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									The economic crisis and the crisis of economics

Title              Destabilizing Effects of Financial Derivatives
                   How structured finance paved the way for the recent crisis
Author             Johannes Mossböck

Date               May 2011

1 Abstract ............................................................................................................... 2
2 A concise description of the securitization process ............................................. 2
 2.1 The definition of securitization ....................................................................... 3
   2.1.1 Benefits of securitization ......................................................................... 4
   2.1.2 Drawbacks of securitization .................................................................... 5
 2.2 History of securitization ................................................................................. 8
 2.3 The delicate subprime mortgage credit ......................................................... 8
3 Crisis derivatives ............................................................................................... 10
 3.1 Upcoming and functioning of a CDO ........................................................... 11
   3.1.1 Disadvantages of CDOs ....................................................................... 13
 3.2 Upcoming and functioning of a CDS............................................................ 15
   3.2.1 Disadvantages of CDSs ........................................................................ 17
   3.2.2 Synthetic CDO ...................................................................................... 18
4 Acquisitive frenzy .............................................................................................. 18
 4.1 Credit agencies gaining power .................................................................... 19
 4.2 The incapability of credit agencies .............................................................. 20
 4.3 The implosion of the doomsday machine .................................................... 22
 4.4 Effects of credit derivatives on the European economy ............................... 23
5 Conclusion......................................................................................................... 25
6 References ........................................................................................................ 26
The economic crisis and the crisis of economics

1     Abstract

The financial crisis of 2007/2008 has caused the biggest downturn in the world econ-
omy after the Great Depression in 1931. What has started as making 'easy' and 'safe'
money in the subprime lending market channeled through New York's Wall Street in
the United States has befallen every single financial center in the world and has
made leaders around the globe bail out their banks and create massive stimuli pack-
ages to keep their economy alive. The aftershocks of the recent crisis may well be
felt in the decade yet to come.

But how could this system of so called structured finance products become so over-
whelmingly influential in the U.S. that it could even cause such a threat to the world
economy? How could every single individual involved in creating and selling these
exotic financial securities unknowingly (or knowingly) oversee the riskiness that lay
beneath them? And how could seemingly safe Credit Debt Obligations (CDOs) have
been responsible for $542 billion of the nearly trillion dollar write-downs in the U.S.
financial sector (Barnett-Hart, 2009)?
These and more questions gave rise to examine derivatives more closely and to writ-
ing this paper.

In this paper I will be explaining the beginnings of the so called securitization process
as well as the subprime mortgage market in the United States and I will stress out the
destabilizing role of often newly invented structured finance products and how they
were introduced into financial markets. The main purpose of this paper will not be the
exact mathematical derivation of such innovations but their effect on people who
traded and profited from them and therefore indirectly created a system which is built
on vague expectations and gamble. As this financially unstable system was invented
on New York's Wall Street my main focus lies on the developments in the U.S. in the
first few parts of this paper. Nonetheless I will return to effects of structured finance
products on the European economy in later parts.

2     A concise description of the securitization process

To understand these opaque and complex structured finance products, it is essential
to begin with and be aware of the underlying rationale of the so called securitization
process. Thus the complex term securitization will be explained in short, followed by
a concise history of this market and why there was such a boom in this system to
evolve and enlarge until the bubble of 2007/2008 burst.
The economic crisis and the crisis of economics

In the subsequent parts I will present the benefits and drawbacks of the securitization
process in general, which stand in sharp contrast to each other, whereby, as we
know now, the drawbacks may have exceeded the benefits by far.

In the last section the topic of subprime mortgage lending will be specified in short
and methods of lending facilities to entice vulnerable subprime borrowers to take on
a mortgage or to refinance an existing mortgage.

2.1    The definition of securitization

Underlying the process of securitization is the principle of risk diversification. This
principle states that pooling together various kinds of unequally and uncorrelated
risky assets, will to a certain degree bear lesser risk to the owner of the asset-bundle
(i.e. portfolio) in case of a loss in one of the asset's values than holding only one
separate asset which also bears a certain amount of risk.
If that one asset looses in value, the whole loss falls onto the owner of that asset. Yet
the fall in value of an asset included in a portfolio will bear lesser damage to the
owner of the portfolio. The risk has thus been diversified.

Securitization is only an extension of this principle, whereby contractual debt is seen
as an asset and therefore pooled together. These assets could be in form of mort-
gages, auto loans or credit card debt, all of them bearing principal and interest pay-

These pools of contractual debts (the term 'securities' will be used for bundles of con-
tractual debts in various forms throughout this paper) are sold off to investors (i.e.
pension funds or any kind of mutual funds), to whom from now on the borrowers (the
owners of debt) have to pay interest and principal payments. The 'middle-man' (i.e.
the originator or servicer) earns a profit by selling these mortgages off, in effect laying
the underlying risk of default on somebody else's shoulders. Securities created from
pooling together many different mortgages are so called Mortgage Backed Securities
(MBS), which played a pivotal role in the recent crisis. An alternative kind of security
are the so called Asset Backed Securities (ABS), which are essentially securities
backed, for example, by credit card debt or student loans. To illustrate the above sit-
uation in a very simplifying manner, consider the following depiction:
The economic crisis and the crisis of economics

                Source: modeled from the depiction on

A corporate entity bundles assets (in this case mortgage payments) into MBS. These
MBS can be split up into different tranches, reflecting their underlying risk of default.
Hence triple A rated MBS (the one in the top 'bucket') reflect almost no risk to inves-
tors, bearing also the lowest interest rate. Further down the stream of mortgage
payments lie the riskier MBS, rated double A to double B, bearing a higher interest
rate to investors (Note that in this simple depiction the amount of credit ratings is
four, yet in real terms the amount of credit ratings can be largely increased).

