An Overview of the 2008 Financial Crisis
(the perspective of an electrical engineer on Wall Street)
Samir Padalkar PhD, samirpad@gmail.com
1
Roadmap
•
•
•
•
•
•
•
Real Estate Bubble
Security Definitions
CDO Issues
Rating Agencies, FNMA, FHLMC, AIG
Federal Reserve
2000 Internet Bubble Comparison
Where are we today
Case Shiller Property Values Index (source Wikipedia)
fed funds rate
7
6
5
4
3
2
1
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
0
fed funds rate
Fed Funds Rate
(source Federal Reserve)
MORTGAGE BACKED SECURITY (MBS)
mortgage
$200k
6%
30 years
mortgage
$250K
6.5%
30 years
MBS
6%
weighted avg
coupon,
30 year
weighted
average
maturity
Several individual mortgages are packaged into one security
MBS has a Weighted Avg. Coupon & Weighted Avg. Maturity
Mortgages made to Prime customers ended up being securitized
By FNMA & FHLMC
Mortgages made to Subprime customers ended up being securitized
by Private Banks
4
COLLATERALIZED DEBT OBLIGATION – CASH CDO
MBS
6%
30 years
Senior
AAA
70%
MBS
6.5%
30 years
Mezzanine
BBB
25%
Equity
5%
Several MBS Bonds are packaged into a CDO
CDO has several Tranches
Lowest Rated Equity Tranche suffers with first defaults, but has highest yield
Mezzanine Tranche suffers next, still Investment grade, but has lower yield
Senior Tranche is AAA rated since at least 30 % defaults before it is affected,
lowest yield
5
Moody's, S&P, Fitch assigned Ratings to Tranches
COLLATERALIZED DEBT OBLIGATION – CASH CDO
MBS
6%
30 years
MBS
6.5%
30 years
Senior
AAA
70%
Mezzanine
BBB
25%
Equity
5%
Cash CDO is made up using MBS bonds
In most cases, MBS Bonds contained subprime mortgages
Subprime --- FICO score < 640
6
CREDIT DEFAULT SWAP
Premium
CDS
BUYER
Face Value upon default
CDS
SELLER
Reference MBS
CDS is insurance on an underlying reference bond
CDS buyer pays a premium to the CDS Seller
CDS Seller pays Reference Bond Face Value minus recovery
To CDS Seller
AIG sold CDS on several Subprime MBS & CDO
7
COLLATERALIZED DEBT OBLIGATION – SYNTHETIC CDO
CDS
6%
30 years
CDS
6.5%
30 years
Senior
AAA
70%
Mezzanine
BBB
25%
Equity
5%
Simpler to create than Cash CDO, since actual MBS bonds
Are not required
Mortgage Bubble even more inflated by such securities
8
CDO SQUARED
Senior
70%
Senior
70%
Senior
70%
Senior 70%
Mezz 25%
Mezz 25%
Mezz 25%
Mezz 25%
Equity 5%
Equity5%
Equity 5%
Equity 5%
Senior 70%
Mezz 25%
Equity 5%
Mezzanine Tranche difficult to sell, so 4 such tranches make up a CDO^2
9
CDO SQUARED– 10 % DEFAULT
Senior
70%
Senior
70%
Senior
70%
Senior 70%
Mezz 25%
Mezz 25%
Mezz 25%
Mezz 25%
Equity 5%
Equity5%
Equity 5%
Equity 5%
Senior 70%
Mezz 25 %
Equity 5%
10 % default results in 20 % default in CDO^2, Equity wiped out,
Mezzanine suffers 15 % wipe-out out of 25 %
10
CDO SQUARED– 13 % DEFAULT
Senior
70%
Senior
70%
Senior
70%
Senior 70%
Mezz 25%
8%
Equity 5%
Mezz 25%
8%
Equity5%
Mezz 25%
8%
Equity 5%
Mezz 25%
8%
Equity 5%
Senior 70%
2%
Mezz 25%
Equity 5%
13 % defaults results in defaults in AAA Senior Tranche of CDO^2
11
Other CDO Failures
• Correlation between individual loans assumed to be low, say
.2 to .3
• In reality, when the Real Estate Bubble burst, correlations in
individual subprime loans jumped almost close to 1
• Especially if CDO contained a high % of loans from Florida,
California, Nevada, Arizona
• Many Subprime borrowers had an ARM, so in the initial years
they could pay the lower interest rate. When the ARM reset to
a higher rate, subprime people began defaulting.
