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Global Financial Crisis 2018 and Collateralized Debt Obligations (CDOs) Market

Debt and Financial Crisis 2008

There are many reasons why the financial crisis could rise and hit society. Some of them are the existence of market failure due to the asymmetric information and inadequate regulation (Tirole, 2017). Moreover, one of the fuels of this crisis is the excessive debt or securitization that circulates in the market. This problem was exactly the heart issue of the Global Financial Crisis (GFC) in 2008. Report from the Financial Crisis Inquiry Commission (2011) shows that from 1978 to 2007, the amount of debt held by the financial sector in the US jump from 3 trillion to 36 trillion dollars. It worsens by the long period of low-interest rate policy by the Fed. In general, the crisis coming from the less prudence action taken by all agents in the financial market. Especially on how to manage the debt in the economic system. The question is, “what makes these debts bad for the economy?”.

The evidence show after the price of houses in the United States goes down, and people could no more pay their residence mortgage (because the decreasing of house prices make higher mortgage interest), the risk spread wildly into the financial system and deteriorate it. Furthermore, the massive default of residential mortgage in the United States (U.S) triggers the collapse of the financial market through the complexion of financial engineering at that time. Collateralized Debt Obligations (CDOs) is one of that complication that makes people encounter the opaqueness of the actual risk behind the financial instruments.

If excessive securitization was the fuel, then the CDOs was the machine of the economic bubble in 2008.  Barnett-Hart (2009) noted CDOs have been responsible for $542 billion of the nearly trillion dollars in losses suffered by financial institutions since 2007[1]. It takes a long explanation about what is CDOs and how CDOs could be one of the things that made financial disasters in 2008. This short paper could not cover all of CDO’s aspects and stories. But, in simple words, CDO is the collection of various financial assets such as the loan. Why these financial assets have to be combined on to CDO? One reason is the diversification benefit coming from combining securities.

 

Collateralized Debt Obligation (CDO) and the “Myth” of Diversification

The basic principle of CDO involves the repackaging of fixed income securities and the division of their cash flows according to a strict waterfall payment structure[2] which related to the risk of each tranche. The reason CDOs made at the first place was to gain lower risk from riskier securities as benefit from diversification. In theory, by pooling together several imperfectly correlated assets, it is possible to use diversification to decrease unsystematic risk[3].

There are five key types of players were involved in the construction of CDOs (Financial Crisis Inquiry Commission, 2011), they are 1) securities firms, 2) CDO managers, 3) rating agencies, 4) investors, and 5) financial guarantors. Each of them has its function as follows:

  1. Securities firms underwrote the CDOs. Their jobs were to approve the selection of collateral, structured the notes into tranches, and responsible for selling them to the investors. Their focus was on generating fees and structuring deals that they could sell;
  2. CDO manager has the responsibility to select the collateral, such as mortgage-backed securities, and in some cases manage the portfolio on an ongoing basis.;
  3. The rating agencies have the role in providing basic guidelines on the collateral and the structure of the CDOs in close consultation with the underwriters;
  4. The CDO investors focused on different tranches based on their preference for risk and return;
  5. Financial guarantors are the issuers of over-the-counter derivatives called credit default swaps. They were played a central role by issuing swaps to investors in CDO tranches, promising to reimburse them for any losses on the tranches in exchange for a stream of premium-like payments.

Basically what CDO made is similar to Asset-Backed Securities (ABS). For example, ABS pooled mortgage[4] loans with different qualities from different states and structured them into some tranches according to its risk. The basic structure is that an ABS was divided into different tranches: senior tranche, a mezzanine tranche, and equity tranche with each has their portion in ABS. Senior tranches are the safest pool of loan (less probability to default) with the lowest return for invertor.

On the other hand, the equity tranches are coming with the highest risk and also the highest return for the investors. It is obvious to look mezzanine tranches are lying between senior tranches and equity tranches. The structure of the ABS can also be characterized in terms of who bears the losses on the underlying portfolio. In this case, the equity tranches holder will bear the risk of default first before other types of the trench (Hull, 2008). Each type of tranches forms the securities could be marked by rating, for example, AAA, AA, and A for senior tranches; BBB, BB, B for mezzanine tranches.

It is not hard to understand that senior or AAA tranche could be easily sold in the financial market that also makes them have a big portion in ABS securities. On the other hand, the BBB or mezzanine tranches are harder to sell in the market. In this situation, Wall Street came up with an idea about repackaging these BBB tranches into new kind of securities products: CDOs[5] (Figure. 1). The process of the CDOs creation could continue by make CDO from CDO’s trenches as it usually called CDO squares. Indeed, it makes the CDOs market extremely complicated to understand by the investor. Furthermore, The credit default swap protection made the financial guarantor much more attractive to potential investors because they appeared to be virtually risk-free. Indeed, it created huge exposures for the credit default swap issuers if significant losses did occur (and it did happen!).

