Brother you were really awesome...i was really having hard time understanding these Terms but the way you explained each and every single thing precisely I'll remember this throughout my entire life
I'm writing my bachelor's thesis and in the first chapter I'm writing about the financial crisis of 2007-2008; this video was incredibly useful in that regard, thanks a lot!
It was necessary at the time but it is an example that financial industries cannot/will not regulate themselves. At the time CDS were not regulate and companies like AIG acted recklessly.
Synthetic CDOs are a nebulous thing. The best I can do in explaining it is to compare it to a typical CDO. An ordinary CDO is comprised of bundled assets like mortgages. A synthetic CDO is comprised of bundled credit default swaps (CDS). So, one type bundled assets and the other bundled insurance.
@@ProfessorOfEconomics Thanks for this, I have one more doubt regarding this though. In all the bundled CDS, we know that the counter-party buying the insurance is the investment bank (hence they stand to profit when the reference assets like the MBS default) but exactly who is the one selling insurance (the 'buying' party in the synthetic CDOs), is it insurance institutions like the AIG, or other investors like Pension funds, Hedge funds etc, or both?
@@suryansh2022 Again, I am not an expert on synthetic CDOs but once a CDS is issued, it can be bought and sold on the secondary market. Once bundled the value of a synthetic CDO comes from insurance premiums of CDS paid for by investors.
May I ask the following questions: (1) How much in percentage do banks earn from selling asset backed loans to investment banks roughly speaking? (2) Why wouldn't the banks create SPE themselves instead of letting the investment banks to get a slice out of the pie? Thank you!
(1) How much in percentage do banks earn from selling asset backed loans to investment banks roughly speaking? I do not have data on profits earned by the commercial banks. But it is safe to say they wouldn't do it if it wasn't more profitable than holding the loans. (2) Why wouldn't the banks create SPE themselves instead of letting the investment banks to get a slice out of the pie? I guess it comes down to doing what you do best. Investment banks have more experience setting up things like SPEs. Another issue could be regulatory. I am not sure but there could be some regulations prohibiting commercial banks from setting up SPEs.
First, great video - thank you. Second, to sum up: C.D.O. = M.B.S. that can be purchased by conservative large/institutional investors (e.g., state or corporate retirement funds).
It is more accurate to say that CDOs are MBSs that are grouped into tranches. Each tranche can be rated. Institutional investors bought CDOs over MBS because some CDO tranches had the required rating (AAA).
Key question: Why can't you evaluate the individual mortgages? Obviously the mortgage underwriters DID evaluate the mortgages and offered mortgage rates accordingly.
You are referring the evaluation when the individual mortgage was issued. Once the mortgages are pooled into a MBS reevaluating the mortgages is very difficult.
I have a few questions : -when they contract is being sold to the Investment bank, does the Investment bank get all the monthly payments of the householders? If so, how does the bank make profit by selling these contracts ? - I don't really understand the CDO system when it comes to payments : Do the diffrent MBS classes have diffrent prices ? Or is it just the fact that an Equity MBS investor gets more money than a Senior MBS investor because of the interests ?
>when they contract is being sold to the Investment bank, does the Investment bank get >all the monthly payments of the householders? Initially, yes. But the investment bank forms a new shell corporation (special purpose entity - SPE) and the mortgages are transferred to the SPE. Share holders of the SPE now have legal claim on the money generated by all of those mortgage payments.
A bank can still make a profit on a mortgage sold before the term is up. It is like selling a bond before the end of its term. >Do the diffrent MBS classes have diffrent prices ? CDOs are MBSs converted into tranches (groups). Holders of the first tranche get paid first so this is considered to be less risky and thus has a lower return than the tranche that gets paid after the first tranche.
@@ProfessorOfEconomics Is this process similar to debt factoring and do the architects use some form of arbitrage to profit? If so, did arbitrage play a major role in leading us into the financial crisis?
Have a Question: I understood the diff products how they started and ended ... however one thing that bothered me all these years is = The money that was put in initially when dishing out mortgages by the small and big banks did go in to those who were selling the houses! ( owners, brokers, govt etc) so mathematically speaking Money changed hands it did not really vanish from the economy ( keeping aside the domino effect) DID it? Lets say a Bank start by investing 1 billion dollars and after dispensing NINJA loans meaning the billion dollars DID go in to economy , then step two Bank lightens it's risk by making MBS,, and CDS etc thus somebody else takes the risk on . The billion that started playing did go in to economy ! be it a luxury spending or retiring other debt etc by those who received it. ( ysh sure few might have kept it under the bed but highly unlikely) Sure it is sad that those who bought the MBS and CDS at wrong time and quality and those who sold the CDS insurance lost , but money did not really disappear from the economy!
