28. July.

2010
Sertaç Yay
20050682

The Financial Crisis of 2007:

Roles of CDOs, CDSs and Subprime Mortgages

HPEC.491
Honors Project in Economics

Instructor: Prof. Sumru G. Altuğ

Contents
1. Introduction ............................................................................................................................................... 2
2.1. What is Credit Default Swap? ................................................................................................................. 3
2.2. How did Credit Default Swap emerge? ................................................................................................... 4
2.3. Usage of Credit Default Swap in the Market .......................................................................................... 5
2.3.1. Speculation....................................................................................................................................... 5
2.3.2. Hedging............................................................................................................................................ 6
2.3.3. Arbitrage .......................................................................................................................................... 7
3.1. What is Collateralized Debt Obligation? ................................................................................................ 8
3.2. Types of CDOs ....................................................................................................................................... 9
3.2.1. Synthetic CDO ............................................................................................................................... 10
4. What is Subprime Mortgage? .................................................................................................................. 12
5. Financial Crisis of 2007 to the present ..................................................................................................... 13
5.1. Stage One: US Housing Bubble........................................................................................................ 14
5.2. Stage Two: Growth in the Subprime Mortgage Market ..................................................................... 16
5.3. Stage Three: Where do CDS and CDO fit in this picture?............................................................... 17
5.3.1. Relations between CDS and CDO ............................................................................................. 17
5.3.2. Relation between CDS and Subprime Mortgage ........................................................................ 18
5.4. Stage Four: Burst of Housing Bubble ............................................................................................... 18
6. Conclusion ............................................................................................................................................... 21
Bibliography................................................................................................................................................. 22

1
1. Introduction
In 2008, a series of bank and insurance company failures triggered a financial
crisis that effectively halted global credit markets and required unprecedented
government intervention. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken
over by the government. Lehman Brothers declared bankruptcy on September 14th after
failing to find a buyer. Bank of America agreed to purchase Merrill Lynch (MER), and
American International Group (AIG) was saved by an $85 billion capital injection by the
federal government Shortly after, on September 25th, J P Morgan Chase (JPM) agreed to
purchase the assets of Washington Mutual (WM) in what was the biggest bank failure in
history In fact, by September 17, 2008, more public corporations had filed for
bankruptcy in the U.S. than in all of 2007. These failures caused a crisis of confidence
that made banks reluctant to lend money amongst them. (ANDREWS, MERCED, &
WALSH, 2008)

The collapse of a global housing bubble, which peaked in the U.S. in 2006, caused
the values of securities tied to real estate pricing to plummet thereafter, damaging
financial institutions globally. Commercial and residential properties saw their values
increase precipitously in a real estate boom that began in the 1990s and increased
uninterrupted for nearly a decade. Increases in housing prices coincided with a period
of government deregulation that not only allowed unqualified buyers to take out
mortgages but also helped blend the lines between traditional investment banks and
mortgage lenders. Questions regarding bank solvency, declines in credit availability,
and damaged investor confidence had an impact on global stock markets, where
securities suffered large losses during late 2008 and early 2009. Critics argued that credit
rating agencies and investors failed to accurately price the risk involved with mortgage-
related financial products such as CDOs, CDSs and Subprime Mortgages and that
governments did not adjust their regulatory practices to address 21st century financial
markets. Hence write downs after home owners failed to keep up their payments, found
several institutions at the brink of insolvency with many being forced to raise capital or
go bankrupt. (TheWhiteHouse, 2008)

In this paper, I would start with explaining and defining above mentioned
mortgage backed securities that involved in the crisis which are Credit Default Swaps,
Collateralized Debt Obligation and Subprime Mortgages that main financial product
that crisis had centered on. Secondly, I would briefly discuss and propose their roles in
the current crisis and relationship with each other.

2
2.1. What is Credit Default Swap?
CDS are the fastest-growing major type of financial derivatives, and have played
a critical role in the unfolding financial crisis. By seemingly providing "insurance" on
risky mortgage bonds, they enabled and encouraged uncontrolled behavior during the
housing bubble. (Varchaver,Nicholas;Benner,Katie, 13 Oct 2008) At its most
fundamental level, the CDS is analogous to an insurance contract, though it differs in
ways that are important in understanding how they are used. An insurance contract
might insure a homeowner by providing a payment in the event of a house fire. The
homeowner pays premiums at set dates, and if a fire occurs, the premiums stop and the
insurance company pays the homeowner the claim, which depends on the amount of
damage done to the house. In the same way, a CDS "insures" the holder of the contract
against a corporate default. In exchange, the writer of the CDS contract receives
"premium" payments. However, the analogy with insurance extends only so far. One
major difference between the two contracts is that the CDS can be bought by a person
who does not actually hold the underlying asset (a bond). (Imagine trying to buy
insurance for a house that one does not own!) Consequently, the total value of CDS
contracts can exceed the amount of outstanding debt being insured. (Cherny, Kent;
Craig, R. Ben, July 2009)

For looking more concrete definitions, it is a swap in which the buyer makes a
series of payments and, in exchange, receives a guarantee against default from the seller
on a designated debt security. That is, the buyer transfers the risk that a debt security,
such as a bond, will default to the seller, and the seller receives a series of fees for
assuming this risk. (Credit Default Swap, 2010) A CDS is a contract involving two
parties that trade credit risk: a credit protection buyer and a credit protection seller.
Each party to a CDS trade is counterparty to the other. A CDS always references one or
more debt obligations as it mentioned above, such as a loan made by a bank or the
bonds of a public company. Under the terms of a CDS contract, a protection buyer must
make periodic
payments to the
protection seller,
and will typically do
so on a quarterly basis for a period of five years. The protection buyer will generally pay
a fee proportionate to the credit risk of the debt obligation referenced by the CDS. In
return, the protection seller must pay the protection buyer if a credit event takes place.
What is credit event? A credit event is a negative development relating to the specified
reference debt obligation, such as a failure to pay under the obligation or the bankruptcy
of the entity that issued the reference obligation. If a credit event occurs, a CDS requires

