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.
1
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.
2
Credit Event
CDS writers have to pay when credit event occurs
on reference obligation.
•
•
•
•
•
bankruptcy
default
failure to pay
repudiation/moratorium
restructuring
3
Securitization (pp. 261-263)
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
Wall St
firm
SPV
investors
rating
agencies
4
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.
6.5% mortgages
SPV
80%, Senior tranche at 4%, AAA
5%, Equity at 10%,
unrated
15%, Mezzanine at 8%,
BB
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.
5
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
2nd and 3rd pools as they could.
Securities issued by a 1st pool called mortgage bonds. Securities issued
by 2nd and subsequent pools called CDOs.
6
Tranche Securities of 2nd Pools
2nd pools called CDOs. Formed out of Mezzanine securities from various 1st
pools. 2nd 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.
Wall St
firm
SPV
Senior (80%)
Equity (5%)
Mezz (15%)
investors
CDO
Senior (70%)
Equity (10%)
Mezz (20%)
rating
agencies
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.
3rd Pools (known as a CDOs-squared)
Wall St
firm
SPV
Se(.80)
Eq(.05)
Me(.15)
investors
CDO
Se(.7)
Eq(.1)
Me(.2)
CDO2
Se(.6)
Eq(.1)
Me(.3)
rating
agencies
As SPV-pools became stuffed with subprime, collapse of CDO and CDO2
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
8
there weren’t enough regular mortgages any more.