What this essentially means is that high rated tranches will get payments even if
some of the mortgagors are not paying their bills, as they get their payments before
every other investor of underlying, riskier, MBS tranches. These AAA 'buckets' are
essentially filled up first, as they are the topmost ones. Yet the stream will slowly be
reduced going further down the tranches. If too many default payments are con-
tained, lower tranches will essentially get no money at all, which, of course, is reflect-
ed by the higher interest rate for they maintain a higher risk.

2.1.1 Benefits of securitization

One might ask why this seemingly complex machine of asset backed securities might
be beneficial and profitable, not only to investors, but also to financial intermediaries
and mortgagors. The following list contains main reasons, distilled to their very ba-
sics, that gave rise to the securitization market (Asset Securitization, 1997):
The economic crisis and the crisis of economics

      Benefits for originators:

      The most beneficial aspect from creating ABS is that it converts on-balance
      sheet loans into off-balance sheet income streams, which is less capital inten-
      sive. Rather than keeping them on their balance-sheet and thus requiring
      a higher level of own savings, they are repackaged and sold. In effect the ori-
      ginators can hand out more credits as their balance sheets are freed up.

      Benefits for investors:
      Along with very attractive yields for investors, securitized assets offer the
      availability of flexibility because various payment streams can be structured to
      meet the investors' special requirements. This effectively means that struc-
      tured finance products are rated and thus categorized. The investors can thus
      choose in which rated security they want to invest.

      Benefits for borrowers (mortgagor):
      Borrowers obviously benefit from an increasing supply of credit, which origina-
      tors probably couldn't have provided had they kept the loans on their balance

2.1.2 Drawbacks of securitization

As described above, securitization, if working properly, has a decent amount of bene-
fits and is thus very attractive for profit seeking financial entities. But these reasons
seem only applicable in a stylized, well regulated world. The securitization process is
prone to several key frictions or drawbacks that occur during the making and selling
of MBS and ABS. The following list contains the main frictions in this process (Ash-
craft, Schuermann, 2008):

1.) Frictions between the borrower (mortgagor) and originator

The first friction comes in mind when considering that not every mortgagor is perfect-
ly aware of every loan that originators are offering or every possible financial option
that lies within their means. Also, but to a lesser degree, not every originator might be
aware of the financial situation a borrower might be in, which gives rise to mortgage
fraud. These unknowns may lead to the friction of so called predatory lending or pre-
datory borrowing, a procedure that was widely used by originators in the housing
boom prior to the crisis. As originators were cutting off a certain amount of the trade,
they were increasingly interested in originating and selling the loans as fast as possi-
ble to investors, creating the incentive to 'borrow to everybody', also increasingly to
The economic crisis and the crisis of economics

subprime borrowers, who were less likely to repay the loan. The following table
shows the top-originators in subprime lending in 2005 and 2006:

                       Source: Inside Mortgage Finance (2007)

2.) Frictions between the originator and the servicer

In the making of ABS or MBS originators often function as servicer or arrangers,
meaning that the pool of loans will be restructured into an MBS or ABS by the same
financial entity (this could be a bank or a credit agency). Yet sometimes external enti-
ties buy these loan-pools and structure them by themselves (i.e. investment banks or
special purpose vehicles, which are not on the banks' balance sheets).
This bears an information problem, as the originator has full information on the quali-
ty of the loans and might not pass these on to the arranger. Also, if the arranger is
lacking in the role of overseeing the originators, they will more likely commit mort-
gage fraud (i.e. give loans to people who are not credit-worthy [predatory lending])

3.)Frictions between the servicer and the rating agencies

As MBS or ABS are more or less handled as bonds, they are also compelled to be
rated by an rating agency1. The accuracy of the credit rating placed on securities is-
sued by a trust is vulnerable to the use of a low-quality servicer. Hence rating agen-
cies try to monitor servicers as closely as possible to reduce the risk for investors by
giving them a publicly available rating of the servicer's offer.

 The three biggest rating agencies in the U.S. are Standard&Poors (S&P), Moody's
and Fitch
The economic crisis and the crisis of economics

4.) Frictions between the asset manager and the investor

Investors provide the 'fuel' for the purchase of a MBS. As the investors might not be
fully aware of the sophisticated financial market they would hire an asset manager,
who tries to formulate an efficient investment strategy. The obvious problem that
arises is yet again the one of information asymmetry. Investors might not fully under-
stand the investment strategy of the asset manager or may not know the manager's
full ability. Also investors cannot know to a certain degree how asset managers con-
duct due diligence of MBS or ABS. It is thus a classical case of the principal (inves-
tor) - agent (asset manager) problem.

5.) Frictions between the investors and the rating agencies

Another friction arises when we think of who 'hires' rating agencies to rate a certain
security, which is the arranger. Ultimately rating agencies are paid by the arranger (or
servicer) for their opinion and not by the investor, which is a huge conflict of interest.
Since investors cannot assess the efficacy of ratings by themselves, they are prone
to 'errors' made by the rating agencies.
This conflict of interest is even more emphasized as the biggest rating agencies
created a huge amount of their revenue from structured finance deals from 2002 until
2007. This diagram shows that rating agencies profited from the boom of exotic fi-
nancial instruments as well:

                          Source: Barnett-Hart (2009) (p.18)
The economic crisis and the crisis of economics

2.2    History of securitization

Before the securitization 'hype' started in the early 1970s in the U.S., banks had strict
regulations and were essentially a dull enterprise, reflecting a conservative and hie-
rarchical profession. Back then banks were mostly portfolio lenders, meaning that
they held loans until they matured or were paid off. The loans were funded by their
own deposits and only sometimes by debt (an obligation of the bank).
Yet after the two World Wars, demand for housing and thus housing credit was in-
creasing at a much faster pace than ever before seen (Asset Securitization, 1997).
Banks could not simply issue as many loans as they would have wished. Hence they
and other financial institutions sensed an emerging market and sought ways of in-
creasing the sources of mortgage and loan funding.