• Defaults in Cash CDO’s got magnified in Synthetic CDO’s
CDO Pricing
• Gaussian Copula
• Monte Carlo Simulation
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
• The copula function was used to price hundreds of billions of dollars'
worth of CDOs filled with mortgages. And because the copula function
used CDS prices to calculate correlation, it was forced to confine itself to
looking at the period of time when those credit default swaps had been in
existence: less than a decade, a period when house prices soared.
Naturally, default correlations were very low in those years. But when the
mortgage boom ended abruptly and home values started falling across the
country, correlations soared.
• "Everyone was pinning their hopes on house prices continuing to rise,"
says Kai Gilkes of the credit research firm CreditSights, who spent 10 years
working at ratings agencies. "When they stopped rising, pretty much
everyone was caught on the wrong side, because the sensitivity to house
prices was huge. And there was just no getting around it. Why didn't rating
agencies build in some cushion for this sensitivity to a house-pricedepreciation scenario? Because if they had, they would have never rated a
single mortgage-backed CDO."
GLOBAL CDO issuance USD ( millions ) SIFMA
Year
Arbitrage
Balance Sheet
Total
2000
67,987.7
2001
78,453.8
2002
83,074.3
2003
86,629.8
2004
157,820.7
2005
213,306.4
37,958.9
251,265.3
2006
454,970.8
65,673.8
520,644.6
2007
431,862.4
49,738.3
481,600.7
2008
47,938.0
13,948.8
61,886.8
2009
3,443.3
892.7
4,336.0
2010
3,231.0
4,451.1
8,003.4
2011
7,610.8
6,594.8
14,205.7
600,000.0
520,644.6
500,000.0
481,600.7
400,000.0
300,000.0
251,265.3
200,000.0
157,820.7
100,000.0
0.0
86,629.8
83,074.3
78,453.8
67,987.7
61,886.8
14,205.7
4,336.08,003.4
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
15
Federal Reserve Response
•
•
•
•
Almost 0 Fed Funds Rate
Massive Quantitative Easing
Balance Sheet Jan 2008 = 943 Billion
Balance Sheet Jan 2009 = 2298 Billion (2.3
Trillion)
• Balance Sheet Jan 2012 = 2964 Billion (nearly
3 Trillion)
Federal Reserve Balance Sheet, Jan 3, 2008, www.federalreserve.gov
Averages of daily figures
Reserve Bank credit, related items, and
reserve balances of depository
institutions
Week ended
Change from week ended
at Federal Reserve Banks
Jan 2, 2008
Dec 26, 2007
Jan 3, 2007
Reserve Bank credit
891,743
+
18,231
+
32,341
Securities held outright
U.S. Treasury1
Bills2
Notes and bonds, nominal2
Notes and bonds, inflation-indexed2
Inflation compensation3
Federal agency2
Repurchase agreements4
Term auction credit
Other loans to depository institutions
Primary credit
Secondary credit
Seasonal credit
Float
Other Federal Reserve assets
Gold stock
Special drawing rights certificate account
Treasury currency outstanding5
740,611
740,611
227,841
470,984
36,911
4,876
0
39,750
40,000
5,787
5,770
0
16
-1,017
66,612
11,041
2,200
38,821
-
+
+
+
+
13,994
13,994
14,015
0
0
21
0
214
20,000
959
968
0
10
115
11,167
0
0
14
+
38,305
38,305
49,178
3,120
6,806
948
0
1,107
40,000
5,554
5,590
0
38
807
27,007
0
0
615
Total factors supplying reserve funds
943,805
+
18,245
+
32,957
+
+
+
+
+
+
+
+
+
+
17
Federal Reserve Balance Sheet, Jan 2, 2009, www.federalreserve.gov
Averages of daily
figures
Reserve Bank credit, related items, and reserve
balances (millions of dollars) of depository institutions at
Federal reserve banks
Week ended
Dec 31,
2008
2,246,527
Reserve Bank credit
Securities held outright
U.S. Treasury1
Repurchase agreements4
Term auction credit
Other loans
Net portfolio holdings of Commercial Paper
