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An Overview of the 2008 Financial Crisis

An Overview of the 2008 Financial Crisis. (the perspective of an electrical engineer on Wall Street). Samir Padalkar PhD, samirpad@gmail.com. Roadmap. Real Estate Bubble Security Definitions CDO Issues Rating Agencies, FNMA, FHLMC, AIG Federal Reserve 2000 Internet Bubble Comparison

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An Overview of the 2008 Financial Crisis

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  1. An Overview of the 2008 Financial Crisis (the perspective of an electrical engineer on Wall Street) Samir Padalkar PhD, samirpad@gmail.com

  2. Roadmap • Real Estate Bubble • Security Definitions • CDO Issues • Rating Agencies, FNMA, FHLMC, AIG • Federal Reserve • 2000 Internet Bubble Comparison • Where are we today

  3. Case Shiller Property Values Index (source Wikipedia) Fed Funds Rate (source Federal Reserve)

  4. MORTGAGE BACKED SECURITY (MBS) mortgage$200k 6% 30 years MBS 6 % weighted avg coupon, 30 year weighted average maturity mortgage$250K 6.5% 30 years 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

  5. COLLATERALIZED DEBT OBLIGATION – CASH CDO Senior AAA 70% MBS 6% 30 years 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 Moody's, S&P, Fitch assigned Ratings to Tranches 5

  6. COLLATERALIZED DEBT OBLIGATION – CASH CDO Senior AAA 70% MBS 6% 30 years MBS 6.5% 30 years 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

  7. CREDIT DEFAULT SWAP Premium CDS SELLER CDS BUYER Face Value upon default 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

  8. COLLATERALIZED DEBT OBLIGATION – SYNTHETIC CDO Senior AAA 70% CDS 6% 30 years CDS 6.5% 30 years 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

  9. 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

  10. CDO SQUARED– 10 % DEFAULT Senior 70% Senior 70% Senior 70% Senior 70% Mezz 25% 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

  11. CDO SQUARED– 13 % DEFAULT Senior 70% Senior 70% Senior 70% Senior 70% Mezz 25% Mezz 25% Mezz 25% Mezz 25% 8% 8% 8% 8% Equity 5% Equity5% Equity 5% Equity 5% Senior 70% 2% Mezz 25% Equity 5% 13 % defaults results in defaults in AAA Senior Tranche of CDO^2 11

  12. 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

  13. CDO Pricing • Gaussian Copula • Monte Carlo Simulation

  14. http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=allhttp://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-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO."

  15. 15

  16. 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)

  17. Federal Reserve Balance Sheet, Jan 3, 2008, www.federalreserve.gov 17

  18. Federal Reserve Balance Sheet, Jan 2, 2009, www.federalreserve.gov 18

  19. Federal Reserve Balance Sheet, Jan 19, 2012, www.federalreserve.gov 19

  20. 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)

  21. 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 $

  22. Source- BIS

  23. Amounts outstanding of over-the-counter (OTC) derivatives By risk category and instrumentIn billions of US dollars. Source BIS

  24. Concentration of Derivative Contracts ($ Billions) Source : Comptroller of the Currency, Washington DC, 3Q 2011

  25. Net Current Credit Exposure Source : Comptroller of the Currency, Washington DC, 3Q 2011

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