In the 1970s it was the Government National Mortgage Association that issued the
first MBS (Roubini, Mihm, 2010). Soon after bankers developed new techniques to
entice investors and after years of trial-and-error to find efficient mortgage securitiza-
tion structures, the securitization market as described above saw the light of the day.
Starting with the introduction of the computer, thus enhancing the speed of transac-
tions in the financial world, in the mid 1980s, the securitization market grew faster
than ever before seen.

Soon later this emerging market found methods to apply mortgage securitization
techniques to a class of nonmortgage assets - auto-loans at first. The ABS was born.
These auto-loan securities had a considerably shorter maturity than mortgages,
which made it much easier to predict cash flows from them. Soon after credit card
receivables were also seen as collateral and were sold off to investors (Asset Securi-
zation, 1997).

The securitization market grew at a high rate, offering higher payments for em-
ployees and thus attracting highly skilled individuals educated by the world's most
prestigious and well known universities, who produced innovative techniques and
procedures such as CDOs (which will be discussed shortly), which ultimately led to
the financial disaster in 2007/2008.

2.3    The delicate subprime mortgage credit

The term subprime has by now fallen a few times and it is necessary to examine this
topic a bit closer to get a glimpse of what risk MBSs and CDOs were bearing.
A paper published in 2001 by the Interagency Expanded Guidance for Subprime
Lending Programs defined subprime borrowers as individuals who generally display
a range of credit risk characteristics. These could be one of the following (Ashcraft,
Schuermann, 2008):
The economic crisis and the crisis of economics

    Two or more 30-day delinquencies in the last 12 months (equivalent to one or
     more 60-day delinquencies in the last 24 months)
    Bankruptcy in the last 5 years
    High default probability, a credit bureau risk score (FICO-score) of 660 or be-
     low. The FICO-score was invented by the Fair Isaac Corporation to measure
     creditworthiness, 850 being the maximum score meaning high creditworthi-
     ness and 300 being the minimum score meaning low creditworthiness

In the originators search for new borrowers they did not only give loans to creditwor-
thy individuals, they started to hand them to subprime borrowers as well who could
rarely present income receipts. They offered low teaser interest rates connected to
so called 'adjustable rate mortgages' to motivate subprime individuals to borrow, and
often these loans did not require much down-payment or even none at all (in 2006
43% of U.S. homebuyers did not make any down-payments [Noelle, 2006] ). Adjust-
able rate mortgages (ARMs) lured low income individuals to take on a mortgage
which offered low teaser rates in the beginning but increased gradually until they
reached a high which was often not affordable by subprime individuals. To present a
phenomenal case of subprime lending, consider the following quote from The Big
Short (Lewis, 2010):

      In Bakersfield, California, a Mexican strawberry picker with an income of
      $14,000 and no English was lent every penny he needed to buy a house for

As housing prices rose steadily the originators could really give away loans easily, as
the underlying collateral of the borrower (the property and the house) was rising in
value. This was the sole reason this system of debt was ultimately working as it
helped the originator as well as the subprime mortgagor tremendously. Indeed the
originator could simply offer the mortgagor to refinance in case of delinquency or de-
fault, effectively giving the mortgagor more money to pay off the old debt and in turn
issue new debt, and thus new profit for the originator by selling the new loan off. The
Big Short (Lewis, 2010) is giving another very good (or bad) example of how such an
event could have happened to many U.S. citizens, by presenting the case of an Ja-
maican housekeeper, who apparently owned six townhouses in Queens, New York:

      It happened because after they [the family of the housekeeper] bought the first
      one [house], and its value rose, the lenders came and suggested they refin-
      ance and take out $250,000 - which they used to buy another. Then the price
      of that one rose, too, and they repeated the experiment. (p.98)
The economic crisis and the crisis of economics

To depict the rise in housing prices consider the following diagram:

                       Source: U.S. Census Bureau New Sales

As long as housing prices were rising, this system of refinancing and issuing new
debt to subprime borrowers was effectively paying off, creating a bigger and bigger
bubble in the financial sector. Yet, as we all know now, housing prices stopped rising
(and soon later even fell) and foreclosures and defaults were summing up in late
2006 and early 2007, letting MBSs run dry and shipwrecking a whole system built on
expectations of rising housing prices. This topic will be addressed in a later part of
this paper.

3     Crisis derivatives

As the securitization process has been concisely described by now, it is time to turn
to the exotic investment instruments that were created from pools of MBS, the so
called Credit Debt Obligations or CDOs. These instruments, as said before, were
seemingly riskless but brought the U.S. financial system down to its knees by mid-
In short I will discuss the principle that underlies a CDO, turning then to the main fa-
cets and try to describe these derivatives as simple as possible, as well as giving
several reasons the CDO was gaining more and more ground on Wall Street.

What will also be contained in this section is the invention and use of Credit Default
Swaps, or CDSs. These were essentially instruments to either hedge against future
default risk from holding debt. As these two instruments are more or less the two ma-
jor categories of credit derivatives (Partnoy, Skeel, 2006), I will constrain my research
The economic crisis and the crisis of economics

solely on them, neglecting other (more complex) financial derivatives, as these are
the ones that largely destabilized the financial system.