3
the protection seller to pay the protection buyer the diminished value of the reference
debt obligation. In this sense, a CDS is a type of insurance for credit risk that can help
banks and other companies better manage their credit risks. (SHADAB, 2009)

2.2. How did Credit Default Swap emerge?

JPMorgan, commercial and investment banking institution, actually was its
father. So, why did JPMorgan need or create such a vital derivative? In order to
understand the creation of CDS we should look at the near history. By the mid-'90s,
JPMorgan's books were loaded with tens of billions of dollars in loans to corporations
and foreign governments, and by federal law it had to keep huge amounts of capital in
reserve in case any of them went bad. JPMorgan bankers were trying to get their heads
around a question as old as banking itself: how do you mitigate your risk when you
loan money to someone? (Philips, 2008)

One of the brands of motor fuel, Exxon, client of the JPMorgan also, needed to
open a line of credit to cover potential damages of five billion dollars resulting from the
1989 Exxon Valdez oil spill (hundreds of thousands of barrels of crude oil in Alaska). J.
P. Morgan was unwilling to turn down Exxon, which was an old client, but the deal
would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-
called Basel rules, named for the town in Switzerland where they were formulated,
required that the banks hold eight per cent of their capital in reserve against the risk of
outstanding loans. That limited the amount of lending bankers could do, the amount of
risk they could take on, and therefore the amount of profit they could make. But, if the
risk of the loans could be sold, it logically followed that the loans were now risk-free;
and, if that were the case, what would have been the reserve cash could now be freely
loaned out. (JP Morgan invented credit-default swaps to give Exxon credit line for
Valdez liability, 2010) What the bankers hit on was a sort of insurance policy: a third
party would assume the risk of the debt going sour, and in exchange would receive
regular payments from the bank, similar to insurance premiums. (Philips, 2008) In late
1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of
selling the credit risk to the European Bank of Reconstruction and Development. So, if
Exxon defaulted, the E.B.R.D. would be on the hook for it—and, in return for taking on
the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P.
Morgan would get to honor its client relationship but also to keep its credit lines intact
for interesting activities. (JP Morgan invented credit-default swaps to give Exxon credit
line for Valdez liability, 2010) JPMorgan would get to remove the risk from its books
and free up the reserves. The scheme was called a "credit default swap," and it was a
twist on something bankers had been doing for a while to hedge against fluctuations in

4
interest rates and commodity prices. While the concept had been floating around the
markets for a couple of years, JPMorgan was the first bank to make a big bet on credit
default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and
science grads from schools like MIT and Cambridge to create a market for the complex
instruments. Within a few years, the credit default swap (CDS) became the hot financial
instrument, the safest way to parse out risk while maintaining a steady return. (Philips,
2008)

2.3. Usage of Credit Default Swap in the Market

Although Credit Default Swap can be seen new to the market, they are growing
rapidly. At the end of 2001, there was $920 billion in credit default swaps outstanding.
By the end of 2007, that number had skyrocketed to more than $62 trillion. (How
Credit Default Swaps Brought Down the World Economy, 2009) There are three main
usages of CDS in today’s world and we can title them as speculation, hedging, and
arbitrage

2.3.1. Speculation
The buyer of credit risk protection does not necessarily need to be exposed to the
underlying risk when entering into a CDS contract. CDS may also be used for pure
trading purposes, where traders try to exploit possible mispricing between different
asset classes or take open positions if they believe the market will evolve in a certain
direction. Similarly, sellers of credit protection are able to gain access to the credit
market via an arm’s length financial transaction. By using CDSs, they do not have to
prefund their exposure (except for the posting of collateral) and do not bear interest rate
risk generally associated with the purchase of bonds or the extension of loans. Through
trading, the CDS market generally becomes more liquid, improving not only the chances
of protection buyers and sellers finding a contract partner, but also enhancing pricing
efficiency. Due to their favorable characteristics, CDS spreads have gained widespread
acceptance as an important indicator of distress. Other examples include the prices
charged for government guarantees for debt issues of banks hit by the financial crisis or
the rates demanded for corporate credit lines, both of which have been directly linked to
CDS spreads. Likewise, rating agencies use information derived from CDS prices to
calculate “market implied ratings”. Thus in practice, CDS spreads serve as an important
source of information for private banks, central banks, supervisors and international
organizations alike. (DeutscheBankResearch, 2009).

Credit default swaps allow investors to speculate on changes in CDS spreads. An

investor might believe that an entity's CDS spreads are too high or too low, relative to

5
the entity's bond yields, and attempt to profit from that view by entering into a trade
that combines a CDS with a cash bond and an interest-rate swap. Also an investor
might speculate on an entity's credit quality, since generally CDS spreads will increase
as credit-worthiness declines and decline as credit-worthiness increases. The investor
might therefore buy CDS protection on a company to speculate that it is about to
default. Alternatively, the investor might sell protection if it thinks that the company's
creditworthiness might improve. (Pinsent)The investor selling the CDS is viewed as
being “long” on the CDS and the credit, as if the investor owned the bond. In contrast,
the investor who bought protection is named “short” on the CDS and the underlying
credit. Credit default swaps opened up important new avenues to speculators. Investors
could go long on a bond without any upfront cost of buying a bond; all the investor
need do was promise to pay in the event of default. Shorting a bond faced difficult
practical problems, such that shorting was often not feasible; CDS made shorting credit
possible and popular. Because the speculator in either case does not own the bond, its
position is said to be a synthetic long or short position.

