfer
of risk, and the total risk of potential loss in the system increases. The
fact that speculators add to the
liquidity of the market and thereby enhance
the ability of other participants to hedge does not negate the fact that pure speculation increases the risk in the system as a whole and, as a
result, reduces the stability of the system as a whole.
While in theory, pure speculation is a
zero-sum game where the losses of one party
are equal to the gains by another and all that occurs is a transfer of
wealth from one group of individuals to another, in practice this is not
necessarily the case and often is, in fact, not the case. This theory
ignores the possibility of default on the part of those who speculate and
the damage that can be done to those who are directly and indirectly
affected by the speculative bubbles that are created as a result of
speculation. When speculative bubbles burst, the inability of those affected
to meet their contractual obligations can have a cascading effect that can
bring the entire economic system to its knees. The history of this being so
goes back at least 800 years. (Kindleberger
MacKay
Graeber) The recognition of this problem led
to the establishment of
exchanges and
clearinghouses. These are institutions that
are designed to minimize the risk of default and also to minimize the risks
of manipulation and fraud within the market.
The markets for options and futures contracts have become highly efficient
as these contracts have been standardized and are widely traded on
exchanges where an exchange is simply a
central meeting place where trading takes place. The importance of an
exchange is that it provides a place where trading is in the open, and all
of the participants in the market can see the quantities bought and sold and
the prices at which trades are made. This kind of openness, or what is
referred to as
transparency in the market, is designed to
minimize fraud and the ability of traders to manipulate prices.
In addition, the risk of default on derivative contracts has been minimized
through the establishment of
clearinghouses whereby the contracts agreed
upon between individuals at the exchange are cleared through a separate
corporation where that corporation—the clearinghouse—becomes the
counterparty to the buyers and sellers in the contracts that are agreed upon
in the exchange. The way in which the risk of default is minimized for those
derivatives that are traded through an exchange with a clearinghouse can be
seen by examining the way in which a futures contract comes into being.
If you wish to enter into a contract to buy (or sell) wheat or some other
commodity at some point in the future you go to your broker and place an
order. Your broker submits your order to the exchange where all of the
offers to buy and sell are submitted by the brokers that are members of that
exchange. The brokers’ traders on the floor of the exchange match the offers
to buy with the offers to sell in the future where the prices at which the
commodities are to be bought and sold are determined through an auction
process among the traders. The contracts that have been agreed upon are
submitted to the clearinghouse at the end of each trading day to be cleared,
and the cash transactions between the brokers and the clearinghouse are
settled. The outstanding contracts held by each broker's clients are then
revalued in accordance with the prices set during the day, and each broker
is required pay to the clearinghouse any balance his or her clients may have
accumulated in order to maintain the margin required on their contracts as a
result of the day’s trading. Once the trades of the day have been
reconciled, and the margin requirements have been met by the members of the
exchange, the contracts between the clients of the brokers are dissolved,
and the clearinghouse becomes the counterparty to both sides of each of the
contracts the clients have entered into. Your broker then delivers to you
your contract with the clearinghouse that you sought to enter into.
The efficiency of this system arises from the fact that all of the
participants in the market are policed by the brokers, by the exchange, by
the clearinghouse, and the entire process is regulated by the government.
All transactions are executed publicly on the floor of the exchange,
available for all to see, and changes in the values of the outstanding
contracts are reconciled each day in order to maintain the collateral each
broker must deposit with the clearinghouse as determined by the margin
requirement on the contracts his or her clients have with the clearinghouse.
You are legally responsible to your broker to perform on your contract and
your broker is legally responsible for your performance to the clearinghouse
as well. That means that if you default on your contract your broker is
responsible to make that contract good to the clearinghouse, and if your
broker defaults to the clearinghouse, the clearinghouse is on the hook to
make that contract good to whomever originally made it with you. That
protects your original counterparty from default on your part, and it also
protects you from default on the part of your original counterparty since
your counterparty’s broker is responsible for the contract his client made
with you as is the clearinghouse.
The only situation in which your contract will not be honored is if the
clearinghouse were to default. This is clearly a possibility, but the fact
that 1) the changes in the values of all outstanding contracts between
brokers and the clearinghouse must be reconciled each day, 2) each broker is
required to maintain the margin on his or her clients’ contracts with the
clearinghouse as the values of his or her clients’ contracts fluctuate each
day, 3) the brokers’ clients are required to maintain the margin on their
contracts with their brokers as the value of the contracts fluctuate each
day, and 4) the fact that the behavior of all of the participants in the
market is strictly regulated and supervised by the government minimizes this
possibility.