3.1   Upcoming and functioning of a CDO

The first CDO ever being issued was one from Drexel Burnham Lambert Inc. in 1987.
Back then the creation of such an instrument was nothing more than diversifying risk
substantially more by pooling different tranches of MBS together.
Yet the rapid growth of these instruments did not start until the dot-com bubble burst
in 2000, leaving the U.S. in a recession and attracting more and more people into
investing in now higher yielding CDOs with the same credit rating as U.S. treasury

What also helped giving CDOs a kick start in the early 2000s was the plain fact that
securitization helped banks to free up their balance sheets by either selling CDOs to
investors or storing them in so called off-balance sheet vehicles, such as conduits or
structured investment vehicles (SIVs).
By getting loans off the balance sheet the bank could thus decrease capital charges
required by the Basel2 requirement and issue new loans with the now freed up cash
(Barnett-Hart, 2009).
The following diagram depicts the rapid upcoming of CDOs in the years prior to the
crisis, fueled by the reasons just described:

                           Source: Barnett-Hart (2009) (p.6)

  the Basel I requirement dictates that banks must hold capital of at least 8% of their
The economic crisis and the crisis of economics

The diagram shows that starting from the first quarter of 2004 CDO issuance has al-
most nine folded up to the peak in early 2007 (values on the vertical axis: billions is-

The working of a CDO will now be explained in a very simplifying manner. We can
think of a CDO as a sort of fund conducted by an investment bank or a similar entity,
which pools together sets of MBS. The risk of one of the MBSs defaulting can thus
be diversified. Hence by pooling MBS together, risk can yet again be seemingly re-
duced to investors investing into a CDO, just as described in the securitization

Indeed, even very dodgy BBB or worse rated MBS could be pooled together into a
CDO. Later on these CDOs could be sliced up into different tranches as well, some
of them even receiving the highest credit rating, AAA, even though they were ulti-
mately made of risky subprime mortgages (Roubini, Mihm, 2010). This process is
best made clear by the following depiction:

                Source: modeled from the depiction on

To sum the situation wholly up, CDOs were essentially dependent on the perfor-
mance of MBS, which were ultimately dependent on mortgage payments.
Thus, in theory, if one of the 'buckets' representing an MBS does not fill up, underly-
ing an increase in mortgage defaults, a CDO could dampen the loss by diversifying
The economic crisis and the crisis of economics

risk even more, as the holder of the safest triple-A CDO tranche (the top 'bucket' in
the rightmost column, representing CDO tranches) will still receive his payments, and
yet again has risk for the investor been diminished.

Indeed, as mortgage defaults start to sum up, only the highest rated CDO tranches
will receive payments, leaving the lower tranches dry, as investors of the higher rated
tranches receive payments before every other investor of riskier tranches. This is yet
again reflected by the higher yield these tranches are bearing.
Going further down the CDO tranches, risk of default is increasing, yet the yield of
these tranches is also higher. The CDO is thus another convenient instrument for
institutional investors, who are bound to purchase safe investment-grade securities,
to invest their money in (Barnett-Hart, 2009).

3.1.1 Disadvantages of CDOs
As a CDO has by now been described as a fairly risk-diversifying venture, it must be
stated that this derivative can indeed lead to huge drawbacks for potential investors.
In the following I will list several points that refer to a CDOs' dark side.

1.) CDOs create wrong incentives for CDO managers (1)

As was previously described in the section about the drawbacks of securitization, the
creation of a CDO can cause several 'bad' incentives to those who put together mort-
gage bundles into a CDO. Indeed as the CDO managers ultimately shift the underly-
ing credit risk onto innocent investors by means of a 'super' safe triple-A rated CDO
tranche, they have no real further interest in watching how the underlying assets per-
form. Indeed, they have shifted risk onto investors, sacking a handsome profit from
the collected fees. If the CDO managers (who are ultimately employed by, for exam-
ple, investment banks) create such a complex derivative and finds enough investors,
they have every incentive not to monitor the performance anymore.

2.) CDOs create wrong incentives for CDO managers (2)

Also, taking the above thought one step further, we can say that CDO managers just
want to put together the right amount of often not very good rated assets, to create a
shiny triple-A investment. This process is roughly described in section 4.2. Thus they
do not really care about the underlying asset's credit risk as long as they are the per-
fect building blocks for the super-safe investment. Their risk will yet again be shifted
onto the investors.

3.) CDOs can fall prey to systemic risk

As noted above, if too many underlying loans are defaulting for the same reasons,
the process of diversification is somehow crooked. Diversification relies on the fact
that the assets are not equal with regards to their probability of default, hence they
should be uncorrelated. This simply means that if one asset fails another one is not
going to fail because of the same reasons.
The economic crisis and the crisis of economics

Yet this was exactly the case with a high amount of CDOs in the recent crisis. These
nifty Wall Street engineers thought that by putting together subprime mortgage from
California and subprime mortgages from Florida they could eliminate the apparent
assumption that they were not exposed to the same forces (Lewis, 2010). They were
indeed thoroughly wrong, because as the house prices in these states stopped rising
and later fell, the CDOs constructed from these seemingly uncorrelated subprime
mortgages defaulted greatly too. The principle of risk diversification was prone to the
underlying systemic risk. To illustrate this process, it is best to look at the following

              Source: modeled from the depiction on

The mistake the CDO managers made was that they thought that if subprime default
rates in California were increasing, they would not be increasing in Florida. What
happened was quite the contrary, namely that subprime mortgagors were defaulting
because of the same underlying reasons (fall in house prices) no matter in which
state they lived. In effect the badly rated MBS tranches were dried up. Furthermore
the CDO tranches that were constructed out of them were dried up as well, leaving
investors with massive losses.
The economic crisis and the crisis of economics

3.2    Upcoming and functioning of a CDS

In this section we turn to even more complex financial derivatives. The credit default
swap (CDS) takes thus another pivotal role in the complex structured finance ma-
chine working on Wall Street in the years prior to the financial crisis.
Yet, as with a CDO, the CDS was not invented to bring the system of structured
finance down to its knees. It was invented to do quite the opposite, namely making
this system safer by hedging against future risk of default.