For example, a hedge fund believes that SY Corp will soon default on its debt.
Therefore, it buys $10 million worth of CDS protection for two years from X-Bank, with
SY Corp as the reference entity, at a spread of 500 basis points (=5%) per annum. If SY
Corp does indeed default after, say, one year, then the hedge fund will have paid
$500,000 to X-Bank, but will then receive $10 million, thereby making a profit. X-Bank,
and its investors, will incur a $9.5 million loss However, if SY Corp does not default,
then the CDS contract will continue for two years, and the hedge fund will have ended
up paying $1 million, thereby making a loss. X-Bank, by selling protection, has made
$1 million. On the other side suppose after one year, the market now considers SY Corp
more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The
hedge fund may choose to sell $10 million worth of protection for one year to X-Bank at
this higher rate. Therefore over the two years the hedge fund will pay the bank 2 * 5% *
$10 million = $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a
total profit of $500,000. (Mengle, 2007)

2.3.2. Hedging
First of all, “hedging” is any action such as transaction and investment to reduce
the risk of price fluctuations for an asset or investment. Normally, a hedge consists of
taking an offsetting position in a related security, such as a futures contract. (Financial
Dictionary, 2010)There are many specific financial vehicles to reduce risk of adverse
price movements in a security, including insurance policies, forward contracts, swaps,

6
options, many types of over-the-counter and derivative products. However, Credit
default swaps are often used to manage the risk of default which arises from holding
debt. (Choudhury, 2006) CDSs are derivative instruments because their financial value
is derived from the value of an underlying financial asset, usually a bond. The ability to
trade derivatives allows the various risks of an asset to be transferred to counterparties
willing to bear them without the underlying asset being involved in the trade—or even
being held by either the buyer or the seller. CDS contracts represent the exchange of a
specific risk—corporate or sovereign default—between two investors making opposite
bets, the CDS seller who bets the borrower will not default, and the CDS buyer who bets
it will. This exchange of risk leads, naturally, to investment hedging, an important use of
CDSs. (Cherny, Kent; Craig, R. Ben, July 2009)

For example, suppose an investment fund owned mortgage bonds from

riskymortgage.com.tr. It might be worried about losing all its investment. Therefore, to
hedge against the risk of default, they could purchase a credit default swap from SY-
Bank. If riskymortgage.com.tr defaulted, they will lose their investment, but receive a
payoff from SY to compensate. If they don’t default, they have paid a premium to SY
but have had security. (Credit Default Swaps Explained, 2008)

2.3.3. Arbitrage

Arbitrage refers to the buying of one item and the selling of the same item for a
higher price, therefore making a profit on the difference or in our case refers to the
simultaneous purchase and sale of an asset in order to profit from a difference in the
price. It is a trade that profits by exploiting price differences of identical or similar
financial instruments, on different markets or in different forms. Arbitrage exists as a
result of market inefficiencies; it provides a mechanism to ensure prices do not deviate
substantially from fair value for long periods of time. (Financial Dictionary, 2010)

Arbitrage is used to utilize CDS transactions. It relies on the fact that company’s
stock price and its CDS spread should exhibit negative correlation. Hence, if the position
for a company improves then its share price should go up and its CDS spread should
tighten, since it is less likely to default on its debt. However if its position worsens then
its CDS spread should expand and its stock price should fall. Techniques reliant on this
are known as capital structure arbitrage because they exploit market inefficiencies
between different parts of the same company's capital structure; i.e. mis-pricings
between a company's debt and equity. (Chatiras,Manolis;Mukherjee, Barsendu,
February 2004)

7
3.1. What is Collateralized Debt Obligation?
In order to understand what Collateralized Debt Obligation is, let’s try to
understand what collateral means. In finance, collateral refers to assets pledged as
security for a loan. In the event that a borrower defaults on the terms of a loan, the
collateral may be sold, with the proceeds used to satisfy any remaining obligations.
Actually, high-quality collateral reduces risk to the lender and results in a lower rate of
interest on the loan. (Scott, 2003) So, we can predict that concrete definition of CDOs will
lead us an asset-backed security (ABS).

One of the most significant developments in international credit markets in recent

years has been the trade in Collateralized Debt Obligations (CDO), which has enabled
financial institutions to repackage the credit risk of an asset portfolio into tranches to be
transferred to investors. The first CDO was issued in 1987 by bankers at now-defunct
Drexel Burnham Lambert Inc. for Imperial Savings Association. A decade later, CDOs
emerged as the fastest growing sector of the asset-backed synthetic securities market. A
major factor in the growth of CDOs was the 2001 introduction by David X. Li of
Gaussian copula models, which allowed for the rapid pricing of CDOs. According to the
Securities Industry and Financial Markets Association, aggregate global CDO issuance
totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$
486 billion in 2007. Research firm Celent estimates the size of the CDO global market to
close to $2 trillion by the end of 2006. (Rösch & Scheule, 2008)CDO's, or Collateralized
Debt Obligations, are sophisticated financial tools repackaging individual loans into a
product that can be sold on the secondary market. These packages consist of auto loans,
credit card debt, or corporate debt. They are called collateralized because they have
some type of collateral behind them. If the package consists of corporate debt, CDO's are
called asset-backed commercial paper. They are called mortgage-backed securities if the
loans are mortgages. CDO's were created to provide more liquidity in the economy. It
allows banks and corporations to sell off debt, which allows more capital to invest or
loan. (Amadeo, 2010)

Collateralized debt obligations are securitized interests in pools of generally non-

mortgage assets. Assets called collateral usually comprise loans or debt instruments. A
CDO may be called a collateralized loan obligation (CLO) or collateralized bond
obligation (CBO) if it holds only loans or bonds, respectively. Investors bear the credit
risk of the collateral. Multiple tranches of securities are issued by the CDO, offering
investors various maturity and credit risk characteristics. Tranches are categorized as
senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If
there are defaults or the CDO's collateral otherwise underperforms, scheduled

8
payments to senior tranches take priority over those of mezzanine tranches, and
scheduled payments to mezzanine tranches take priority over those to
subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with
the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB.
The ratings reflect both the credit quality of underlying collateral as well as how much
protection a given tranch is afforded by tranches that are subordinate to it.
(Collateralized Debt Obligation, 2010)

