This document discusses structured finance products like collateralized debt obligations (CDOs) and credit default swaps (CDS) that contributed to the recent financial crisis. It explains how CDOs pooled and tranched various debt obligations, and how CDS allowed entities to synthetically buy and sell credit risk. It also describes how low interest rates, rising home prices, and securitization of lower quality loans created a loop that increased risk. When the crisis emerged, it was initially seen as a liquidity problem, but government takeovers of Fannie Mae, Freddie Mac, and Lehman Brothers showed it was also a solvency issue.

1. Structured Finance and the recent
turmoil
J. Ericsson

2. Primer on Structured Credit
 Credit default swaps.
 Collateralized debt obligations.
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5. Intuition
 Buying a corporate bond and insuring the default
risk (CDS) is the same as buying a government bond
to start with.
 Buying a treasury and selling insurance (CDS) is
equivalent to buying a corporate bond synthetically.
 AIG was a big seller of various forms of default
insurance.
 Lehman was an important counterparty to CDS
contracts (300 vs. 6 $B)
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7. Basic CDO structure
Individual CDS ... are pooled ... ... and tranched
Contracts / credits
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8. – who were the CDO tranche buyers?
– how does one sell an equity tranche to a
pension fund?
– problems – leverage and transparency
combined with a brand new market
barely understood by many participants.
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10. A not very virtuous loop of
– low rates >
– increasing RE prices >
– new categories of homebuyers accepting
harsher terms >
– Institutions securitizing lower quality loans and
creating “safer” securities (and some riskier
equity tranches) >
– Buy side financial institutions funding investments
in these securities by borrowing short term at
lower yields (cf riding the yield curve).
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17. FED REACTION – liquidity vs solvency
 crisis mainly viewed as a market liquidity
problem between late summer 2007 and
2008
 central bank significantly extended its
balance sheet to address the liquidity
problem and the seizure of money markets.
 This led to perverse incentives -- “problem
collateral” found its way to central banks.
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18. • Take over of Fannie and Freddie and the
collapse of Lehman Brothers, and the near
failure of others have demonstrated that the
problem is one of solvency as well as
illiquidity.
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19. – Now that the crisis is viewed more as a
solvency problem , FED is approaching the
problem by seeking to “nationalize”
problem assets and hold them until the
housing prices stabilize.
– This raises questions about incentives: a)
recapitalization requirements, b) equity
stake for tax payers etc...
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