How did the derivatives market 'collapse' in 2008?

Question

I just watched the film 'The big short', and have been trying to think in context with the financial markets in 2008. I think the film does a great job of explaining how sub-prime mortgages came to be issued and sold by opportunists to investors who were blinded to their junk value.

One key thing that I feel though is brushed over though is what the market for derivatives on the mortgage industry looked like at that time, and how the eventual defaults on the mortgages caused this to 'collapse'. They claim that the derivatives market had grown to 20 times the size of the market itself. According to the film,

if... the mortgage bonds were the kerosene soaked rags, then the 'synthetic CDOs' were the atomic bomb with the drunk president holding his finger over the button

but what did these derivatives look like? I understand how someone may invest in a mortgage, which is money lent that will have to be written off in case of default. But how did the actual defaults magnify in the event to hit investors twenty fold? What were people investing in on top of the mortgages themselves? And why did these objects all necessarily become junk when the mortgages themselves did?

Answer 1

The question is quite complex and an answer should be far beyond looking only at the structure of the derivatives, but i try my best.

The initial situation:

• Between 1998 and 2006, the price of the typical American house increased by 124%
• Global saving glut due to the dotcom-bubble in the early 2000s, seeking institutions for alternative investments, cutting out financial risks
• The Community Reinvestment Act which helped low- and moderate-income Americans to get mortgage loans

These points led to a situation, where in fact everyone could get a mortgage to buy a house, not only for using them as own-property, but as a financial asset. Also people with "no income, no job, no assets", leading to the term Ninja-Loan, were granted loans and mortgages. Times were great, as long as house prices increased. The US financial markets were flood by money from investors, wanting to become part of that upswing. How they took part, answers how the derivatives look like, and how their structure led to the financial crisis:

CDOs and CDSs

Lets take a look an a classic CDO:

CDOs pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of mortgage loans. There are several tranches, which catch the cash flow of interest and principal payments in sequence based on seniority.

As CDOs became popular, some investment banks repackaged selected tranches into yet another iteration, known as CDO-squared, a complex and intransparent structure of financial derivative.

A CDS (credit default swap) is a financial agreement that the seller of the CDS will compensate the buyer in the event of a loan default. It can be considered as an insurance for a creditor of the referenced loan.

Synthetic CDOs

Synthetic CDOs are CDOs, which do not only bundle the mortgage loans in the picture above, but also other assets and derivatives. Up to 2008 it was popular to construct CDOs, bundling single CDSs, rather then mortgage loans. This is the structure of a synthetic CDO, created in times before 2008.

How did defaults of mortgages hit investors twenty fold?

Synthetic CDOs described above can be considered as a bet on the performance of CDSs, rather than the performance on a real mortgage security. In fact, the derivatives were detached from a single mortgage due to repeated securization in CDOs and there use as an underlying for CDSs. They became solid derivatives offering high returns.

As stated in the New York Times (1), from 2005 through 2007, at least $108 billion synthetic CDOs were issued, but the actual volume can be much higher because synthetic CDO trades were unregulated.

Debate and further topics

Synthetic CDOs are well known for their destructive character during the financial crisis. They were easy to construct, barely supervised or regulated and offered high returns. As the former Citigroup CEO said, referring to the leveraged lending practice: "As long as the music is playing, you’ve got to get up and dance. We're still dancing." As long as there was a market for these derivatives, they were constructed. Current research address the missing incentives for each, buyer and seller of CDOs, CDSs and synthetic CDOs during the time before the financial crisis: As long as the risks of defaulting mortgages could be transfered to other parties, the credit-worthiness of a borrower does not matter any more. Furthermore, speculatives without any real insurable interest could invest in these derivatives, which increased the demand for these derivatives additionally.

For further information to the structure of the derivatives mentioned above see here or (2). On the role of rating agencies see (3).

(1): The New York Times, Banks Bundled Bad Debt, Bet Against It and Won, by Gretchen Morgenson and Louise Story, Published: December 23, 2009

(2) Joseph R. Mason, Josh Rosner: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, May 14, 2007

(3): Markus K. Brunnermeier, DECIPHERING THE LIQUIDITY AND CREDIT CRUNCH 2007-08, NBER Working Paper No. 14612.

Answer 2

I am not sure which is your current level of understanding so tailoring the answer seems difficult. At a very basic level, the idea is as follows. Commercial banks and other institutions originate mortgages but have a preference for liquid assets and so they would rather sell them to third parties instead of keeping them in their portfolio until all the money is paid back.

Because the market has to be thick, one cannot simply sell 'Fato's mortgage'. One pools together a bunch of mortgages with similar characteristics and then sells 'shares' on this pool. So far so good.

The problem becomes more complicated because the optimal structure of these 'shares' is not simple equity. This is because (i) different investors have different preferences for liquidity and (ii) there are information asymmetries in the market. In general, these assets are structured into tranches. The prime tranche offers debt (a fixed payment unless there is default) and uses the first income that the mortgage originates. The last tranche is equity and is the most junior so they only get money if the mortgage is paid in full. In the middle, the mezzanine tranches, are some sort of combination between the two. These assets' returns are completely tied to the mortgages so that if the mortgages fail, some of these assets become junk.

Notice also that, in principle, different people buy different tranches and the risk is spread. Furthermore, the bank does no longer have a stake in the mortgage.

Securitization had many problems that people failed to foresee, or at any rate, failed to fully understand. First, precisely because the originators no longer had a stake in the game, they did not provide accurate monitoring and screening and the quality of the mortgages dropped (this is accurately captured in the movie). Second, because the assets pooled together similar mortgages, they failed to take into account the full correlation structure of the different mortgages. Third, many investors did not fully understand these complex securities and held extremely long positions on some of the original mortgages, although they had normal positions on each of the assets (e.g. Lehman Bros was extremely long in subprime mortgages although it was not extremely long on any particular asset). As it happened, if a mortgage in Florida for a 200k house for a guy with credit score such and such defaults, it is quite likely that others would do too. This makes the whole castle crumble.

So back to the questions you raised at the beginning. First, if you buy the equity tranche of a mortgage (which is ex-ante very attractive) you only get paid at all if a large chunk of the mortgages in the pool are fully repaid. If a significant fraction defaults, then only the top tranches get anything and the rest get paid nothing. So it may be that you only get 5% of what you invested (but if things went well, you would get twice or more).

Hope this helps. If you need some further clarification feel free to ask. I can also add some numerical examples and give some more advanced references. Wikipedia has a good set of articles on it too.