CDS were first introduced on the markets in the mid 1990s and immediately attracted
the attention of many Wall Street bankers. Before the upcoming of CDSs, banks
sought more and more ways to lay off credit risk by means of securitization.
But it was not until huge corporate names like Enron or Worldcom filed for insolvency
that banks increasingly had to take more effort in managing their credit portfolios
(Weistroffer , 2009). For them the CDS was a perfect instrument to hedge against risk
of credit default and it could even be hedged separately from interest rate risk. Ac-
quiring a CDS did not require any prefunding from the protection seller, which made it
even more convenient than acquiring securities.
Figures depicting gross notional amounts outstanding in between 2002 and 2007
confirm the vast expansion of CDSs in the years prior to the crisis. Amounts out-
standing rose from below $2 trillion in 2002 to around $60 trillion in 2007 (Weistroffer,

To fully understand how a CDS worked it is useful to begin with a short description of
the mechanics underlying a CDS as well as a description of an exemplary (single
name) CDS process.
The process starts when a financial entity, say a hedge-fund, buys bonds from a firm
of which the hedge-fund thinks it might default on their bonds (which is actually a
'loan' handed out by the hedge-fund). It thus calls an insurer, the protection seller, to
sign a contract in case of a default of the firm.
They, the protection buyer (our hedge-fund) and the protection seller (the insurer),
define terms and conditions of the contract thoroughly (i.e. the credit events), and
decide on a yearly premium the protection buyer has to pay over a predetermined
number of years (Bomfim, 2001).

Such an credit event could be one of the following: a) bankruptcy, which is only rele-
vant for corporate entities; b) failure to pay, which is the case described above in
which the firm, or in banker's jargon the 'reference entity', cannot make any due
payments anymore; c) obligation acceleration, in which the obligation becomes due
and payable before its normal expiration date.

In case of that specific credit event happening (in financial jargon it is said that the
CDS has been triggered), the protection seller has to make up the loss incurred to
the protection buyer. It thus resembles an insurance contract. To display the above
situation, consider following depiction:
The economic crisis and the crisis of economics

            Source: modeled from the depiction in Weistroffer (2009) (p.4)

Indeed, if the credit event never takes place, the contract simply matures and ex-
pires. The premium paid to the protection seller has thus to compensate the protec-
tion seller for bearing the risk of default.
What has been described as the payment of the protection seller for the incurring
loss for the protection buyer, the so called CDS settlement, is not quite easy to set in
real terms. Ideally the incurred loss is just the difference between the face value of
the underlying security and the amount that can be recovered from the reference ent-
Yet in practice, the post-recovery value of the reference entity is not exactly known in
times when the contract is settled.

Also what might appear illogic is that the protection buyers do not have to own the
bonds (or securities) for themselves (Garbowski, 2008). This is one of the main rea-
sons why CDS ultimately differ from regular insurances. CDSs are thus highly spe-
culative derivatives, granting the buyer of CDSs to 'bet' on a default of an underlying
security (they are then referred to as naked CDS). To put it more plainly, if someone
owns a house and later insures against the case of the house burning down, some-
one else could insure it as well, collecting a decent payment from the insurer in case
of that house going up in flames, for example. This is exactly what U.S. hedge-fund
billionaire John Paulson did in the years prior to the crisis, but with somehow illegal
means as will be explained later on.
Indeed, as the market for CDSs grew and made the pricing for such an CDS more
easily available to the market, these derivatives did provide market participants with
additional information about a company's financial health, which can be seen as an
additional advantage these derivatives were bearing. It gave potential individuals who
wanted to hedge against risk or simply speculate another source of information de-
spite the credit ratings offered by the rating agencies (Partnoy, Skeel, 2006)
The economic crisis and the crisis of economics

3.2.1 Disadvantages of CDSs
As with the securitization process in general, CDS also exhibit quite an amount of
drawbacks that occur in the process of such a derivative. In the following part I will
stress out the main disadvantages of CDSs.

1.) Wrong incentives for lenders

CDSs tend to give banks an incentive not to monitor their loans with their best avail-
able means. Indeed, banks would not have to care much about the loans they are
giving if they for themselves hedged against the risk of default. This was, for exam-
ple, the case with the big oil company Enron. Banks, who had lent billions of U.S.
dollars to the company, used approximately 800 CDSs to lay off risk of about $8 bil-
lion (Partnoy, Skeel 2006).
Indeed, one could say that by this lack of risk monitoring from banks the counter-
party, i.e. an insurance company, could make an effort and monitor for themselves.
Yet the insurers may not have such a close relationship to the borrower and thus
cannot make righteous credit risk assessments.
As a final note to this point we can say that CDSs pose the risk of moral hazard onto
this machinery as banks (i.e. the lenders) are less interested in the credit risk of a
company (i.e. the borrowers) as they will be compensated by these derivatives any-
way. This can lead to predatory lending or predatory borrowing on a higher level.

2.) Wrong incentives of speculation by means of CDS

A second point occurs if we look again at the topic of naked CDSs. Indeed, as I sup-
posed earlier, financial entities could speculate on a company defaulting by means of
such a derivative. So ultimately this entity would only gain by such a deal if the com-
pany defaulted (that is, triggered a credit event). This gives every incentive to the fi-
nancial entities to make sure this company is losing in value and may thus default on
their loan. The instruments they could use to deteriorate a firm's value are manifold
and would go highly beyond the topic of this paper. Yet it is exactly this incentive of
buying a CDS naked and make a handsome profit out of it that nurtures the wish of
protection buyers to deteriorate a firm's value.