In this scheme, the B to BBB tranche or the mezzanine type from ABS could be “upgraded” into AAA rate in CDOs.  Still, it is not clear how they could be transformed like that, but the rating agencies believed that diversification could make a benefit for the investor by imposing significant lower risk. The basic theorem about the diversification also said so.

The basic theorem to assess the risk in the financial market is known as Modern Portfolio Theory (MPT). It commonly uses the mean-variance portfolio optimization technique to find an efficient combination of different portfolios. Under the Capital Asset Pricing Model (CAPM) assumption[6], the efficient portfolio is the market portfolio of all stocks and securities. As a result, the expected return of any security depends upon its beta with the market portfolio (Berk & DeMarzo, 2014). The mean-variance portfolio optimization technique firstly introduced by Markowitz (1952). He showed that the diversification provided the opportunity to reduce risk without sacrificing expected return. Further study by Tobin (1958) known as “Separation Theorem,” applied Markowitz’s techniques to find this optimal risky portfolio. Tobin shows that investors could choose their ideal exposure to risk by varying their investments in the optimal portfolio and the risk-free investment.

At the beginning of CDO was introduced, it contained relatively safer securities, but it gradually changes from 1997 to 2007 by embrace riskier assets. Barnett-Hart (2009) found that the CDO managers began investing more heavily in structured finance securities, most notably subprime RMBS, as opposed to corporate bonds (Table 1). The changes of CDO composition had created a tremendous latent risk that dramatically emerged upon financial markets in 2007. The more concentrated securities in CDO expose all parties with higher risk as the portfolios becoming more correlated with each other.

When risky asset concentrated in CDOs, it made the conditions for using the mean-variance portfolio optimization technique was not fulfilled. The subprime mortgages have a systemic risk which they could be massively affected by the market fluctuation. The prediction of diversification makes an efficient portfolio combination cannot be met then.  When one mezzanine trench of ABS failed, then others same trench most likely have the same way to collapse. Even when one trench was marked by AAA in CDO, because it was originally from the subprime mortgage loan, the systemic risk still appeared through the entire market.

The question now, how the Credit Rating Agencies (CRAs) give a good rate for such this risky CDO at the first place? It also raises the question about why this kind of asymmetric information could not be mitigated by CRAs as their function as information provider about the signal of the quality type of securities.

Asymmetric Information and Credit Rating Agencies (CRAs)

The asymmetric information literature which looks at the impact of financial structure on economic activity mostly discuss the differences in the information available to different parties in a financial contract. In the context of a borrower-lender transaction, borrowers mostly have Informational advantage about the investment quality than the lenders. The situation could end up with the classic “Lemon Market” described firstly by Arkelof (1970).  

One result of this lemons problem in the financial market is that some high-quality borrowers may out of the market, then profitable investment projects should not exist in the market. This result happens since high-quality borrowers have to pay a higher interest rate than they should because low-quality borrowers pay a lower interest rate than they should (Miskhin, 1990). It lefts the market with the just low-quality borrower, which means make the economy as whole the vulnerable.

This lemons problem is quite similar to what happened with the subprime mortgage crisis in the US in 2008. Before the crisis hit the U.S, many of the largest CDO dealers were fully integrated (doing origination, issuance of RMBS, issuance of CDOs, and, finally, servicing the mortgages), which gave them an informational advantage over potential buyers (Beltran, Coldren, Thomas, 2013). On the other sides, the creation of CDO makes underwriters of CDOs could decrease the capital charges imposed by the Basel Accords and their internal risk requirements. Then the CDO underwriters could free up cash to make new loans to the market regardless of the high risk of the loan. The combination of these two situations caused, somehow created one situation that of the asymmetric theorem said, that low-quality borrowers pay a lower interest rate than they should.

In the financial market, Credit Rating Agencies (CRAs) filled the gap of information between lender and borrower. CRAs produced the rating for the securitize sold in the market by gathering information about an important category of the borrowers specifically bond issuers (White, 2016). Indeed, In CDOs market, investors came to rely almost solely on CRAs’ ratings to assess CDO investments quality due to its complexity. Similarly, with the theory of asymmetric information, this rating provides such kind of signal in the lemon market problem to segregate different type of quality of the borrower or the issuer of securities.

