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).