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Contents

Introduction ............................................................................................................................................ 2
The Housing Bubble ................................................................................................................................ 3
Tranches .................................................................................................................................................. 4
The Final Fall ........................................................................................................................................... 5


The Role of
CDOs in
subprime Crisis.
Security Analysis and
Portfolio
Management
KUNAL BHODIA
FSB2013002291
Introduction

It is to be understood that instruments are not the cause of the crisis;
It is how they were used which caused the crisis.
There are two key terms which are necessary to be defined before going any
further.
First Subprime:- Subprime Mortgage is a type of mortgage that is primarily
given out to borrowers with lower credit ratings. As a result of the borrower's
lower credit rating, a predictable mortgage is not offered because the lender
views the borrower as having a larger-than-
average risk of defaulting on the loan. Lending institutions often charged intere
t on subprime mortgages at a rate which is higher than a normal mortgage in
order to shield them for carrying more risk.
Second CDOs:- A Collateralized Debt Obligation (CDO) is a security whose value
is collaterized by a pool of underlying fixed-income assets. It is an investment
that yields a standard return, its payments being derived from the
performance of this pool. It is a financial instrument that traders use to sell
securities that individually would be hard to sell.
The Mechanics of the System
In a CDO, an investment bank collected a series of assets -- often high-yield
junk bonds, mortgage backed instruments, credit-default swaps and other
high-risk, high-yield products from the fixed-income market. The investment
bank then created a corporate structure -- the CDO -- that would distribute the
cash flows from those assets to investors in the CDO.
CDOs were marketed as investments with a defined risk and reward and
divided them into tranches. In other words, if you bought one you would know
how much of a return you could expect in exchange for risking your capital.
The investment banks that were creating the CDOs presented them as
investments in which the key factors were not the underlying assets. Rather,
the key to CDOs was the use of mathematical calculations to create and
distribute the cash flows. In other words, the basis of a CDO wasn't a
mortgage, a bond or even a derivative -- it was the metrics and algorithms
of mathematics and traders. In particular, the CDO market skyrocketed in 2001
with the invention of a formula called the Gaussian Copula, which made it
easier to price CDOs quickly.
In early 2007, Wall Street began to feel the first tremors in the CDO
world. Defaults were rising in the mortgage market. And many CDOs
included derivatives that were built upon mortgages -- including risky,
subprime mortgages.
Hedge fund managers, commercial and investment banks, and pension
funds, all of which had been big buyers of CDOs, found themselves in
trouble. The assets at the core of CDOs were going under. More
importantly, the math models that were supposed to protect
investors against risk weren't working.
Complicating matters was that there was no market on which to sell the
CDOs. CDOs aren't traded on exchanges. CDOs aren't really
structured to be traded at all. If you had one in your portfolio, there
wasn't much you could do to unload it.
The CDO managers were in a similar bind. As fear began to spread, the
market for CDOs' underlying assets also began to disappear. Suddenly it
was impossible to dump the swaps, subprime-mortgage derivatives and
other securities held by the CDOs.
The Housing Bubble
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. The flip side, 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. 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 payment sand easy access to credit
that makes homes more affordable. Hence, all of these variable scan combine to
cause a housing bubble.
Tranches
A CDO is divided into tranches containing securities with varying
degrees of risk. Tranching means taking an income stream and dividing
it into multiple tradable instruments. The 'senior' tranche contains the
safest securities (lowest risk). Payments are made in order of seniority,
so the most junior tranche (otherwise known as the equity tranche or
'toxic waste') is at greatest risk of not receiving a payment, and as such
offers the highest coupon payments to offset the increased risk of such a
default. Investors can therefore specify the exact credit, yield, maturity
and currency characteristics of the security they wish to invest in.
It was the junior tranches that were backed in a large part by the
subprime mortgages. These were mortgages given to customers with
the lowest credit-ratings and debt-to-income ratios, and hence at the
greatest risk of being unable to make their payments. The dividends for
these CDOs were high to offset the increased risk, and while times were
good, interest rates low and the housing market headed steadily
upwards, the demand for these securities particularly from hedge funds
looking to speculate on the markets did likewise. Indeed institutions such
as Freddie Mac and Fannie Mae set up by the US federal government
provided guarantees on loans made to farmers, students and the poor,
which went to exacerbate the US housing bubble. Loans could be made
to subprime borrowers as while the property prices rose, if a borrower
defaulted on their mortgage the lender could sell the house and cover
their losses or even make a profit.
With fees earned on each loan sold on via securitisation, the high yields
that US subprime mortage backed securities provided, and the belief
that there were not high risk as the housing market rose, these CDOs
spread throughout the International Financial Markets like wildfire.
Everyone from banks to pension funds, investment funds and insurance
companies were buying them up.

The Final Fall
Banks were finding themselves increasingly stuck with toxic tranches
they could no longer shift. In February 2007 HSBC wrote down $10
billion worth of its US mortgage book. Shortly after Century, the main
subprime lender in the US filed for bankruptcy. Many CDOs were
downgraded by ratings agencies, forcing pension funds to sell them as
they were now no longer legally entitled to have their investments tied
up in them.
By early 2008, the CDO crisis had morphed into what we now call the
credit crisis.
As the CDO market collapsed, much of the derivatives market tumbled
along with it. Hedge funds folded. Credit-ratings agencies, which had
failed to warn Wall Street of the dangers, saw their reputations severely
damaged. Banks and brokerage houses were left scrambling to increase
their capital.
Then, in March 2008, slightly more than a year after the first indicators
of trouble in the CDO market, the unthinkable happened. Bear Stearns,
one of Wall Street's biggest and most prestigious firms, collapsed.
Eventually, the fallout spread to the point that bond insurance
companies had their credit ratings lowered (creating another crisis in the
bond market); state regulators forced a change in how debt is rated, and
some of the bigger players in the debt markets reduced their stakes in the
business or exited the game entirely.

When the financial crisis peaked in 2008 crippling the banking sector,
banks found themselves with a trillion dollars tied up in now worthless
assets. Of this, around half, that's $500 billion, was tied up in CDOs.
With many banks sitting on huge losses, the interbank lending market
dried up, as no bank wanted to lend to another bank that was potentially
going bust. CitiGroup lost $34 billion on mortgage CDOs, Merrill Lynch
lost $26 billion. The insurer AIG was crippled due to selling $500 billion
worth of Credit Default Swaps to in effect insure against defaults on
CDOs, and payments of which it could not meet.

By the middle of 2008, it was clear that no one was safe. As the dust
settled, auditors began to assess the damage. And it became clear that
everyone -- even those who had never invested in anything -- would wind
up paying the price.

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