3.) CDS poses additional uncertainty on a company's affiliates

A cost that comes indirectly into the picture is if we think of how all the different inves-
tors, other creditors and bondholders of companies (the reference entities) will be-
have if they know that the banks, in their role as a lender, have for themselves
hedged against the risk of default of that company. It is something completely differ-
ent if a bank buys bonds and keeps them on the balance sheet, effectively having to
monitor the actions of that entity closely to react accordingly, or if the bank buys
bonds and hedges against their credit risk and therefore places no such monitoring
actions (Partnoy, Skeel, 2006). Hence all affiliates of a company (i.e. suppliers) will
not know whether the bank puts its whole confidence into buying these bonds, thus
giving all market participants the sign of trusting this particular company, or if it has
hedged against the risk and thus simply does not care if the bonds are defaulting or
The economic crisis and the crisis of economics

not. The market participants do not know exactly how to behave and this places addi-
tional uncertainty onto the market.

4.) Possibility of systemic risk in the CDS market

As protection buyers (i.e. hedge funds) place relatively high bets on CDSs, a small
change in the economy could trigger credit events and thus contribute to a massive
liquidity problem for the protection sellers and furthermore to the whole international
financial market (Partnoy, Skeel, 2006). This is exactly what happened in the recent
financial crisis, namely that the defaulting of some derivatives and the subsequent
rush to unwind these interconnected contracts led to an international liquidity trap.

3.2.2 Synthetic CDO
To get a glimpse of how branched out CDSs, CDOs and other financial derivatives
were back in the U.S. financial system in 2007 and prior, consider another exotic and
opaque instrument Wall Street machinery invented to hedge against risk or simply to
speculate, the so called synthetic CDO.

A synthetic CDO is substantially made up of various CDSs. As with 'normal' CDOs,
that would contain real bonds or securities, the synthetic version contains only CDS
and is thus referencing a particular group of mortgage bonds (Nocera, 2010).
One might ask who could need such an opaque instrument in the first place. Yet in-
deed the invention of such instruments was not demanded by the ones believing that
the underlying securities would rise in value and thus insuring against future loss. It
was quite the opposite fraction, the ones who believed these securities would lose,
who demanded these derivatives, indeed a tiny minority back in 2007.

As noted before, one spectacular case was the one of hedge-fund investor John
Paulson, who pushed Wall Street engineers to create such an instrument for him to
bet against the subprime securitization market, which he knew would fail. Ultimately
this paid off for him, yet the reason why he was urging for such an instrument was
later subject for the Securities and Exchange Commission (SEC) to investigate into
this matter. Their findings were that Paulson helped choosing securities, which were
prone to default, to be made into synthetic CDOs so that Paulson could bet on them
(Nocera, 2010).
Indeed these complex instruments did nothing more than adding another speculative
element to the sector of financial derivatives, which paid off for people who saw that
the underlying subprime lending was bound to blow up.

4     Acquisitive frenzy

For some financial derivatives have now been described in their most basic forms, it
is now time to turn to the underlying reasons why they were formed at such a high
pace, why they created more and more profits, but also how they destabilized the
delicate system of credit lending.
The economic crisis and the crisis of economics

It is thus crucial to notice the role of credit agencies in the process of rating all these
opaque derivatives, which more or less gave investors confidence to invest in them, if
just the credit rating was good enough.
In the next section I will provide a short overview of the upcoming of credit agencies
until their peak performance in 2007 and later turn to simplified mechanics how a ap-
parently bad rated MBS could be repackaged to become part of a triple A rated CDO.
Information that was assumed as given in previous sections, namely the credit rating,
will thus be revised to present a now more complete picture of the securitization

4.1    Credit agencies gaining power

To start off it is best to get an overview of how credit agencies could become such
indispensable elements on the derivative market.
The three big rating agencies were starting their business in the late 19th century to
the early 20th century. In the case of Moody's, it was John Moody, a Wall Street ana-
lyst who gave birth to the idea of putting together all sorts of credit information to
create one final credit rating. This idea has caught on investors who in return bought
his advice and subscribed to his service.

The credit rating he invented back then, ranging from a eventually no risk A over a
moderately risky B to poor standing C rating, did not change much in the course of
time. Also, almost all the rating agencies applied credit ratings that were more or less
similar to each other.
Yet the service of credit agencies did not take off immediately. It was not until the
1970s when various happenings sped up the rating business.

One of them was the collapse of Penn Central in 1970, an event that the credit agen-
cies could not foresee. This downturn of the economy has led the U.S. government to
step in and it penalized investors for holding bonds that were less than investment
grade (a term that referred to the top 10 credit ratings by the three big agencies, who
the government officially designated [Lowenstein, 2008]). From this time on, rating
agencies knew they were holding the key to a vast 'golden treasure'. Buying bonds
was now much more dependent on credit ratings, and thus much more dependent on
their business. Also what was not in the center of their business anymore was how
well they researched for a particular rating, it was just necessary that it ultimately got

Regulators did not stop and extended their penalties on banks and pension funds,
mutual funds or insurance companies for not buying high enough rated bonds. Soon
these funds were even forbidden to purchase under graded investments.
It was in this time of change that the biggest conflict of interest came into the busi-
ness of the ratings agencies. The ones paying the rating agencies were exactly the
ones demanding a rating of them. As is described as a key friction in part two in this
paper, this gave rise to one of the main conflicts rating agencies had to deal with
(even nowadays).
The economic crisis and the crisis of economics

The agencies changed their role from giving opinions about credit risk to subscribers
to selling 'licenses' to issuers of bonds.
Yet it was not until the upcoming of structured finance products that the revenue of all
three big rating agencies really took off. As all of these derivatives had to be rated
accordingly, they became more and more powerful on the derivatives market for giv-
ing derivatives a 'golden seal' and thus presenting the investors a seemingly safe
opportunity to invest. This was also a substantially huge money machine for the rat-
ing agencies as the diagram presented in section 2.1 shows us.