Funding Facility LLC7
Net portfolio holdings of
money market investor
Net portfolio holdings of
Net portfolio holdings of
LLCs funded through the
funding facility8
Maiden Lane LLC9
Maiden Lane II LLC10
Net portfolio holdings of Maiden Lane III LLC11
Float
Other Federal Reserve assets
Gold stock
Special drawing rights certificate account
Treasury currency outstanding12
Total factors supplying reserve funds
Change from week ended
Dec 24, 2008
+
39,255
Jan 2, 2008
+1,354,752
496,227
475,961
80,000
450,219
187,770
+
+
-
233
106
0
29,413
9,098
+
+
+
244,384
264,650
40,250
410,219
181,983
332,410
+
6,614
+
332,410
0
0
0
26,974
20,059
+
+
56
26
+
+
27,990
-862
625,741
11,041
2,200
38,857
2,298,625
+
+
95
305
11,802
0
0
14
39,269
+
+
+
+
+
26,974
20,059
27,990
166
559,086
0
0
+
176
+1,354,928
18
Federal Reserve Balance Sheet, Jan 19, 2012, www.federalreserve.gov
Averages of daily
figures
Reserve Bank credit, related items, and
reserve balances of depository institutions at
Federal Reserve Banks (millions of Dollars)
Reserve Bank credit
Securities held outright1
U.S. Treasury securities
Federal agency debt securities2
Mortgage-backed securities4
Repurchase agreements5
Loans
Net portfolio holdings of Maiden Lane LLC8
Net portfolio holdings of Maiden Lane II LLC9
Net portfolio holdings of Maiden Lane III LLC10
Net portfolio holdings of TALF LLC11
Float
Central bank liquidity swaps12
Other Federal Reserve assets13
Gold stock
Special drawing rights certificate account
Treasury currency outstanding14
Total factors supplying reserve funds
Week ended
Jan 18, 2012
2,903,761
2,602,187
Change from week ended
Jan 11, 2012
+
20,871
+
7,369
Jan 19, 2011
+
487,459
+
395,648
1,647,279
102,030
852,878
0
+
5,964
1,281
14,614
0
+
-
575,660
44,174
135,839
0
8,598
-
239
-
18,030
7,171
9,146
17,798
811
+
-
69
3
1
0
+
19,289
6,800
4,747
146
-916
103,266
155,700
+
+
+
24
10,985
2,799
+
+
+
887
103,196
40,218
+
+
0
0
14
20,884
+
+
0
0
632
488,090
11,041
5,200
44,277
2,964,278
19
Internet Bubble Vs. Housing Bubble
•
•
•
•
Equity (Internet) Vs. Debt-Derivative (Housing)
Derivatives expanded the Housing Bubble much more.
Housing Bubble used more complicated Math to justify pricing
Most of the Housing Bubble Derivatives remained on the books of a few
Financial Institutions.
• Housing Bubble used CDS Insurance to further add to risk. AIG is an
example of a company that significantly underpriced Housing risk, and had
to be bailed out ($ 50+ billion)
Current Situation
• Global Notional Value of OTC Derivatives = 707 Trillion $
• Global Notional Value of Exchange Traded Derivatives = 80
Trillion $
• Global GDP = approximately 60 Trillion $
• Global Bond Market Size = 90 - 100 Trillion $
• Global Equity Market Size = 45 – 55 Trillion $
Table 23A: Derivative financial instruments traded on organized exchanges
By instrument and location
Source- BIS
Notional principal in billions of US dollars
Instrument / location
Futures
All markets
Interest rate
Currency
Equity index
North America
Interest rate
Currency
Equity index
Europe
Interest rate
Currency
Equity index
Options
All markets
Interest rate
Currency
Equity index
North America
Interest rate
Currency
Equity index
Europe
Interest rate
Currency
Equity index
Amounts
outstanding
Dec 2009 Dec 2010 Jun 2011
Turnover
Sep 2011
2009
2010
21,738.1 22,312.0 30,335.3 26,313.4 1,126,519.2
1,380,538.9
20,627.7
144.3
966.1
10,720.9
10,284.9
90.7
21,013.4
170.2
1,128.4
11,863.5
11,351.1
114.8
28,933.0
205.3
1,197.0
16,523.8
15,966.1
128.9
24,999.2
204.5
1,109.8
14,309.6
13,781.4
123.9
1,016,361.6
24,598.7
85,558.8
599,025.0
