The CDO role in financial crisis

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How is this finding related to the CDOs performance? Since home prices grew at a high rate till almost the end of 2007 and peaking in 2005, CDOs backed by mortgage-backed securities (MSS) were an ideal high return investment till approximately November 2005, assuming a short term maturity (18 month). Even the use of liquidity puts for short term CDOs to boost sales would have not been disastrous. However, some of the financial institutions ignored these early signs. Citigroup kept their liquidity puts after October 2006 even though an internal memo identifies this risk.

Now I can also give a personal opinion that from the investing perspective, the use of Synthetic CDOs, an respective CDS, after November 2005 will have been with some mischievous intention. In its annual letter to shareholders, Goldman Sachs defends their role in the financial crisis and their relationship to AIG. Goldman Sachs wrote that their exposure to AIG was through insurance purchased on superior tranches CDOs.

Another question that begs an answer is, was the financial crisis unforeseeable? Using the same home prices convergence/divergence I can forecast the future values of home prices using existing 12 month and 24 month values using best fit linear regression. The 6 month home prices forecast is then plotted. Using 24 month existing values I could have predicted that the home prices growth peaked on January-February 2006 and inversed on September 2007. It is hard to believe that the financial institutions and credit rating agencies involved in the CDO business had sophisticated risk analysis simulations, but did not forecast price movements of the underlying collateral.

I mentioned earlier the short term maturity CDOs were better suited for low-risk investments. SIFMA estimates that the majority of CDOs issued are long term maturity. There were USD 501 billion and USD 465 billion long term CDOs issued in 2006 and 2007 respectively. Issuing long term maturity CDOs in 2006 and especially in 2007 carried considerable risk.

The contribution of monetary-policy expectation to the financial crisis is hard to quantify. The monetary-policy assumptions and scenarios and how it was constructed in the risk modeling remains a mystery. Did the lax monetary-policy push investor’s appetite to higher risk higher performance financial instruments from relative safer bonds? We may never know.

CDOs played a notable role in the financial markets. Did the CDO cause the financial crisis or was it blindness, greed and the need for riskier assets? The constructors of the CDOs may not bear direct responsibility. Rather their reckless use, misunderstanding and ignorance of key warning signs likely contributed to the magnitude of the financial crisis. You can observe the financial landscape today and recognize from the survivors, walking wounded and the absentees those who knew and those who had not understood the use of these tools.

More and more banks began churning out CDO's to enable them to lend more and more - and the buyers demanded more CDOs as they saw this as a way of improving returns in a time of artificially low interest rates. A perfectly valid idea pushed to extremes by greed on both sides and woefully poor timing.

The Financial Crisis Inquiry Commission (FCIC), the congressional panel mandated to scrutinize the financial crisis, failed to pinpoint the cause during the April hearing. Was a perfectly valid idea the cause of the global financial crisis, or was it bad timing, or was it pushed to extremes by greed?

Interesting arguments that became pertinent during the hearing were the surge in transactions of Collateralized Debt Obligations (CDOs) and the timing of these transactions, inaccuracies defining key CDOs parameters (e.g. maturity, degree of diversification, average rating), erroneous risk models, perhaps inadequate monetary-policy expectations that created a faulty scenario. Or were there just inconceivable events that, as key participants testified, from banking officials to regulators, they did not perceive the risks. These are the questions that need to be examined.

Former Federal Reserve Chairman Alan Greenspan told the FCIC “Let me respectfully reiterate that, in my judgment, the origination of subprime mortgages – as opposed to the rise in global demand for securitized subprime mortgage interests – was not a significant cause of the financial crisis”. Also, Mr. Greenspan adds that the long term mortgage rates galvanized prices, not the overnight rates of central bank. However, Mr. Greenspan fails to address the impact of changes in monetary policy expectations on financial institutions’ willingness to take on risky assets. With a low federal funds target rate, financial institutions were looking for higher profit margin bonds which drove the demand for CDO manufacture.

CDOs that had become a notable feature of the financial landscape hit a rough spot for being at the center of the financial storm. That is somewhat in contrast with the nature of the CDO that tries to create value by constructing a portfolio of well diversified assets and reduce risk through diversification. However, the quality of the CDO depends on the quality of the assets in the portfolio and most important on the correlation of different risk classes (tranches).

At the peak of 2006, Securities Industry and Financial Markets Association (SIFMA) estimated the size of the global of CDO market at USD 520 billion. As shown in the graph the vast bulk of CDO issuance was concentrated around Cash Flow and Hybrid CDO. The Synthetic CDO represents a small percentage. A Synthetic CDO is backed by credit default swaps. Furthermore the percentage of Synthetic to Cash Flow and Hybrid CDOs decreased each year from 2005 till 2008 (this does not count for the Synthetic CDOs included the Hybrid CDOs). As I will mentioned later in the article the use of Synthetic CDOs after 2005 would have been very risky.

To analyze the functioning of the CDOs, first we should look at the underlying home prices trend that was the basis for so many mortgages losses. To do this we are using the S&P/Case-Shiller Home Price Index for 20 major metropolitan areas from January 2000 till December 2009. We make here a note that the Wall Street Challenger questions the accuracy of the S&P/Case-Shiller Home Price Indices pointing out that the indices weights down or eliminates data points that are market driven.

The home prices convergence-divergence (CD) presented in the attached graph is calculated by subtracting from the 9 month exponential moving average (EMA) and a 24 month EMA. The 9 month EMA has the purpose of smoothing out the sales prices seasonality involving the February lows and August highs. It can be easily observed that the peak home price increase rate was achieved around November 2005 and home prices still growing till November 2007 (when the CD starts to turn negative).