Your logic is sound but the important thing you're leaving out it the asset appreciation factor. The lowering of credit standards to create new loans to fill CDOs caused massive appreciation in home prices. This also made CDOs look more attractive because the collateral backing up the CDO (ie the home) was more valuable. When home prices collapsed in the bubble regions, this wiped out wealth in the economy. This also caused CDOs to fall in value causing another massive wipeout in wealth.
Definitely. A derivative is simply a financial asset that derives its value from another asset. In the case of MBSs, this structured asset derives its value from the bundled mortgages.
A brief description of the situation, please correct me if I am wrong: MBS and ABS becoming CDO and synthetic CDO, after that become the CDS on the CDO? thanks advance
Almost any asset can become a CDO. A MBS is a particular type of ABS. I really do not know why the word "synthetic" is used when a CDS is bundled into a CDO. It could have to do with the fact that a CDO is a financial derivative and so is a CDS. So, making a derivative (CDS) into another derivative (CDS into a CDO) is something complex and different. Maybe this is why they attached the word "synthetic" to it.
I was a bit imprecise in the video. They could rate the MBSs but the rating were low due to the inability to assess the credit worthiness of the individual mortgages. The CDOs made it possible to give parts of a MBS AAA ratings because the senior tranches were paid first and it was considered unlikely that mortgage defaults would be so high that the senior tranche would not be paid.
@@VuNguyen-yg5yb I am not sure I know to whom you are referring. The only people who I know of who profited by CDO defaults are the investors who purchased CDS (credit default swaps). The amount that these investors made depended on the size of their CDS positions. Some made billions$$$.
@@VuNguyen-yg5yb No. The priority given to owners of the senior tranche of CDOs does not have anything to do with the insurance (CDS). In some cases, the senior tranche were given a AAA rating because they were perceived to be safer than other tranches of CDOs with lower priority in terms of payment. The insurance (CDSs) could be taken out on any tranche. The insurance would be collected if a CDO tranche defaulted (regardless of their credit rating).
synthetic CDOs are complex . But on a basic level they are a bunch of CDSs bunched together to form a CDO - like mortgages are bunched together to form a mortgage backed security (another type of CDO).
A CDS essentially mirrors the returns and losses of a CDO. Think of it this way: when an insured CDO loses 100 bucks, a CDS holder gains that 100 bucks. Though it is much more complicated, think of it as a zero sum situation. So since you have an insurance contract that mirrors the inverse of a CDO, this means you can stick it in another CDO and it is essentially mirroring the returns and losses of the first CDO. This is a synthetic CDO. The problem is that now people can take out a CDS on that ‘fake’ CDO also. Some didn’t even know that some of the CDOs they were buying were not actually backed by MBS’s but backed by insurance contracts that mirrored another CDO. So now you have people buying swaps on synthetic CDOs. The process could then be repeated effectively and Infinite amount of times which is what got the entire financial system into so much trouble. The market insuring or effectively ‘betting’ on the mortgages was so over-leveraged that the amount of mortgages backing them were basically non existent.
I was not completely accurate when I stated that MBSs were not rated. It is more accurate to say the ratings were not that accurate due to the inability to assess the credit worthiness of the individual mortgages. When they were broken into tranches, investors felt more confident in the ratings for the reasons I gave in the video.
professor, please correct me if I'm wrong, so the tranches (senior, mezzanine, and equity) are determined by the rating given by the credit rating agency?
@@htdiah9587 Unfortunately, I do not know of the method in which the tranches are created. In the cast of mortgage back CDOs, it could have something to do the credit scores of the home buyers (i.e., the quality of the loan itself).
@@ProfessorOfEconomics so once they are already grouped into tranches then the credit rating agency will exam and rate them. Can i say that the credit rating agency will obviously give good rating let say AAA to the senior tranche that already created by the investment bank. Is there a possibility when the investment bank create a senior tranche then the credit rating agency can't give high rating, can that happen?
@@htdiah9587 Yes, the rating agency will give the senior tranche a higher rating than the mezzanine or equity tranches because the senior tranche gets paid first.
True. That is a discussion for another video. But it has to be said that even though companies like AIG were "bailed out" the share holders in those companies incurred severe losses.
The money investment banks made from CDOs fluctuated. The same can be said for commercial banks from the sale of the mortgages to investment banks. Now, as for why didn't commercial banks create their own CDO there are two reasons: 1)core competency. This means firms should only do those things in which it specializes. Commercial banks do not do things like forming SPEs. 2)Regulations. Commercial banks cannot legally operate like an investment bank.
Your explanation is wrong. What you say a CDO is, is actually a CMO (collateralized mortgage obligation) since in your example it only consists of mortgages. A CDO is the same, but consists of all kind of loans, not only mortgages. So a CMO is e special (simpler) kind of CDO.
Agree to disagree. CMO (a term not commonly used) can be considered a type of CDO. Derivatives backed by mortgages are commonly referred to as CDOs. Alan Blinder, the author of When the Music Stopped (the text I use when teaching about the Financial Crisis) never uses the term CMO.