3.2. Types of CDOs

CDOs can be classified using three criteria: motivation, asset type, and form of
risk transfer as you can see above. From the motivations’ perspective, CDOs can be
categorized into two main categories, balance sheet or arbitrage transactions. A balance
sheet transaction is intended to remove loans or in some cases bonds, from the balance
sheet of financial institution. The purpose is to free up regulatory capital, to improve

liquidity and generate a higher return on the assets through redeployment of capital.
The main sponsors of balance sheet transactions are banks and insurance companies. A
further classification of the balance sheet transactions is the division into cash flow and
synthetic structures. (Das, 2001) The classic example of balance sheet transactions is a
bank that has originated loans over months or years and now wants to remove them
from its balance sheet. Unless the bank is very poorly rated, CDO debt would not be
cheaper than the bank’s own source of funds. But selling the loans to a CDO removes
them from the bank’s balance sheet and therefore lowers the bank’s regulatory capital
requirements. This is true even if market practice requires the bank to buy some of the
equity of the newly created CDO (Lucas & Laurie S. Goodman, 2007)

9
 An arbitrage transaction is setup to make money from the credit-spread
difference between the yield of the collateral and the yield of the issued CDO notes.
Arbitrage CDOs can be broken into three categories. If the primary source is the interest
and maturing principal from the collateral assets, then the transaction is referred to as a
cash flow transaction. If the proceeds depend heavily on the total return generated from
active management of the collateral assets, then the transaction is referred to as a market
value transaction. The third category is an arbitrage synthetic CDO structure. The
arbitrage CDO market has emerged as one of the most important structured product
markets. The reasons were wider swap spreads and therefore higher arbitrage
opportunities as well as the slowdown of the activity in the high yield bond market due
to rating downgrades and corporate defaults. (Deacon, 2004) Simply, the aim of
Arbitrage CDOs is to capture the arbitrage opportunity that exists in the credit-spread
differential, between the high yield collateral and the highly rated notes. The idea is to
create collateral with a funding cost lower than the returns expected from the notes
issued. Most arbitrage deals are private ones, where size is not large and the number of
assets included in the deal is very limited compared to the cash flow type. (Picone, 2008)

3.2.1. Synthetic CDO

The development of the credit derivatives market, particularly the credit default
swap (CDS) market, fostered the development of the synthetic CDO. A synthetic CDO
does not actually own the portfolio of assets on which it bears credit risk. Instead, it
gains credit exposure by selling protection via CDSs. In turn, the synthetic CDO buys
protection from investors via the tranches it issues. These tranches are responsible for
credit losses in the reference portfolio that rise above a particular attachment point; Each
tranche’s liability ends at a particular detachment or exhaustion point. The first
synthetic CDOs were initiated by U.S. and European banks in 1997 for balance sheet
purposes. The motivation was to achieve regulatory capital relief without forcing the
banks to sell loans they had originated. Instead, synthetic balance sheet CDOs allowed
sponsoring banks to purchase credit protection on loans they continued to own, which
reduced their credit risk and required capital. A synthetic CDO’s ability to delink the
credit risk of an asset from its ownership affords banks substantial flexibility in balance
sheet management.

As explained earlier, there are balance sheet CDOs and arbitrage CDOs. The same is
true for the synthetic variety. Synthetic arbitrage CDOs come in the following forms:

10
 • Full capital structure CDOs, which are the oldest, include a full complement of
tranches from super senior to equity. These CDOs have either static reference
portfolios or a manager who actively trades the underlying portfolio of CDSs.
• Single tranche CDOs are newer, and are made possible by dealers’ faith in their
ability to hedge the risk of a CDO tranche through single name CDS. Single
tranche CDOs often allow CDO investors to substitute credits and amend other
terms over the course of the CDOs’ life. (Lucas & Laurie S. Goodman, 2007)

Hence, a synthetic CDO is a portfolio of credit default swap. The problem with
buying a CDS is that it usually references only one security, and the credit risk to be
transferred in the swap may be very, very large. In contrast, a synthetic CDO references
a portfolio of securities and is itself securitized into notes in various tranches, with
progressively higher levels of risk. In turn, synthetic CDOs give buyers the flexibility to
take on only as much credit risk as they wish to assume. The buyer of the synthetic CDO
gets premiums for the component CDS and is taking the "long" position, meaning they
are betting the referenced securities (such as mortgage bonds or regular CDO's) will
perform. The seller of the synthetic CDO is paying premiums and is taking the "short"
position, meaning they are betting the referenced securities will default. The seller
receives a large payout if the referenced securities default, which is paid to them by the
buyer.

The term synthetic CDO arises because the cash flows from the premiums (via
the component CDS in the portfolio) are analogous to the cash flows arising from
mortgage or other obligations that are aggregated and paid to regular CDO buyers. In
other words, taking the long position on a synthetic CDO (i.e., receiving regular
premium payments) is like taking the long position on a normal CDO (i.e., receiving
regular interest payments on mortgage bonds or credit card bonds contained within the
CDO).

Let’s try to understand with an example. Suppose Party A wants to bet that at
least some mortgage bonds and CDO's will default from among a specified population
of such securities, taking the short position. Party B can bundle CDS related to these
securities into a synthetic CDO contract. Party C agrees to take the long position,
agreeing to pay Party A if certain defaults or other credit events occur within that
population. Party A pays Party C premiums for this protection. Party B, typically an
investment bank, would take a fee for arranging the deal. (Conerly, 2010)

11
 A synthetic CDO has a lot of advantages over a cash flow CDO. The main
advantage is the funding advantage, i.e. that the super senior bond does not need to be
funded and that CDS are often cheaper than the underlying cash bond(cheaper
collateral assets).Another economic advantage is the efficient deal execution with no
ramp-up risk. A transaction can be issued and priced in a very short time horizon.
Synthetic CDOs have bullet maturities where the entire principal sum falls due on
maturity date. The maturity is therefore determined by the maturity of the underlying
CDS. The last advantage is the fact that there is also no interest rate and currency risk on
a synthetic CDO, because the CDS addresses only the credit risk on the instrument.
(Basel II- A new Bank Architecture , 2003)