Even though derivatives have been around for a very long time, the way in
which they have been used has changed dramatically over the past forty
years. Prior to the 1970s, futures contracts were used for commodities, and
options contracts in commodities had been outlawed since 1936. In the 1970s
futures contracts for financial assets were introduced, and the ban on
option trading in commodities was lifted in 1981. Option trading was
subsequently extended to include financial assets and foreign exchange as
well as commodities, and new kinds of options and futures contracts were
created—contracts based on indices of commodity and financial asset prices
as opposed to those based on individual commodities and individual financial
assets.
At the same time, much of the trading in derivatives moved from an
exchange/clearinghouse environment to the
over-the-counter market where contracts are
not standardized and are made directly between individuals or institutions
without the protection of a clearinghouse, with very little government
regulation, and with very little, if any, transparency. In addition, an
entirely new category of derivative came into being: the
swap, whereby contracts were devised that
allowed income streams generated by assets to be exchanged in domestic as
well as in foreign currencies,
and in 1997 the
Credit Default Swap was born.
A
Credit Default Swap (CDS) is a kind of
insurance contract wherein the seller of a CDS agrees to compensate the
buyer against the consequence of an adverse credit event such as the issuer
of a bond defaulting on its interest or principal payment. The buyer pays
the seller a quarterly or biannual premium for the protection provided by
the seller where the protection generally consists of an agreed upon,
lump-sum payment from the seller to the buyer should the adverse credit
event (e.g., default) occur.
The market for
Credit Default Swaps
came into being in the
late 1990s, and this market played an important role in the mortgage market
in the 2000s. In particular, it played an important role in the markets for
Mortgage-Backed Securities and
Collateralized Debt Obligations since CDSs
made MBSs and CDOs more attractive to those who sought protection against
the risk of these kinds of bonds defaulting. Some regulated institutions
could reduce their capital requirements by purchasing credit default
protection against the MBSs and CDOs they held, and hedge funds and other
financial institutions could use CDSs to hedge positions that involved MBSs,
CDOs, or other forms of
Asset-Backed Securities.
Insurance is generally subject to government regulations that force
insurance companies to maintain reserves commensurate with their obligations
to policy holders. In addition, insurance companies generally refuse to
issue insurance policies where the beneficiary of the policy does not have
an
insurable interest in what is being insured.
In particular, they bar people from obtaining insurance on property they do
not own or on which they will not otherwise suffer a loss if the property is
destroyed or damaged. In addition, people are generally not allowed to
insure property for more than the damages they will incurred if the property
is lost or damaged. But even though CDSs are a kind of insurance, the
Commodity Futures Modernization Act (CFMA)
passed in 2000 explicitly blocked regulation of the market for Credit
Default Swaps. This made it possible for financial institutions to purchase
and sell
Credit Default Swaps 1) to insure debt
instruments that were not owned by the purchaser, 2) to purchase and sell
multiple CDS contracts against these same debt instruments, and 3) for
financial institutions to sell CDS insurance contracts without setting aside
reserves against the contingency that a credit event covered by their
contracts might actually occur and they would have to honor the terms of
their contracts. It also made
synthetic CDOs
possible.
A
synthetic CDO offering is structured in the same way an ordinary CDO
offering is structured, but there are a number of important differences
between synthetic and ordinary CDOs. The first is that the Special Purpose
Vehicle (SPV) that creates a synthetic CDO sells Credit Default Swaps and
holds safe securities (such as government bonds) as collateral instead of
purchasing and holding the debt instruments that underlie the CDO. The way
this works is the sponsor of a synthetic CDO incorporates a SPV and puts
together a list of debt instruments for which the sponsor wishes to sell
default protection. The SPV then sells Credit Default Swaps to those who are
willing to pay a premium for default protection on the listed securities.
These Credit Default Swaps sold by the SPV are the primary earning assets of
the SPV.
The SPV then structures an offering of synthetic CDO tranches similar to the
structure of the MBS offering shown in Figure 8.1 with the same kind
of subordinated payout to the investors in the synthetic CDOs that is used
in the payout structure of an ordinary CDO or MBS. The proceeds from the
sale of the synthetic CDOs are, in turn, invested in safe securities. These
safe securities (government bonds, for example) become the collateral held
by the SPV. The interest payments received from these securities combined
with the premium payments received from the
Credit Default Swap (CDS) contracts sold by
the SPV provide the funds needed to make the interest and principal payments
to those who invest in the SPV.