Problems of CDO ratings by CRAs came from two reasons. First, because of the rapid growth CDOs push the analyst form CRAs tho release the rating without doing proper due diligence on the risk of the loan assets. In a way, the shortcoming of knowledge analyst contributes to poor rating model that should be avoided in the first place. Second, because not only the lenders but also the borrowers should be interested in providing credible information about their creditworthiness to prospective lenders, thus both sides should be willing to pay for the services. This situation creates an incentive for CRAs to give a higher rating on CDOs issued by securities firms. The inclination of the CRAs to make their clients, the securities agencies, happy one of their problem in CDOs market, which then has substantial consequences for Global Financial Crisis 2008.

All those reasons made CRAs that initially have a role in reducing the asymmetric information in the financial market, converted to such a reckless analyst who developed CDO’s rating with insufficient modeling and inadequate historical data. Thus, the CDAs failed to capture the systemic risk due to the wrong calculation about the correlation among the CDO’ asset-backed securities the underestimate the risk of the house price fluctuation. Besides, the ratings of subprime RMBS relied on historical data consist of a relatively healthy economic environment, with very little data on periods of significant declines in house prices. Then, the calculation for default probability that might be used to develop the rating score could not give any senses of risks at all.

 

Conclusion and Lessons

Collateralized Debt Obligation (CDO) multiple the exposure of risk to the lender or investor. The asymmetric information did happen through CDO’s market and then became one of the factors that lead to the economic downturn in 2008.  Credit Rating Agencies (CRAs) worsen the situation by producing an unreliable rating for CDO’s. The high ratings erroneously given CDOs by CRAs encouraged investors and financial institutions to purchase them and enabled the continuing securitization of nonprime mortgages.

There are some solutions that could be provided by either strengthening the financial regulation by the government or by enforcing the agents within the derivative market, such as CDO, to conduct the better rules within their company. First, the transparency of securities products and how it’s rating calculate. This paper has discussed how the complexity of derivative product lead investor hugely relied on CRAs’ rating to make the investment decision. These complexities did not ever try to be simplified by CRAs so the investors can have full acknowledgment about the risk that they had to take.

Secondly, on the other side, the government has to construct a precise regulation that gives the right rules for every agent involved in CDO’s business process so they could play their role correctly. For example, one idea is that the originator of CDO has obligatory to keep a certain percentage of all tranches. It makes them could become a capable administrator of the securitized portfolio in the first case while increasing the confidence of the investors (because they know that the originators also held the same product). Furthermore, the CRAs could make this behavior as one of their variables to give a certain level of rating.

[1] According to CreditFlux Newsletter, as of January 8, 2008.

[2] Waterfall payment is a repayment system by which senior lenders receive principal and interest payments from a borrower first, and subordinate lenders receive principal and interest payments after (https://investinganswers.com/dictionary/w/waterfall-payment).

[3] Unsystematic risk is unique to a specific company or industry. Also known as “nonsystematic risk,” “specific risk,” “diversifiable risk” or “residual risk,” in the context of an investment portfolio, unsystematic risk can be reduced through diversification. (https://www.investopedia.com/terms/u/unsystematicrisk.asp)

[4] It is also called Residential Mortgage Backed Securities (RMBS).

[5] Some references called it as ABS CDOs since it came from the tranches in ABS. I use only “CDOs” within this papers as to reference ABS CDOs.

[6] The cost of capital for a risky investment equals the risk-free rate plus a risk premium. The Capital Asset Pricing Model (CAPM) states that the risk premium equals the investment’s beta times the market risk premium:

References

Akerlof, G. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84(3), p.488.

Barnett-Hart, A. (2019). The Story of the CDO Market Meltdown: An Empirical Analysis. Bachelor of Arts. Harvard.

Berk, J. and DeMarzo, P. (2014). Corporate finance. 3rd ed. Boston, USA: Pearson.

Hull, J. (2009). The credit crunch of 2007: what went wrong? Why? What lessons can be learned?. The Journal of Credit Risk, 5(2), pp.3-18.

  1. Mishkin, F. (1990). Asymmetric Information and Financial Crises: A Historical Perspective. NBER Working Paper, [online] 3400. Available at: https://www.nber.org/papers/w3400.pdf [Accessed 13 May 2019].

The Financial Crisis Inquiry Commission 2011, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, viewed 9 April 2019, available at: https://fcic.law.stanford.edu/report .

Tirole, J. (2019). Economics for The Common Good. London: Princenton University Press.

White, Lawrence J., The Credit Rating Agencies and Their Role in the Financial System (June 7, 2018). Forthcoming in E. Brousseau, ed., Oxford Handbook on Institutions, International Economic Governance, and Market Regulation, Oxford University Press . Available at SSRN: https://ssrn.com/abstract=3192475

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