4. What is Subprime Mortgage?

Actually, Subprime Mortgage is a type of Subprime Loan. In order to understand
what Subprime Mortgage is let’s try to understand what Subprime Loan is. The Federal
Deposit Insurance Corporation (FDIC) has defined subprime borrowers and loans: "The
term subprime refers to the credit characteristics of individual borrowers. Subprime
borrowers typically have weakened credit histories that include payment delinquencies
and possibly more severe problems such as charge-offs, judgments, and bankruptcies.
They may also display reduced repayment capacity as measured by credit scores, debt-
to-income ratios, or other criteria that may encompass borrowers with incomplete credit
histories. Subprime loans are loans to borrowers displaying one or more of these
characteristics at the time of origination or purchase. Such loans have a higher risk of
default than loans to prime borrowers.” (Subprime Lending, 2010)Hence, we can
conclude that Subprime Mortgage is a type of mortgage that is normally made out to
borrowers with lower credit ratings. As a result of the borrower's lowered credit rating,
a conventional mortgage is not offered because the lender views the borrower as having
a larger-than-average risk of defaulting on the loan. Lending institu-
tions often charge interest on subprime mortgages at a rate that is higher than a
conventional mortgage in order to compensate themselves for carrying more risk.
(Financial Dictionary, 2010)Subprime lending is a relatively new and rapidly growing
segment of the mortgage market that expands the pool of credit to borrowers who, for a
variety of reasons, would otherwise be denied credit. For instance, those potential
borrowers who would fail credit history requirements in the standard (prime) mortgage
market have greater access to credit in the subprime market. Two of the major benefits
of this type of lending, then, are the increased numbers of homeowners and the
opportunity for these homeowners to create wealth. (Chomsisengphet & Pennington-
Cross, 2006)

12
 There are several different kinds of subprime mortgage structures available. The
most common is the adjustable rate mortgage (ARM). A type of mortgage in which the
interest rate paid on the outstanding balance varies according to a specific benchmark.
The initial interest rate is normally fixed for a period of time after which it is reset
periodically, often every month. The interest rate paid by the borrower will be based on
a benchmark plus an additional spread, called an ARM margin. An adjustable rate
mortgage is also known as a "variable-rate mortgage" or a "floating-rate mortgage".
(Financial Dictionary, 2010)

Unlike fixed rate mortgages that have an interest rate that remains the same for
the life of the loan, the interest rate on an ARM will change periodically. The initial
interest rate of an ARM is lower than that of a fixed rate mortgage, consequently, an
ARM may be a good option to consider if you plan to own your home for only a few
years; you expect an increase in future earnings; or, the prevailing interest rate for a
fixed rate mortgage is too high.

An ARM has four components: (1) an index, (2) a margin, (3) an interest rate cap
structure, and (4) an initial interest rate period. When the initial interest rate period has
expired, the new interest rate is calculated by adding a margin to the index. Your lender
will disclose the margin at time of loan application. As the index figure moves up or
down, your interest rate will be adjusted accordingly. Among the most common indices
are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds
Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their
own cost of funds as an index, rather than using other indices. This is done to ensure a
steady margin for the lender, whose own cost of funding will usually be related to the
index. Increases or decreases in the interest rate will be limited by the interest rate cap
structure of your loan. (The Federal Reserve Board, 2010)

5. Financial Crisis of 2007 to the present

The financial crisis of 2007 to the present is a crisis triggered by a liquidity
shortfall in the United States banking system caused by the overvaluation of assets It has
resulted in the collapse of large financial institutions, the bailout of banks by national
governments and downturns in stock markets around the world. In many areas, the
housing market has also suffered, resulting in numerous evictions, foreclosures and
prolonged vacancies. It is considered by many economists to be the worst financial crisis
since the Great Depression of the 1930s. (Mah & Lim, 2008)

13
5.1. Stage One: US Housing Bubble

Above figure shows the behavior of housing prices in the United States from
January 2000 through March 2009. While these two indexes of housing prices show
different increases and decreases due to differences in coverage and methodology, the
overall picture is the same: increases in housing prices until Summer 2006 or Spring
2007 followed by decreases. This fall in housing prices occurred in the context of rising
and then falling housing prices in many other parts of the world.

The United States housing bubble is an economic bubble affecting many parts of
the United States housing market; in several states housing prices peaked in early 2005,
started to decline in 2006, and may not yet have hit bottom. On December 30, 2008 the
Case-Shiller home price index reported its largest price drop in its history. Increased
foreclosure rates in 2006–2007 among U.S. homeowners led to a crisis in August 2008 for
the subprime, collateralized debt obligation (CDO), mortgage, credit, hedge fund, and
foreign bank markets. (Tkac & Dwyer, 2009)In 2008 alone, the United States government
allocated over $900 billion to special loans and rescues related to the US housing bubble,
(Reuters, 2008)

14
 So, what were reasons behind the housing bubble? The answer is easy. The price
of housing, like the price of any good or service in a free market, is driven by supply and
demand. When demand increases and/or supply decreases, prices go up. In the absence
of a natural disaster that might decrease the supply of housing, prices rise because
demand trends outpace current supply trends. Just as important is that the supply of
housing is slow to react to increases in demand because it takes a long time to build a
house, and in highly developed areas there simply isn't any more land to build on. So, if
there is a sudden or prolonged increase in demand, prices are sure to rise. Once you've
established that an above-average rise in housing prices is primarily driven by an
increase in demand, you might ask what the causes of that increase in demand are.
There are several: First, an improvement in general economic activity and prosperity
that puts more disposable income and encourages home ownership. Second, an increase
in the population or the demographic segment of the population entering the housing
market can simply increase the demand. (Wheaton & Nechayev, 2009)Third and finally
the important one for our issue, a low general level of interest rates, particularly short-
term interest rates, innovative mortgage products with low initial monthly payments
and easy access to credit that makes homes more affordable. Hence, all of these variables
can combine to cause a housing bubble. (Smith & Smith, 2006) However, first two
reasons were not actually there rather than third reason according to Baker. He says:
“The increase in house prices is not being driven by fundamental factors in the housing
market, such as income and population growth.” And “The market in Mortgage backed
security exceeds $6 trillion in 2005” (BAKER, 2005)