4.2   The incapability of credit agencies

To get an overview on the market share of the three rating agencies , it is best if we
look at the following diagram. As we can see, all CDOs that have been issued in the
years prior to the crisis were rated by one of the big rating agencies.

                              Source: Barnett-Hart (p.18)

The diagram shows us the percentage of CDOs that were rated by one of the three
rating agencies. As the sum obviously exceeds 100% year by year, it indicates that
CDOs have been rated by more than one agency.

Indeed, knowing which loans were ultimately contained in all these CDOs and giving
them an appropriate rating seems sheer impossible. Just imagine that one MBS can
The economic crisis and the crisis of economics

contain between 2000 and 3000 loans, and putting various of these together creates
risk that no one can assess correctly.
Yet this was the agencies main business. And they have failed to gauge the real risk
these complicated derivatives were bearing.
As investment banks (who were bundling the CDOs together) would unload massive
spreadsheets full of information of the borrowers' credit history prior to a rating onto
the agencies, they should have been more than aware that something was wrong
with them. Especially CDOs constructed in 2006 consisted of almost only adjustable-
rate mortgages of subprime borrowers, who would have to refinance as soon as the
rate would go up. Effectively this is what gives any bubble steam, lending in the belief
that new money will bail out the old (Lowenstein, 2008).

What could have been alarming for the agencies as well is that many borrowers
came from the same area. This is a huge problem for the principle of risk diversifica-
tion, because if one specific geographic area is showing more and more default rates
(which is most likely the case), and if all of these have been included in the same
MBS, this MBS is going to suffer a tremendous loss. What came on top of it is that
sometimes the agencies did not have more than a single day to rate this vast pack-
ages of information and their statistical models were relying on historical patterns of
default. They did not have models that could keep pace with the many changes in the
credit business and basically modeled a world that no longer existed.

One might ask how dodgy triple B rated subprime MBSs could be made into shiny
triple A CDO tranches. The reason behind this is another fancy trick Wall Street is
pulling off, yet the idea behind it is surprisingly consistent.
The trick is that the financial entity who puts together CDOs (i.e. investment banks or
special purpose vehicles, who are essentially non-existent unless on paper), would
bring different classes of bonds on the market (the CDO tranches as depicted in sec-
tion 3.1) who were paid in order of their credit rating (first the triple A ones and so
It is exactly this order of payments that enabled rating agencies to put a triple A rating
on the topmost tranches, because these were essentially protected from losses as
they were paid before every other tranche, no matter which securities ultimately laid
beneath them.

Yet another odd behavior rating agencies showed prior to CDOs rating was that they
allowed investment banks to run tests with the models of the agencies by themselves
to see how good the CDO would perform. The bankers could thus for themselves put
together just the right amount of risky MBS that a rating agency would later rate with
a triple-A rating, and thus make a first class investment.

Also, in section 3.1, CDOs were essentially described as mostly static instruments,
with a fixed amount of MBSs in them. In fact CDO managers could buy or sell mort-
gage bonds and thus adding or removing them to the CDO, giving rating agencies
the task of rating a perpetually shifting monstrous financial derivative.
The economic crisis and the crisis of economics

So as we can see, not all but at least the greater part of the fault of misevaluating a
CDO falls onto the rating agencies. This is especially crucial if we think of how credit
ratings affected investing. And thus not only investing in the U.S., but really globally.
Not only were U.S. investors dependent on an accurate rating but also foreign inves-
tors from Europe or Asia, who knew essentially nothing about the U.S. mortgage
market. These seemingly super-safe triple-A ratings of CDOs were part of the reason
why the crisis of the U.S. financial market spread out to the rest of the world and had
devastating effects.

4.3    The implosion of the doomsday machine

In 2006 and 2007, as more and more borrowers could not afford to pay their monthly
payments of their mortgage because house prices stopped rising and ARMs were
showing a significant increase in rates, the constructed derivatives were in serious
trouble. It seemed that all frictions related to securitization were summing up to this,
as Michael Lewis puts it, doomsday machine that caused the crisis and the recession
from 2007 until the recent period of time. Yet there seems to be no single reason for
this machine to have faltered. Some blame the credit agencies for not assessing the
risk inherited in these opaque derivatives correctly, the credit agencies blame mort-
gage originators for not bringing all required information of the borrowers together or
sometimes none. Others blame the U.S. government for not intervening and not see-
ing how this bubble gathered steam through relentless policy relaxation. Investment
banks and ruthless bonus-seeking individuals were also targeted. Yet it seems to be
a mix of reasons really, but they all have several keyword in common: that is, either
securitization, CDOs, financial derivatives or subprime, which are all related to the
same idea presented in this paper.

Indeed the inability of mortgagors to pay their monthly bills has several devastating
effects on many financial entities. In the following I will list the main effects on the
involved parties:

1.) Effects on banks

As CDOs were increasingly created by so called structured investment vehicles
(SIVs), which are nothing more than instruments of (investment) banks to conduct
trades off their balance sheets (for they would be required to maintain a higher level
of capital), the banks would ultimately catch the downfall in these CDOs. As their val-
uation of mortgage assets were based on estimates of payment collection from home
owners, they had to revalue these assets as the stream of payments subsided. When
these values would fall below a certain level, investors may have rights to pull out
some of their investments, in effect taking the SIV's collateral. Hence these entities
were dried out as investors pulled out, damaging the bank who housed these ve-
The economic crisis and the crisis of economics

2.) Effects on investors

As described above, investors could be compensated by collateral of the SIV, yet in
most of the cases the devaluation of mortgage based assets hit them hard, as they
are affected by the lower earnings of their assets. As they tried to pull their money
out they ultimately lost some or even all of it.