This brings us to the second way in which synthetic CDOs differ from
ordinary CDOs. There are two kinds of investors in a synthetic CDO. The
first is the fully-funded investor described above. Fully-funded investors
are required to put up 100% of the money they are putting at risk. They
actually lend money to the SPV in order to receive interest payments on the
CDOs they purchase. This money is used to purchase the safe assets that the
SPV uses as collateral.
The second kind of investor is the unfunded investor. Unfunded investors are
not required to put money up front and do not lend money to the SPV.
Instead, unfunded investors, in effect, sell credit-default
protection to the SPV—protection that insures payment to those who purchased
Credit Default Swaps
from the SPV. All
other investors are subordinate to the unfunded investors in a synthetic CDO
offering, which means, of course, that all other investors in a synthetic
CDO get paid after the unfunded investors get paid. This adds another
level of subordination to the tranche structure of the synthetic CDO,
namely, what is referred to as the super-senior tranche that is sold
to unfunded investors.
The way in which synthetic CDOs are structured is illustrated in
Figure
8.2 which shows the structure of the
ABACUS 2004-2 offering sponsored by Goldman
Sachs in 2004. In spite of the obvious differences between Figure 8.2
and Figure 8.1, they are very much the same in that 87% of the
synthetic CDOs in Figure 8.2 are rated AAA or are subordinated above
the triple-A tranches compared to 78% of the MBSs in Figure 8.1, and
only 5% are rated less than investment grade in Figure 8.2 compared
to 4% in Figure 8.1.
Figure 8.2: Structure of the ABACUS 2004-Synthetic CDO
Offering.
Source:
Financial Crisis Inquire Commission.
In terms of the payout from the investment, there is no difference between a
synthetic CDO sells credit default swaps against MBSs and holds safe
investments and an ordinary CDO that actually holds the MBSs insured by the
synthetic CDO. If there are no defaults in the underlying MBSs the CDO
investors will all get paid whether the CDO is synthetic or not. If some of
the underlying MBSs in a synthetic CDO default, some of the investors who
purchased the lower tranches of the synthetic CDOs will not get paid as some
of the safe securities will have to be sold to pay the CDSs that insured
those MBSs in the synthetic CDO. But the same would be true if those
investors had invested in the lower tranches of an ordinary CDO sold by an
SPV that actually held the MBSs that defaulted. It makes no difference from
the perspective of the payout to the investor what form the CDO takes. In
either case, the amount the investor gets paid or looses is the same.
There is, however, a fundamental difference between investing in a synthetic
CDO and investing in an ordinary CDO in terms of the kind of
investment being made. Investors who purchase ordinary CDOs are investing in
the mortgage business. The money they are investing is used to
purchase mortgages—albeit indirectly by way of financing the tranches of the
CDOs that are used to purchase MBSs that are used to finance the purchase of
mortgages.
Investors who purchase synthetic CDOs are investing in the
insurance
business, not the mortgage business. The money they are investing is used to
insure the debt instruments that underlie the Credit Default Swaps
sold by the SPV, not to purchase mortgages. In addition, the collateral held
by the SPV is not put up by the borrowers. It is put up by the lenders—those
who purchase the synthetic CDOs. And it is not held to protect those who
lend by purchasing the synthetic CDOs; it is held to protect those who
purchase the Credit Default Swaps that are sold by the SPV.
In the case
of a default on an underlying asset, the collateral is sold to pay the CDS
holders, not the synthetic CDO holders.
Not only were the fully funded investors in synthetic CDOs investing in the
insurance business, they were investing in the insurance business in an
unregulated market. There were no government regulations that prevent those
who were buying the MBS insurance offered by the SPV from being the very
same people who selected the MBSs that were being insured. The conflict of
interest here should be obvious; especially since the people who purchased
the insurance and selected the MBSs to be insured did not have to own the
MBSs they had selected. They had nothing to lose if the MBSs they selected
to insure went bad, and they receive a huge payout if the MBSs they
selected did in fact go bad.
Initially, the institutions that sold Credit Default Swaps were pretty much
limited to
AIG and a few
monocline insurance companies such as
MBIA
and
Ambac, but with the invention of the synthetic
CDO the major players in the MBS and CDO markets such as
J. P. Morgan
and
Goldman Sachs were able to secure credit
protection from an ever increasing number of investors through the sale of
the fully-funded, synthetic CDOs. All that was required to sell a
fully-funded synthetic CDO was to find a buyer who
1.
had enough money to make the purchase,
2.
sought the safety of the investment-grade rating of these bonds
seemed to provide, and
3.
was unable to understand exactly what it was that was being
purchased.