15
5.2. Stage Two: Growth in the Subprime Mortgage Market
Subprime lending is a relatively new
and rapidly growing segment of the mortgage
market that expands the pool of credit to
borrowers who, for a variety of reasons, would
otherwise be denied credit. For instance, those
potential borrowers who would fail credit
history requirements in the standard (prime)
mortgage market have greater access to credit
in the subprime market as I mentioned before.
Because of its complicated nature, subprime
lending is simultaneously viewed as having
great promise and great peril. The promise of
subprime lending is that it can provide the
opportunity for homeownership to those who
were either subject to discrimination or could
not qualify for a mortgage in the past. in fact, a loan subprime is the existence of a
premium above the prevailing prime market rate that a borrower must pay. In addition,
this premium varies over time, which is based on the expected risks of borrower failure
as a homeowner and default on the mortgage. (Chomsisengphet & Pennington-Cross,
2006)

In order to catch the high trend of housing, people of US started to get loans by
using advantages of subprime mortgage. Subprime mortgages simply mean lending to
house borrowers with weak credit. Lenders did so by providing teasers like minimal or
zero down payment, and low introductory adjustable rate mortgages, as well as
negligent documentation and credit checks. Between 2004 and 2006, $1.5 trillion (15% of
the total U.S. housing loans) of subprime mortgages were booked. Total subprime loans
form 25% of the housing mortgage market; these subprime loans were fine as long as the
housing market continued to boom and interest rates did not rise. When these
conditions disappeared, the first to default were subprime borrowers. (Mah & Lim,
2008)

16
5.3. Stage Three: Where do CDS and CDO fit in this picture?

5.3.1. Relations between CDS and CDO

David Li's formula, known as a Gaussian

copula function was adapted by everybody from
bond investors and Wall Street banks to ratings
agencies and regulators. And it became so deeply
entrenched—and was making people so much
money—that warnings about its limitations were
largely ignored. In 2000, while working at
JPMorgan Chase, Li came up with an ingenious
way to model default correlation without even
looking at historical default data. Instead, he used
market data about the prices of instruments known
as credit default swaps. When the price of a credit
default swap goes up, that indicates that default
risk has risen. Li's breakthrough was that instead of
waiting to assemble enough historical data about
actual defaults, which are rare in the real world, he
used historical prices from the CDS market. Armed
with Li's formula, Wall Street's mathematicians saw
new possibilities. The first thing they did was start creating a huge number of brand-
new triple-A securities. Using Li's copula approach meant that ratings agencies no
longer needed to puzzle over the underlying securities. All they needed was that
correlation number, and out would come a rating telling them how safe or risky the
tranche was. As a result, just about anything could be bundled and turned into a triple-
A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked.
The consequent pools were often known as collateralized debt obligations, or CDOs.
You could tranche that pool and create a triple-A security even if none of the
components were themselves triple-A. The CDS and CDO markets grew together,
feeding on each other. At the end of 2001, there was $920 billion in credit default swaps
outstanding. By the end of 2007, that number had skyrocketed to more than $62
trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by
2006. (How Credit Default Swaps Brought Down the World Economy, 2009)

17
5.3.2. Relation between CDS and Subprime Mortgage

As I mentioned before, a credit default swap is, essentially, an insurance contract

between a protection buyer and a protection seller covering a corporation’s, or
sovereigns (the “referenced entity”), specific bond or loan. A protection buyer pays an
upfront amount and yearly premiums to the protection seller to cover any loss on the
face amount of the referenced bond or loan. CDSs are subject only to the collateral and
margin agreed to by contract. They are traded over-the-counter. They are subject to re-
sale to another party willing to enter into another contract. Most frighteningly, credit
default swaps are subject to “counterparty risk.” If the party providing the insu-
rance protection – once it has collected its upfront payment and premiums – doesn’t
have the money to pay the insured buyer in the case of a default event affecting the
referenced bond or loan or if the “insurer” goes bankrupt the buyer is not covered –
period. The premium payments are gone, as is the insurance against default. Credit
default swaps are not standardized instruments. In fact, they technically aren’t true
securities in the classic sense of the word in that they’re not transparent, aren’t traded on
any exchange, aren’t subject to present securities laws, and aren’t regulated. They are,
however, at risk – all $62 trillion (ISDA) of them. (Moars, 2009)

What happened, however, is that risk speculators who wanted exposure to

certain asset classes, various bonds and loans, or security pools such as residential and
commercial mortgage-backed securities (subprime mortgage-backed securities), but
didn’t actually own the underlying credits, now had a means by which to speculate on
them. The bad news is that there are even worse bets out there. There are credit default
swaps written on subprime mortgage securities. It’s bad enough that these subprime
mortgage pools that banks, investment banks, insurance companies, hedge funds and
others bought were over-rated and ended up falling sharply in value as foreclosures
mounted on the underlying mortgages in the pools. (Baker, 2008)

5.4. Stage Four: Burst of Housing Bubble

By the end of 2007, real house prices had fallen by more than 15 percent from
peak.4 House prices in many of the most over-valued markets, primarily along the two
coasts, had fallen by more than 20 percent. Furthermore, the rate of price decline was
accelerating, with prices in these cities falling at more than a 30 percent in annual rate at
the beginning of 2008.5 The rate of price decline in the Shiller indexes imply that real
house prices will be down by more than 30 percent from their 2007 peaks by the end of

18
2008. This would mean a loss of more than $7 trillion in housing bubble wealth
(approximately $100,000 per homeowner). The lost wealth is almost equal to 50 percent
of GDP. There is no way that an economy can see a loss of wealth of this magnitude
without experiencing very serious financial stress. (Baker, 2008)

