The Credit Crisis -----Continued

Penetrating all the jargon in finance articles has been tough, but I

think I've done it.
So I'm going to write it up here.

The subprime mortgages and defaults are the easiest part to understand, but wasn't clear to me what exactly the investment banks had done and why everyone is panicked.

Now I think I do.
It’s all due to the invention of new financial technology (yes, we quants are called financial engineers officially).

Its an instrument called the Credit Default Swap (CDS) and its heavyweight cousin, the CDO.

I've been working in this area doing models and all the last few years, but the big picture was never made clear to us all this time. Turns out, the models were window dressing, it was mainly a lot of fraud.

Here goes...

Credit Default Swap - Part I

The CDS is a very simple instrument.

The idea is, suppose you have XYZ company which is BBB rated (very bad shape). Now you own $1m worth of XYZ bonds and you are getting interest. But problem is, XYZ can go bust any day and you'll lose $1m.

So, big investment bank, let us refer to it as Evil I-Bank, offers you a credit default swap on XYZ.

The CDS on XYZ specifies that you will pay a quarterly premium to Evil I-Bank, (usually specified as a percentage on the underlying, in this case, $1m). In return, if XYZ goes bust, Evil I-Bank, pays you $1m.

Typical insurance scheme.
So how can that cause a crisis ?

Because, rather than just insurance, CDS can also be used for speculation.


Credit Default Swaps – Speculation

So, now suppose you are a speculator. You know that XYZ is BBB rated, so could go bust any day.

How do you take advantage of that ?

Well, the standard way is to short XYZ stocks. You can even short XYZ bonds (though more complicated).

But there's a problem with that. You need someone to lend you the XYZ stock to short it, and there's only a limited number around.

Maybe $10m max, since XYZ is a small company. Ditto with bonds.

But now you have a new means. Simply get into a $10m CDS with Evil I-Bank on XYZ company. You see, one doesn't need to actually own any XYZ bonds to set up a CDS on XYZ !

Its as though, I can buy car insurance which will pay me if my neighbour has an accident.
And so can all of you.

Thus, previously if XYZ went bust, the max total loss to anybody is $10m.

Now it can be $1 billion, $10 billion, who knows ? Because everyone can set up a CDS to bet against a company and many people did.

This is the leveraging everyone's talking about.

But on the other hand, why were the I-banks so eager to set up CDS's with whoever wanted them.

Weren't they liable to lose a lot ?

Enter the CDO.


CDOs

Collateralized Debt Obligations (CDOs), the hot product of the last few years, engineered by all us math/physics PhDs.

The idea is suppose you are Evil I-Bank.
You have 100 BBB rated companies like XYZ. You've just sold $10m worth of CDS on each. So, now if they all go bust, you can lose $1billion. What do you do ?

Answer: Slice it up !

So, you create a "0 to 3%" slice. (technically, tranche)

Which means you go to a client and say, Look, I have an asset based on 100 underlying companies. Now I'm going to pay you a quarterly premium. In return every time a company in this pool goes bust, you pay me $10m, but *only up to the first 30m dollars* (so that's 3% of 1bn). Of course, the client will want a high premium for bearing this risk.
But lets go on.

Then you have a "3 to 7%" slice. So, you pay another client a somewhat
smaller premium. The idea is in return he will start paying you back when the total loss
to the underlying portfolio exceeds 30m (i.e., from when he 4th company goes bust), but stops at 70m (so from 8th company onwards, not his problem).

And so it goes, till you usually have a 15 - 100% slice.

This total scheme of slices is a CDO.

So, now here's the deal.

Note that every time one of the 100 XYZ companies defaults, you have just passed the loss onto one of the clients of the CDO.

And in return you can pay them a part of the quarterly premiums you were getting from the people who had CDS on the XYZ companies !

So, the more CDS's you sell on one end, the more CDO's you can sell on the other.
Perfect !

But is it really so great. Who wants to take these slices ??


CDOs and the ratings debacle

Its all in the ratings.
If you have a basket of BBB rated companies, not many people will want to buy into those.

But now what if you've sliced and diced it the way I described ? How much are those slices worth ? What's theirs rating ?

Underneath all the high math, here's the heart of the business.

The I-banks managed to convince the ratings agencies hat the 15 - 100 % slices were AAA !! You'd get interest on those, but it was extremely unlikely that more than 15 of the 100 companies would default, so as good as having a bond of a blue-chip corp !

And this is the crux of the crisis. Any type of long term investor, like a pension fund, wants to invest in AAA securities. But these are generally hard to find, expensive, etc.

Now I-banks had a way to (spuriously) manufacture them out of thin air. Simply, sell tons of CDS on crap companies to speculators and charge them high premium (because these are BBB rated).

Join them together into CDO's. Sell the 15 - 100% slices to long term investors. Since, these are AAA rated, you pay them a low premium and they are happy. Voila ! Money for nothing !

And long term investors were snapping these up, so big bonuses and party time.

What about the 3-7% slice etc. These are bought by hedge funds as a way of getting easy cash in the short term. Hedge funds always need quick, short term cash


All fall down

So, that's the big picture.

Once things started going south and companies went bankrupt, losses were magnified gigantically by the proliferation of CDSs.

The AAA rated CDO slices built on the CDS turned out not to be AAA after all, so the long term investors are collapsing.

Hedge funds are dying by the thousands as the earlier slices get hit.

I-banks are hit hard. After all you think you are well hedged. But what happens when the pension funds you duped go down and *can't* pay the losses you passed on ?

Plus they have to mark to market, which means the books start showing big losses long before companies actually collapse.

All because of the CDS, which allows you to 'take out insurance on your neighbours life'.

There's still an estimated 45 to 60 *trillion* worth of CDS liability which can be called in as recession deepens and more companies fall.
No one knows how corresponding CDO slices are placed...