6.4. CMO and the crisis (2) – securitization, CMO tranches, credit rating and insurance, SPV. Toxic assets

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From the course by Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 rating

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 rating

Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

СМО and the 2008 World Financial Crisis. The Ascent of Moral Hazard. Globalization. Wrap-Up. Some Positive Messages

Week 6, the final week of the Course covers securitization and CMO’s. We will reveal the role of the CMO market in the development of the world financial meltdown that peaked in 2008 and, as many believe, is not yet over. We will study the details of the role of CMO’s in the development of the crisis. We will consider the measures taken by the regulators, the “too big to fail” phenomenon, and will understand why the governments so actively helped the biggest international investment banks found to have been on the verge of bankruptcy. We will also talk about the globalization of capital markets and the first signals of a counter-trend – de-globalization. We will clearly see how modern geopolitical and technological trends contribute to the ascent of moral hazard that is now a global problem. Finally, some clear and useful recommendations are provided. As a result, you will be able to successfully apply the obtained knowledge and skills not only in finance but also in your career and life in general.

6.1. CMO – the idea14:51

6.2. CMO – the mechanism, cash flows, and risk12:11

6.3. CMO and the crisis (1) – the market, mortgage brokers, and substandard mortgages5:14

6.4. CMO and the crisis (2) – securitization, CMO tranches, credit rating and insurance, SPV. Toxic assets6:32

6.5. “Too Big to Fail”8:06

6.6. Globalization in capital markets and its challenges7:46

6.7. What has been done to fight the crisis? New regulation, QE, negative interest rates18:46

6.8. The first signs of “de-globalization”. Brexit. Problems and challenges7:58

6.9. Wrap-up and conclusions. Positive messages and practical advice10:34

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, let's proceed.

So we have a bank here,

and the bank has these mortgages.

Well, if these mortgages behaved okay,

then the bank wouldn't care much.

But let's say, what if these mortgages are poor?

So instead, you have very little cash coming,

or you expect them to become poorer,

and then you don't know what to do because mortgages per se,

they are really liquid and so you are kind of locked.

But now, you see a savior.

You see an investment bank who buys all these mortgages and

then sells ACMO with tranches A,

B, C, and Z.

Now, see what happens.

In this case, first of all,

the bank is happy because it got rid of some mortgages

that might be actually quite poor at the same time.

But now, why is that the IB is happy?

Well, because like I said,

there is a market for this,

and the IB can market tranche A to

really conservative institutional investors because tranche A is the lowest risk.

You can obtain a credit rating as high as triple A.

You can buy insurance for that.

And on top of that,

you do not have the obligation to show all these tranches on your balance sheet.

Well, so the bank sells A to some conservative investors,

then it sells B to some risk-taking investors,

who are pursuing higher rate of return,

and then the bank keeps C and Z for itself.

If things go nicely,

then the bank pockets a huge interest.

If the thing do not go so nicely,

then this is a problem of investment bank.

But all this is stored at the balance sheet of an offshore subsidiary.

So the bank's position is not so badly damaged here.

So this is all great if there is enough money to arrive.

And these tranches A were marketed to the most conservative investors in the world,

but if we see that the pool is

poor because there are too many substandard mortgages there,

what do we see as a result?

We see that problems accumulate.

Problems do accumulate, but these highly risky things,

they do not show up on balance sheets.

You do not report them to accounting.

So as a result,

it seems sort of very much like the situation that we saw,

observed earlier in the S&L crisis,

but the scale is much higher.

Now, another thing to jump ahead a little bit is that this situation becomes global.

Now, the market is not limited to the US,

but you can sell this to whatever.

As one, a very funny cartoon on the Internet goes,

you can sell those to the municipals of Norwegian villages.

And therefore, you have a lot of people involved,

a lot of money involved,

and it is not until something really bad happens when everyone

realizes that things went off rails.

And, in this case,

it becomes clear that if this pool is so poor,

that not only owners of tranches B, C,

and Z are hit, but also tranches A they say,

"Well, how come we have triple A ratings?"

Well, ratings were based on

proprietary risk management systems of these investment banks,

and they were not correct. How about the insurance?

They said, "Well, insurance companies did sell these policies,

but they cannot deliver on these promises because

they do not have enough money to cover that."

So as a result,

losses accrue to the abusers,

and all that results in a huge collapse.

The other thing is that indeed these guys,

you might have heard this term that was really populated,

toxic assets, they're on the balance sheet of,

if you take not all of this,

in aspect all subsidiary.

So you have consolidated statement.

And therefore, you see that these assets,

they are shown there,

but they are really worth nothing.

And that creates, again,

a problem very much like what we saw in the S&L crisis.

So this situation actually is quite bad,

and not only did this result in huge losses,

but it also challenge the major question,

should the market take care of that?

And the answer was,

although the developed markets,

they normally vote for that.

Well, we will take care of that.

We don't need regulators.

And they allowed Lehman Brothers to fail.

And as a result,

the market started collapsing,

and it became very clear that if the regulators kept waiting and were

allowing other large financial institutions

that were actually in trouble at that point to fail,

that may bury the whole architecture of capital markets.

And that brought up the issue of too big to fail that although,

at first glance seems to be just plain vanilla blackmail,

but proved to be an important point.

And even drew a lot of attention in the process

of taking measures to alleviate the depth and the damage of this crisis.

So in the next episode,

we will say a few words about what this concept of too big to fail actually is.

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