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-
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-
The home prices convergence-