Author Topic: 2008 Crash and CDO locations in the market.  (Read 3576 times)

TexasRunner

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2008 Crash and CDO locations in the market.
« on: September 16, 2016, 08:04:22 AM »
Hey guys.

So I've been looking into the 2008 crash and the different big players.  I can see CDOs were a significant portion of this (and the place that incurred some of the highest losses, many of which were permanent).  My question is simply, in a modern market where do CDOs fall?  As in, where are they in the market?

I'm assuming they are Corporate Bonds (IE "junk bonds") and that if you purchased those specific bonds then you were exposed (as some pension funds were).  Also, many mutual funds would have purchased these corporate bonds so an investor could have exposure there.  Then the index investor would have been exposed to the stock price of the publicly traded banks and lenders, which would have presented some exposure as well.

Is all of this correct?  Is there some other exposure I'm missing?

Thanks guys!

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #1 on: September 16, 2016, 10:48:26 AM »
43 views and no insights...  Where those old folks at!!!

Just kidding.  I just know there is no way this question is beyond the members of this forum.

Little Aussie Battler

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Re: 2008 Crash and CDO locations in the market.
« Reply #2 on: September 16, 2016, 11:40:06 AM »
No, they are a specific (and separate) product.

They can be used to give an investor access to a broad pool of assets (corporate bonds, mortgages, etc). They are also structured in a way that provides variable levels of risk (and, therefore, returns) by dividing the pool into tranches (with each tranche having a different risk profile). There will always be a significant amount of overlap between investors in different parts of the capital structure, plus the significant impact of contagion risk, but that is a separate point.

It's not entirely clear what you are asking for, which may explain why nobody has responded yet.

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #3 on: September 16, 2016, 12:05:53 PM »
I suppose I'm asking "from the investor side (us), where or how would our investment monies wind up purchasing CDOs?"

Unfortunately, 'they' don't teach any of this in schools or even university level economics anymore (if they ever did) so I'm trying to learn- and connecting the strings and lines of funding can be somewhat difficult.

Little Aussie Battler

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Re: 2008 Crash and CDO locations in the market.
« Reply #4 on: September 16, 2016, 12:21:05 PM »
I suppose I'm asking "from the investor side (us), where or how would our investment monies wind up purchasing CDOs?"

Unfortunately, 'they' don't teach any of this in schools or even university level economics anymore (if they ever did) so I'm trying to learn- and connecting the strings and lines of funding can be somewhat difficult.
Got it - as an investor, you are only directly exposed to the risks of a CDO if you invest directly in that product. Buying a corporate bond does not achieve this.

As an investor you may be indirectly exposed to the risk of a CDO in a number of ways - e.g. if a company you invest in or lend to has direct CDO exposure, if the failure of the CDO creates system-wide issues (such as liquidity or confidence), etc.

eudaimonia

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Re: 2008 Crash and CDO locations in the market.
« Reply #5 on: September 16, 2016, 12:43:44 PM »
Essentially, CDOs became popular with the rise of Mortgage Backed Securities (MBS). Large banks like Deutche Bank, UBS, JP Morgan, Bear and Stearns, and Lehman Brothers would sell a CDO which were essentially very similar to a bond (except the security is the mortgage on the house). Originally, they started off conservatively so that mostly you would have a tranche of AAA mortgages with just a few B mortgages and these were considered very secure. The banks started having a lot of success selling these to mutual and pension funds and eventually the demand for these products as CDOs got to the point where some very shady and opaque practices were used to make bad mortgages look more secure than they were. Of course, the more demand there was for these products, the looser the lending terms became on the mortgages, and the more dangerous the CDOs became (because they were stuffed with riskier mortgages).

By the end of 2007 and beginning of 2008 the weakening of the housing market and raising of the mortgage default rates put Bear and Stearns out of business because the CDOs were highly leveraged and highly illiquid products. This sent ripples throughout the rest of the industry and eventually affected the stock market (since banks, pension funds, etc.) were liquidating stocks to pay off their losses in CDOs. The index investor wasn't directly exposed to CDOs; however, because the banks and pension fund were dumping stocks, this affected the stock market.

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #6 on: September 16, 2016, 12:54:04 PM »
This is probably an overly simplistic answer, but here is what Investopedia says about the issue:

...

Generally speaking, it is rare for John Q. Public to directly own a CDO. Insurance companies, banks, pension funds, investment managers, investment banks and hedge funds are the typical buyers. These institutions look to outperform Treasury yields, and will take what they hope is appropriate risk to outperform Treasury returns. Added risk yields higher returns when the payment environment is normal and when the economy is normal or strong. When things slow or when defaults rise, the flip side is obvious and greater losses occur.

Read more: CDOs and the Mortgage Market | Investopedia http://www.investopedia.com/articles/07/cdo-mortgages.asp#ixzz4KRZLpd5u"

Have you read/seen The Big Short?

Got it - as an investor, you are only directly exposed to the risks of a CDO if you invest directly in that product. Buying a corporate bond does not achieve this.

As an investor you may be indirectly exposed to the risk of a CDO in a number of ways - e.g. if a company you invest in or lend to has direct CDO exposure, if the failure of the CDO creates system-wide issues (such as liquidity or confidence), etc.