First, by the decrease in the prices of house in the market, lenders of subprime
mortgages had increased interest rate on the credit since they are ARMs mainly.
Borrowers who could not make the higher payments once the initial grace period ended
would try to refinance their mortgages. Refinancing became more difficult, once house
prices began to decline in many parts of the USA. Borrowers who found themselves
unable to escape higher monthly payments by refinancing began to default. As more
borrowers stop paying their mortgage payments (this is an on-going crisis), foreclosures
and the supply of homes for sale increases. This places downward pressure on housing
prices, which further lowers homeowners' equity. (Mah & Lim, 2008)

Second and the crucial part is how CDSs and CDOs were involved in the crisis.
As I mentioned before, firstly, CDS were used as insurance for ARMs and secondly,
CDOs included pool of Subprime Mortgages and even CDSs of these Subprime
Mortgages. After decline in mortgage payments, hence, the values of theses mortgage
backed securities declined. (Baker, 2008)

CDS are lightly regulated. As of 2008, there was no central clearing house to
honor CDS in the event a party to a CDS proved unable to perform his obligations under
the CDS contract. Required disclosure of CDS-related obligations has been criticized as
insufficient. By the decline in mortgage backed securities that were “insured” by CDS,
insurance companies such as American International Group (AIG), MBIA, and Ambac
faced ratings downgrades because widespread mortgage defaults increased their
potential exposure to CDS losses. These firms had to obtain additional funds (capital) to
offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its
seeking and obtaining a Federal government bailout. (Harrington & Moses, 2008)

On the CDO side, the situation was not so different. The securitization of
mortgages was only the first step in the financial engineering of residential mortgage-
backed securities (RMBSs). RMBSs then were packaged into collateralized debt
obligations (CDOs). CDOs are far from homogeneous securities, both in terms of the
underlying RMBSs and the contractual structure of the CDO itself. The result was the
proliferation of highly individualized CDO securities spread out among a global market
of investors. The heterogeneity of CDOs then led directly to opacity in security

19
valuation. The value of a particular CDO security can be modeled in a variety of ways,
but all models rely on knowledge of the implications of the entire CDO’s structure plus
knowledge or assumptions about the characteristics of the underlying RMBSs and their
underlying mortgages. Since CDOs are not standardized and trade in the OTC market,
the exposure of any counterparty to CDOs in general was largely unobservable (except
by general ‘‘common knowledge’’). This opacity combined with the difficulty in
assessing the value and risk of any particular CDO holdings increases the level of
counterparty risk in these transactions. (Tkac & Dwyer, 2009)

Hence, decline in subprime mortgage market resulted in decline CDO market

and this effected big investment banks which were holding huge share of CDOs pooled
by mortgages such as Lehman Brothers Inc. Lehman Brothers had a 35 to 1 debt to
equity ratio, that is, it only owned $1 out of every $36 in its bank account — the other
$35 were borrowed from somewhere. This meant that a loss of just 3% of the money on
its balance sheet would have meant the loss of all the money it owned. After suffering
heavy losses (more than 3% of the money in its balance) from CDO, borrowers began to
lose confidence and called back the loans. As Lehman had always relied on short-term
loans, its lenders were able to pull their cash back quickly. Now the bank was in trouble.
It borrowed much more than it was able to return and soon found itself unable to pay
back. On 15th September 2008, the world's fourth biggest investment bank declared its
bankruptcy. (Horatio, 2009)When Lehman Brothers declared bankruptcy, it triggered
the transfer of large sums in the CDS market to insure buyers of Lehman credit default
risk protection against all losses from that event. The sellers of these contracts received
the Lehman debt and in return they were obligated to pay the contract buyers (the
insured parties) enough money to make the buyers “whole” i.e. to give them their full
investment in the bonds back as if they had never bought the Lehman bonds.
Outstanding Lehman Brothers’ CDS have an estimated value of $400 billion. No one
knows just how many CDS have been traded or whose balance sheet they are on
because the market for these swaps is unregulated. The International Swaps and
Derivatives Association in 2008 estimated the market at $54.6 trillion. But since there is
no central clearinghouse, trade volume can’t be tracked and publicly posted. (Lengle,
2008) CNBC had announced on 10 October 2008 that according to Erin Burnett,
“Indications are that people who sold protection on Lehman Brothers going bankrupt
may lose 91.25%”. So not only CDOs dealers such as Lehman Brothers failed as a
consequence of US Housing Bubble but “insurance” companies that had CDSs on CDOs
of Lehman Brothers such as American International Group Inc dragged into the crisis.

20
6. Conclusion

From 2007 to present, the world has seen worst financial crisis since the Great
Depression. Causes of the crisis had been discussed by many economists, businessmen,
and journalist all around the world and lots of varying causes, triggers, indicators had
been proposed. However, on the common path they had this pattern: By decline in the
price of house as an end of US Housing Bubble, both the mortgage market and
mortgage backed security markets that include growing new hot products of financial
markets: Credit default swaps, Collateralized debt obligations and their babies Synthetic
CDO markets started decline and eventually crashed. CDOs and CDS grew together by
feeding each other in the first phase of Housing Bubble but in the second phase they
crashed also together and led big companies such as Lehman Brothers and AIG go
bankruptcy. Although people in the investment world did lots of money by using new
hot derivatives, miscalculations or biased-calculations, unregulated market, opacity of
the market, and enjoying risk that brings higher return led them to end up with liquidity
problems hence the bankruptcy. As a conclusion, since numbers were huge in the
chained losses of investment market and needed big bailouts from the government of
U.S.A which has enormous power in global economy, this credit crunch fed the financial
crisis which had triggered the global economic crisis of 2007 –present.

21
Bibliography
(2010). Retrieved 07 19, 2010, from Financial Dictionary: http://www.financialdictionary.net/

Amadeo, K. (2010). US Economy. Retrieved 07 19, 2010, from About.Com:

http://useconomy.about.com/od/glossary/g/CDOs.htm

Baker, D. (2008). The housing bubble and the financial crisis. real-world economics review , Center for
Economic and Policy Research, USA.

BAKER, D. (2005). The Housing Bubble Fact Sheet. CEPR , 1-5.

