Страница 34 из 50
What You Should Know
An asset-backed security is a specially created financial instrument, or security, custom-built upon a pool of underlying assets. Those assets serve as collateral, and the income they generate is passed on to the ABS holder. Individually, the assets contained in the ABS, like mortgages or car loans, are small and difficult to sell in the open market. The ABS is designed to package them into a single, larger security so they are large enough to interest institutional investors, and if packaged clearly and carefully, to spread risk. If one asset in the portfolio fails, it will be only a small fraction of the portfolio. ABSs were created out of mortgages, car loans, credit card financing, and commercial loans and leases.
ABSs played a key role in the mortgage crisis. To lend more money on mortgages, banks engaged in the mortgage market learned to package mortgages into ABSs (or MBSs) and sell them as a package. The process is known as securitization—the offering institution created a security out of a number of individual assets. This accomplished two things: first, it helped the banks get funding for the loans, and second, it transferred the risk of default to the buyer. Investment banks and institutional investors (see #28 Investment Bank and #75 Institutional Investors) bought these securities because it was a handy way to tap into the mortgage market and chase higher returns than currently offered by the bond market or other fixed-income securities.
Prior to the crisis, as it turns out, the idea of ABSs caught on rapidly as a way to expand the mortgage market and lend into the real estate boom. In fact, this helped cause the boom, because it became easier to get funds to lend. Unfortunately, the buyers of ABSs did not fully understand the underlying risks in these securities; neither they nor the ratings agencies (see #77 Credit Rating Agency) factored in the notion that real estate prices might decline, and didn’t perform a “due diligence” on the credit risk of assets that lay beneath the covers of the ABS. The result was a collapse in the value of ABSs held on bank and institutional books, and that as much as anything else led to the banking crisis. This was made worse by the fact that all ABSs are unique. Each is constructed on a specific batch of assets; no two are alike, so there is no market to value them, and little “transparency” as to their true worth.
Why You Should Care
The expansion of asset-backed securities led to “easier” lending terms, but also ultimately led to the financial crisis when the tide washed out on underlying asset values. The 2008 banking crisis led to a severe contraction in asset-backed security markets, which in turn caused a severe contraction in credit extended to businesses and consumers. It’s a big part of why it got very difficult to get a loan during that period. Today, the ABS market has loosened somewhat, but tighter standards for underlying asset quality, necessary to make the markets work, has caused it to remain somewhat difficult to borrow if you have bad credit—and that’s a good thing. Bottom line: ABSs are not necessarily a bad thing if risks are properly assessed. There is also a well-placed call to standardize ABSs and create more liquid, transparent markets to trade them.
68. COLLATERALIZED DEBT OBLIGATION (CDO)
Collateralized debt obligations are a form of ABS (see #67 Asset-Backed Security) that might be analogous to a stealth fighter jet compared to a small Cessna prop job. They are highly engineered, highly customized, securitized assets based on fixed-income securities, with mortgages again taking center stage in the recent boom.
What You Should Know
For the average consumer, CDOs are one of those topics that the more you know, the more you don’t know. As it turns out, that phrase also applied to many in the financial world who didn’t really understand nor could properly value the CDOs they bought and sold, and we now know the result.
Like ABSs in general, CDOs are carefully created packages containing underlying securities. A financial institution, and most likely a “special purpose entity” residing off the books of a major financial institution like an investment bank, would package a series of underlying assets into a security. These assets could be individual loans and mortgages, or they could be other ABSs. They were often called “structured investment vehicles.” But it would be too simple to stop there. The CDO was then divided into segments, or “tranches,” according to risk and rank of underlying assets, and these assets could be sold individually to other buyers. It gets worse—there were “synthetic” CDOs, “market value” CDOs, “arbitrage” CDOs, and “hybrid” CDOs; the financial engineering details are beyond the scope of this discussion.
The now-defunct Drexel Burnham Lambert engineered the first CDOs in the late 1980s. The market grew furiously in 2004–2006 as CDOs became the favorite tool to resell and transfer the risk of real estate mortgages. Buyers of CDOs included commercial and investment banks, pension funds, mutual funds, and other institutional investors seeking higher returns, which ranged from 2 to 3 percent higher than corporate bond rates at the time. Suffice it to say that, due to the complexity of these products, buyers often did not know what they were really getting.
The boom in CDOs is made clear by the statistics. In 2004 some $157 billion in CDOs were sold; that figure rose to $272 billion in 2005, $521 billion in 2006, $482 billion in 2007—then dropped to $56 billion in 2008 as the market came to appreciate the risks and complexities of these securities. It has remained somewhere near that size.
The lucrative fees paid to the creators of these securities helped lead to the boom and subsequent downfall. Investment banks and individual investment bankers made millions capturing their percentages of these securities as they were sold; the incentive was to build them as big, and sell them as fast, as possible. Those who created these products simply passed on their risks, which now have ultimately been borne or at least backstopped by the taxpayers. Now that these characteristics have come to light, it is likely that CDOs will continue to exist, but in a more transparent, standardized, and regulated form.
Why You Should Care
You’ll never be approached to buy a CDO, but it’s good to know what goes on in the world of high finance. Once the fallout from the credit crisis becomes clear and turns into appropriate regulation, transparency, and controls, CDOs should continue to be with us, although not at “boom” volumes, and their existence will help make credit more available to all of us.
69. CREDIT DEFAULT SWAP (CDS)
There are CDOs, CDSs, ABSs, MBSs, and more. The three-letter alphabet soup of high finance reached all-time proportions in the middle part of the first decade of the twenty-first century. It became hard to keep track of what these new i
What You Should Know
A credit default swap is a special kind of derivative contract (see #66 Derivatives and Derivative Trading) in which the buyer pays a sum, known as a spread, for a contract specifying that if a certain company defaults on a credit instrument, like a bond or loan, the buyer gets a payoff. For example, a buyer might pay a spread of $50,000 to $100,000 for $10 or $20 million of default coverage. If this sounds like insurance, it is, and as a legitimate financial product, CDSs help bond buyers insure their risk.