1 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 1.bond issuers at time of issue to help sell bond (often done with munis). 2.bond holders interested in protecting themselves from bond default. 3.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.

2 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.

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

4 Securitization (pp ) Prior to financial crisis, housing prices sometimes dropped regionally, but never all at once across the country. Securitization – conversion of a pool of assets (e.g., auto loans, student loans, mortgages) into securities that can be sold in the capital market. borrower lender investors rating agencies SPV Wall St firm

5 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 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 tranche securities not yet paid off, with any extra going to 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. 80%, Senior tranche at 4%, AAA 5%, Equity at 10%, unrated 15%, Mezzanine at 8%, BB

6 Mortgage Bonds vs. CDOs Equity tranche securities often kept by the Wall St firms because so profitable. Investors (municipalities around the world, pension funds, individuals) were ravenous for Senior tranche (ie, AAA) securities. Investors generally relied on AAA rather than trying to learn 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 decided to get clever – tried to form as many 2 nd and 3 rd pools as they could. Securities issued by a 1 st pool called mortgage bonds. Securities issued by 2 nd and subsequent pools called CDOs.

rating agencies Tranche Securities of 2 nd Pools 2 nd pools called CDOs. Formed out of Mezzanine securities from various 1 st pools. 2 nd pools then sold tranche securities (also called CDOs) to pay for them. In this way, with rating agency complicity, AAA securities could be manufactured out of BB. SPV Senior (80%) Equity (5%) Mezz (15%) investors CDO Wall St firm Senior (70%) Equity (10%) Mezz (20%) 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 a supply problem. Takes several SPVs to produce enough mezzanine securities to form a CDO. Somehow need to generate more mortgages.

rating agencies 8 3 rd Pools (known as a CDOs-squared) SPV Se(.80) Eq(.05) Me(.15) investors CDO Wall St firm Se(.7) Eq(.1) Me(.2) As SPV-pools became stuffed with subprime, collapse of CDO and CDO 2 tranche securities just a matter of time. The few who saw this coming, bought CDSs on the whatever tranches securities they could (from AIG and others who were complacent from previous profits), and became rich. Why subprime? Because CDOs were clamoring for more product and there weren’t enough regular mortgages any more. CDO 2 Se(.6) Eq(.1) Me(.3)