Investment-grade, fully-funded, synthetic CDOs were sold to banks, pension
funds, endowment funds, hedge funds, mutual funds, insurance companies, and
municipal governments throughout the country and all over the world.
Virtually any entity that met the above criteria was fair game to those who
sold these securities. (FCIC
WSFC)
Finally, as is clear from the way in which the synthetic CDOs were
structured, those who bought the unfunded, super-senior tranches were given
added protection from loss by the fully-funded tranches since the
fully-funded tranches were subordinated to the super-senior tranches and
took the first losses. This was particularly appealing to many of the
institutions that sponsored synthetic CDOs since these institutions did not
have to put up cash to purchase the Super-Senior tranches they had created
and could receive income from these tranches without having to set aside
capital to support them. As a result, many of the super-senior tranches of
the synthetic CDOs ended up on the books of the financial institutions that
sponsored these CDOs, much to their regret when the crisis came. In other
words, these institutions assumed the risk of selling credit-default
protection to the SPV, a practice that proved disastrous in the fall of
2008. (FCIC
WSFC)
The
systemic risk the shadow banking system
posed—that is, the threat to the financial and economic systems as a
whole—especially when combined with unregulated derivative markets that
operated without exchanges or clearinghouses, should have been obvious to
regulators, but ideological blindness inspired by an almost religious faith
in free markets made it impossible for policy makers and elected officials
to even see this kind of risk let alone take it seriously. When this
blindness was combined with the fact that the vast majority of our elected
officials knew virtually nothing about the history of the financial system,
the stage was set for the financial crisis that began in 2007 and reached
its climax in 2008.
The irony is that the first run on a shadow bank occurred fully ten years
before the entire shadow banking system collapsed in the fall of 2008 when a
run on a single hedge fund,
Long-term Capital Management, nearly caused a
worldwide financial meltdown in 1998. This run caused a near panic among
policy makers and within the financial community at the time, and, yet, as
we will see, nothing was done to curb the excesses of the shadow banking
system or to regulate the over-the-counter derivatives markets in the wake
of this near disaster.
Endnotes
The ratings, AAA, BBB, etc., represent the
rating agencies estimate of the probability of default for the security
being rated based on the historical performance of securities that have
held that particular rating in the past. The ten year time horizon for
the historical performance of Moody’s ratings from 1970-2010 is given in
Moody’s
Confidence Intervals for Corporate Default Rates.
It should be noted reserve and capital
requirements are not the same thing. Capital requirements define the
amount of equity an institution must have relative to its assets (or
liabilities) and are designed to limit the total amount of leverage the
institution can achieve. They are designed to minimize the solvency
problem of the institution. Reserve requirements limit only deposits and
are designed to minimize the liquidity problem of depository
institutions. In addition, just as there are different reserve
requirements for different kinds of deposits, there are different
capital requirement for holdings of different kinds of assets in
different kinds of regulated institutions. See
Feinman for a discussion of how reserve
requirements are determined. The determination of capital requirements
is discussed in
Baily.
See
Tobin for a discussion of the kinds
interactions that take place within the financial system that determine
the reserve positions of banks.
It is
worth noting that a futures contract only hedges against the risk of
adverse price changes. It does not hedge against other kinds of risks
such as the possibility of adverse weather conditions that the farmer
may have to face.
It
should be noted that given the fact that futures contracts generally
require the counter parties to maintain their margin requirements as the
values of their contracts fluctuate, it is very unlikely that anyone
would suffer an actual loss of this magnitude on a futures contract. It
is most likely that at some point they would choose to cut their losses
and liquidate their contract as the market turned against them rather
than try to wait until the market turned in their favor. Even if they
did try to wait it out they would have to be able to meet the margin
requirement as their losses accumulated. When they ran out of cash and
could no longer meet their margin requirement their position would be
liquidated by their counterparty. In general, only if they chose to wait
it out and have sufficient resources to meet their margin calls would
their loss be this great. It is possible, however, that the market could
change so quickly that neither party to a futures contract is able to
liquidate the contract before this kind of loss occurred.
Interest Rate Swaps comprised the largest segment of the derivatives
market in
2008 (52%) and in
2013 (65%), but since they appear to have played a relatively minor
role in the financial crisis (other than by adding to the degree of
uncertainty and apprehension) they are not discussed here. See:
BIS and
FCIC.