3.) Effects on mortgage originators

As the main business of many mortgage originators was to find as many potential
borrowers as possible, thus also giving loans to subprime borrowers, so that the se-
curitization industry could carry on producing structured finance products, the in-
creasing loss of CDO investors made this task senseless. As interest rates increased
and house prices decreased, hindering mortgagors to refinance, more and more ori-
ginators filed for bankruptcy in the time following the climax.

4.4    Effects of credit derivatives on the European economy
In the last part of this paper I will discuss briefly the effects of the recent financial cri-
sis on European banks and then turn in short to the effects of securitization on the
European economy in general before the crisis hit.
It may seem surprising that a problem which was rooted in delinquencies and de-
faults of single-family home owners in the U.S. could have such devastating effects
on the global capital markets.

The trick behind this, as has been thoroughly described by now, was packing these
bundles of debt together and selling them, with the blessing of the credit agencies, to
investors all around the globe. As problems started to occur in mid-2007 and inves-
tors shifted globally to safer government bonds (Modell, 2008), banks saw their li-
quidity evaporate and their funding falter. Indeed, the most severe effects in Europe
were sighted on the British financial markets. It was no surprise that soon later the
first real bank runs started to appear, starting with the British bank Northern Rock
who depositors feared would file for bankruptcy as it was exposed to the so called
'toxic assets' (CDOs and alike). Soon later, HSBC, a British investment bank, an-
nounced a total of one billion U.S. dollar in write-downs.

Traders in Britain had basically introduced these formally U.S.-only derivatives to the
European market. But not only were they offering to invest in U.S. securities, they
also bundled many European home owner mortgages to form structured finance
products. In 2006 and 2007mortgages constituted the vast majority of loan securities
in Europe. Most of them originated in Britain, almost 54%, followed by Spain with
around 14% and the Netherlands with 11% (Kiff, Mills, Spackman, 2008).

To get a good glimpse of the European securitization market of the years prior to the
crisis, consider following diagram:
The economic crisis and the crisis of economics

                        Source: Kiff, Mills, Spackman (2008)

This diagram shows the European issuance of securitization products in billions of
U.S. dollars. The issuance in Europe was far below the issuance in the U.S., yet the
processes in 2007 on the U.S. derivatives market had also severe impacts on Euro-
pean issuance, which can be seen by the drop in 2008. MBS issuance dropped from
€307 billion in 2007 to €28 billion in 2008. The numbers of CDO issuance did no bet-
ter (they dropped from €471 billion to €63 billion in the same amount of time).

In effect the missing liquidity on the securitization market brought European banks to
think over their investment strategies. Many of them took back securitized assets
onto their own balance sheets and shifted their business to less riskier assets. These
banks were later seeking financial bail-outs by their respective governments. Indeed,
this is more or less the process of how the crisis took its course, which exceeds the
topic of this paper by large.
The economic crisis and the crisis of economics

5     Conclusion

To sum up how this securitization system, which was essentially created to protect
investors from losses by means of risk diversification, brought down the U.S. and lat-
er on caused recession of various other economies around the globe, it is pivotal to
notice the vast amount of unknown variables which are included in the process of
securitization. Starting from mortgage originators who are tempted to lend in form of
predatory lending and sell this debt off their shoulders, over Wall Street bankers who
wanted to earn bonuses by issuing more and more securities, to investors who were
misled by triple-A ratings by rating agencies. The system was involuntarily crooked.

Indeed, a handful of bankers tried to determine or neglect every single unknown vari-
able and thus create a system which took presumptions and false certainty for un-
iversally valid. Too many individuals were dependent on these presumptions which
proved so wrong in the later course. The underlying principle of derivatives may have
been honest, yet the people operating them were misusing them for their own good.
It remains to be seen if this system can be revived in a more honest way.
The economic crisis and the crisis of economics

6     References

Ashcraft A. B., Schuermann T., (March 2008) Understanding the Securitization of
Subprime Mortgage Credit, Federal Reserve Bank of New York, Staff Reports no.

Asset Securitization, ( November 1997) Comptroller's Handbook

Barnett-Hart, A. K., (March 2009) The Story of the CDO market meltdown: An Empir-
ical Analysis

Bomfim, A.N., (11.7.2001) Understanding Credit Derivatives and their Potential to
Synthesize Riskless Assets

Garbowski, M., (24. 10. 2008) United States: Credit Default Swaps: A Brief Insurance
Primer, AKO'S Policyholder Advisor

Kiff, J., Mills, P., Spackman, C., (28.10.2008) European securitisation and the possi-
ble revival of financial innovation

Lewis, M., (2010), The Big Short: Inside the Doomsday Machine, Norton Paperback

Lowenstein, R., (27.4.2008) Triple A-Failure, The New York Times

Modell, J.-F.,(February 2008) The impact of the Subprime-Crisis on European Banks

Nocera, J., (16.4.2010), A Wall Street Invention Let the Crisis Mutate, The New York

Noelle, K., (17.1.2006) 43% of first-time home buyers put no money down, USA

Partnoy, F., Skeel, D.A., (2006) The Promise and Perils of Credit Derivatives

Roubini, N., Mihm S., (2010), Crisis Economics: A Crash Course in the Future of
Finance, Penguin Press New York

Weistroffer, C., (21.12.2009) Credit Default Swaps: Heading towards a more stable
system, Deutsche Bank Research

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