543,950.8
19,606.8
1,235,907.4
35,771.2
108,860.3
729,195.9
658,193.5
28,649.0
345.3
8,053.6
7,608.7
2.7
442.1
397.6
6,345.3
5,816.6
2.5
526.1
428.8
8,933.5
8,373.4
2.9
557.2
404.4
7,981.1
7,453.9
2.8
524.4
35,467.4
449,389.8
420,030.6
78.8
29,280.4
42,353.4
533,297.9
498,836.1
255.2
34,206.5
51,379.6 45,634.6 52,507.6 54,207.7
533,634.9
606,661.8
434,601.0
1,980.3
97,053.6
216,390.4
188,438.5
657.5
27,294.3
258,556.9
240,483.9
7.7
18,065.4
468,872.0
3,048.5
134,741.3
261,543.9
225,342.9
1,600.9
34,600.2
251,485.3
233,930.0
5.1
17,550.2
46,428.7
147.3
4,803.5
23,874.9
21,817.7
65.3
1,991.9
26,322.6
23,905.0
0.3
2,417.2
40,930.0
144.2
4,560.3
24,353.4
22,070.2
72.3
2,210.9
19,247.2
17,320.8
0.3
1,926.1
47,105.0
183.6
5,218.9
28,868.2
26,154.6
61.8
2,651.8
21,641.0
19,546.9
0.2
2,093.8
49,080.7
119.0
5,008.0
28,162.5
25,585.7
77.4
2,499.5
24,504.6
22,460.5
0.2
2,043.9
22
Amounts outstanding of over-the-counter (OTC) derivatives
By risk category and instrument In billions of US dollars. Source BIS
Notional amounts
outstanding
Gross market values
Risk Category / Instrument
Jun 2009 Dec 2009 Jun 2010
Dec 2010 Jun 2011
Total contracts
594,553 603,900 582,685 601,046 707,569
Jun 2009 Dec 2009 Jun 2010
Dec 2010 Jun 2011
25,298
21,542
24,697
21,296
19,518
64,698
31,113
22,228
11,358
2,470
870
1,211
389
2,070
683
1,043
344
2,544
930
1,201
413
2,482
886
1,235
362
2,336
777
1,227
332
465,260
51,587
364,377
49,295
553,880
55,842
441,615
56,423
15,478
130
13,934
1,414
14,020
80
12,576
1,364
17,533
81
15,951
1,501
14,746
206
13,139
1,401
13,244
60
11,864
1,319
6,260
1,754
4,506
5,635
1,828
3,807
6,841
2,029
4,813
879
225
654
708
176
532
706
189
518
648
167
480
708
176
532
2,944
423
2,521
1,675
846
2,852
417
2,434
1,551
883
2,922
397
2,525
1,781
744
3,197
468
2,729
1,846
883
682
43
638
545
48
497
458
45
413
526
47
479
471
50
421
36,098
24,165
11,933
–
32,693
21,917
10,776
...
30,261
18,494
11,767
7,500
29,898
18,145
11,753
7,476
32,409
18,105
14,305
12,473
2,973
1,950
1,023
1,801
1,243
558
1,666
993
673
1,351
884
466
1,345
854
490
62,291
63,270
38,329
39,536
46,543
2,816
2,398
1,789
1,543
1,414
3,744
3,521
3,581
3,480
2,971
Foreign exchange
contracts
Forwards and forex swaps
Currency swaps
Options
48,732
23,105
15,072
10,555
49,181
23,129
16,509
9,543
53,153
25,624
16,360
11,170
57,796
28,433
19,271
10,092
Interest rate contracts
Forward rate agreements
Interest rate swaps
Options
437,228
46,812
341,903
48,513
449,875
51,779
349,288
48,808
451,831
56,242
347,508
48,081
Equity-linked contracts
Forwards and swaps
Options
6,584
1,678
4,906
5,937
1,652
4,285
Commodity contracts
Gold
Other commodities
Forwards and swaps
Options
3,619
425
3,194
1,715
1,479
Credit default swaps
Single-name instruments
Multi-name instruments
of which index products
Unallocated
Memorandum Item:
Gross Credit Exposure
23
Concentration of Derivative Contracts ($ Billions)
Source : Comptroller of the Currency, Washington DC, 3Q 2011
Type
Futures & Fwrds
Top 5 Banks
$
All Other
banks $
Total $
Top 5 Banks %
35,797
3,994
39,791
14
Swaps
150,502
5,630
156,132
61
Options
35,157
1,211
36,368
14
Credit
Derivatives
15,521
140
15,661
6
236,977
10,974
247,952
96
TOTAL
Net Current Credit Exposure
Source : Comptroller of the Currency, Washington DC, 3Q 2011
$ in billions
3Q11
2Q11
Change
%
Gross Positive Fair
Value (GPFV)
6,021
3,942
2,078
53%
Netting Benefits
5,517
3,579
1,938
54%
Netted Current
Credit
Exposure
(NCCE)
504
364
141
39%
Potential Future
Exposure
(PFE)
795
821
-26
-3%
1,299
1,185
114
10%
91.60%
90.80%
0.90%
1%
Total Credit
Exposure
(TCE)
Netting Benefit %