Basel II- A new Bank Architecture . (2003). UBS Invetment Research . London: UBS Limited.

Chatiras,Manolis;Mukherjee, Barsendu. (February 2004). Capital Structure Arbitrage: An Emprical

Investigation using Stocks and High Yield Bonds. Center For International Securities and Derivatives
Markets .

Cherny, Kent; Craig, R. Ben. (July 2009). Credit Default Swaps and Their Market Function. Economic
Commentary .

Chomsisengphet, S., & Pennington-Cross, A. (2006). The Evolution of the Subprime Mortgage Market.
Federal Reserve Bank of St. Louis Review , 31-56.

Choudhury, K. (2006). Credit Default Swaps: Development, Pricing and Correlation to Default Risk.
CRISIL Young Thought Leaders .

Collateralized Debt Obligation. (2010). Retrieved July 19, 2010, from Risk Glossary:
http://www.riskglossary.com/link/collateralized_debt_obligation.htm

Conerly, B. (2010, April 21). Why The Synthetic CDO Matters In The Goldman Sachs Case. Retrieved
June 19, 2010, from Daily Markets: http://www.dailymarkets.com/stocks/2010/04/21/why-the-synthetic-cdo-
matters-in-the-goldman-sachs-case/

Credit Default Swap. (2010). Retrieved 07 18, 2010, from Financial Dictionary: http://financial-
dictionary.thefreedictionary.com/Credit+Default+Swap

Credit Default Swaps Explained. (2008, November 11). Retrieved 07 19, 2010, from Economics.Help:
http://www.economicshelp.org/blog/finance/credit-default-swaps-explained/

Das, S. (2001). Structured products and hybrid securities. Singapore: John Wiley & Sons.

Deacon, J. (2004). Global Securitisation and CDOs. Chicester,England: John Wiley & Sons Ltd.

DeutscheBankResearch. (2009). Credit default swaps: Heading towards a more stable system. International
Topics , 1-28.

22
Harrington, S. D., & Moses, A. (2008, November 06). Credit Swap Disclosure Obscures True Financial
Risk . Retrieved July 18, 2010, from Bloomberg:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKKRHZsxRvWs&refer=home

Horatio. (2009, June 1). How maths killed Lehman Brothers. Retrieved july 20, 2010, from Plus Magazine:
http://plus.maths.org/issue51/features/boedihardjo/index.html

How Credit Default Swaps Brought Down the World Economy. (2009, February 24). Retrieved july 18,
2010, from Washingtons Blog: http://www.georgewashington2.blogspot.com/2009/02/how-credit-default-
swaps-brought-down.html

JP Morgan invented credit-default swaps to give Exxon credit line for Valdez liability. (2010, May 26).
Retrieved July 18, 2010, from Climate Progress: http://climateprogress.org/2010/05/26/jp-morgan-invented-
credit-default-swaps-to-give-exxon-credit-line-for-valdez-liability/

Lengle, K. (2008, October 20). A Warning Sign From Lehman. Retrieved July 19, 2010, from CBS News:
http://www.cbsnews.com/stories/2008/10/20/cbsnews_investigates/main4535072.shtml

Lucas, D. J., & Laurie S. Goodman, F. J. (2007). Collateralized Debt Obligations and Credit Risk Transfer.
Yale International Center For Finance .

Mah, M., & Lim, H. (2008). Old Wine in New Bottles: Subprime Mortgage Crisis – Causes and
Consequences. JARAF , 3-15.

Mengle, D. (2007, 05 17). Credit Derivatives: An Overview. Retrieved 07 20, 2010, from FEDERAL
RESERVE BANK OF ATLANTA: http://www.frbatlanta.org/filelegacydocs/erq407_mengle.pdf

Moars, K. (2009, September 08). The Real Reason for the Global Financial Crisis…the Story No One's
Talking About. Retrieved July 18, 2010, from Money Morning:
http://moneymorning.com/2008/09/18/credit-default-swaps/

Office of the Comptroller of the Currency, X. (2010). Subprime Lending. Retrieved July 19, 2010, from
FDIC: http://www.fdic.gov/news/news/press/2001/pr0901a.html

Philips, M. (2008, 10 27). The Monster That Ate Wall Street. Retrieved 07 18, 2010, from NewsWeek:
http://www.newsweek.com/2008/09/26/the-monster-that-ate-wall-street.html

Picone, D. (2008). Collateralised Debt Obligations. City University Business School, London , Royal Bank
of Scotland.

Pinsent, W. (n.d.). Credit Default Swaps: An Introduction. Retrieved 07 20, 2010, from Investopedia:
http://www.investopedia.com/articles/optioninvestor/08/cds.asp

Reuters. (2008, September 17). Retrieved June 18, 2010, from

http://www.reuters.com/article/idUKN16126320080917

Rösch, D., & Scheule, H. (2008). Credit rating impact on CDO evaluation. Global Finance Journal .

23
Scott, D. L. (2003). Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor.
Houghton Mifflin Company.

SHADAB, H. B. (2009). Counterparty Regulation and Its Limits: The Evolution of the Credit Default
Swaps Market. NEW YORK LAW SCHOOL LAW REVIEW , 689-705.

Smith, M. H., & Smith, G. (2006). Bubble, Bubble, Where's the Housing Bubble? Project Muse , 1-67.

The Federal Reserve Board. (2010). Retrieved July 19, 2010, from The Federal Reserve:
http://www.federalreserve.gov/pubs/arms/arms_english.htm

Tkac, P., & Dwyer, G. P. (2009). The financial crisis of 2008 in fixed-income markets. Journal of
International Money and Finance , 1293–1316.

Varchaver,Nicholas;Benner,Katie. (13 Oct 2008). The $55 Triiiion Question: Witt the Obscure Worid of
Credit Default Swaps be the Next Disaster? Fortune , 134-140.

Wheaton, W. C., & Nechayev, G. (2009). The 1998-2005 Housing “Bubble” and the Current “Correction”:
What’s Different This Time? Journal of Real Estate Research , 1-26.

24