Ok, got it.  I knew most of that but didn't know how that all came down to investment money.  So the main exposure is through owning stocks of companies that have purchased CDOs or from mutual funds or hedge funds that buy CDOs (or invest in companies that buy CDOs).  It is similar to a corporate bond in that company/investment pool A buys into risk presented by company B (who holds the CDO) under the assumption that business B's practices will not drive it out of business, but generally doesn't have the direct time imposition of a true corporate bond. 

No I haven't seen The Big Short (or read it, but it is now on the list) but I watched Inside Job and Margin Call.  Been reading for a few months now on other areas of the breakdown (and the worldwide fallout).  Basically the entire market suffered as a whole and taxpayers were left with some of the bill through bailouts.  I'm just wondering how a repetition of the scenario in ten years would play out with indexed investing.  'Not Good' is the answer I'm getting back...  lol

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #7 on: September 16, 2016, 01:47:05 PM »
Essentially, CDOs became popular with the rise of Mortgage Backed Securities (MBS). Large banks like Deutche Bank, UBS, JP Morgan, Bear and Stearns, and Lehman Brothers would sell a CDO which were essentially very similar to a bond (except the security is the mortgage on the house). Originally, they started off conservatively so that mostly you would have a tranche of AAA mortgages with just a few B mortgages and these were considered very secure. The banks started having a lot of success selling these to mutual and pension funds and eventually the demand for these products as CDOs got to the point where some very shady and opaque practices were used to make bad mortgages look more secure than they were. Of course, the more demand there was for these products, the looser the lending terms became on the mortgages, and the more dangerous the CDOs became (because they were stuffed with riskier mortgages).

By the end of 2007 and beginning of 2008 the weakening of the housing market and raising of the mortgage default rates put Bear and Stearns out of business because the CDOs were highly leveraged and highly illiquid products. This sent ripples throughout the rest of the industry and eventually affected the stock market (since banks, pension funds, etc.) were liquidating stocks to pay off their losses in CDOs. The index investor wasn't directly exposed to CDOs; however, because the banks and pension fund were dumping stocks, this affected the stock market.

Thanks for the insight!  The need for the banks and index funds to dump stocks (converting into cash) to pay for losses helps explain the market's ripple effects.  The massive selling of stocks was necceary to secure capital in the books to offset unsecure (IE confirmed losses) for the failing CDOs.  I hadn't realized exactly how thing drove into the market downfall, but that makes sense.

Quick question, the two major 'losers' after the dust settled were those whose funds depleted and never recovered (particularly pension funds that were directly vested in the CDOs) and taxpayers who had to give over capital to banks and businesses in order to keep things running.  Is this correct or was there some other group that I am missing out on?

markbike528CBX

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Re: 2008 Crash and CDO locations in the market.
« Reply #8 on: September 16, 2016, 05:42:55 PM »
Example of direct hit to equity.

IFMI  (was at times  COHN or AFN ,names changed to obscure the idiodicy)

disclosure. 3/5/08  buy 500@2.01 =  $1005

I mean really, it had already gone down by a factor of 4 from its peak, how far could it possibly drop?

Answer, a another factor of 20.

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #9 on: September 16, 2016, 06:01:47 PM »
Example of direct hit to equity.

IFMI  (was at times  COHN or AFN ,names changed to obscure the idiodicy)

disclosure. 3/5/08  buy 500@2.01 =  $1005

I mean really, it had already gone down by a factor of 4 from its peak, how far could it possibly drop?

Answer, a another factor of 20.

Dang.  http://finance.yahoo.com/quote/IFMI?ltr=1  Looking at the 10-year. 

Anybody willing to explain how this affected indexing?  The index fund simply took a permanent hit as that part of the market eroded?  (Obviously it rebounded significantly, just not in that sector).

MustacheAndaHalf

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Re: 2008 Crash and CDO locations in the market.
« Reply #10 on: September 16, 2016, 06:56:42 PM »
There's some pretty good explanations in this article:
"Welcome Back, Leveraged Super Senior Synthetic CDOs"
https://www.bloomberg.com/view/articles/2013-11-27/welcome-back-leveraged-super-senior-synthetic-cdos

My overall impression of the 2008 crisis was mostly about leverage.  The CDOs did "launder quality" if you will, making sub-primes look prime.  But it was leverage that magnified the impact to the level of destroying a large company.  And OP left out credit defaults, where if one large company defaults, there's massive leverage on that unthinkable event... which brings down another company, and keeps pushing each financial company over like dominoes.
(CDOs + leverage) x (credit defaults x leverage) = 2008 ?

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #11 on: September 19, 2016, 07:57:36 AM »
And OP left out credit defaults, where if one large company defaults, there's massive leverage on that unthinkable event... which brings down another company, and keeps pushing each financial company over like dominoes.
(CDOs + leverage) x (credit defaults x leverage) = 2008 ?

So the cross-trading was the issue?  As in Company A had 20$ collateral into Company B's CDO, and Company B only had 5$.  When Company A goes bankrupt and defaults on Company B's over-leveraged CDO, then Company B subsequently goes under.  Is this accurate? 

This crap was WAY too mixed together.  No wonder it was a CF waiting to explode.

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #12 on: September 19, 2016, 08:26:21 AM »
Came across this while examining the data questioned in another thread.  Worth a read.

https://oversight.house.gov/hearing/credit-rating-agencies-and-the-next-financial-crisis/

Particularly ERIC KOLCHINSKY's testimony.

eudaimonia

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Re: 2008 Crash and CDO locations in the market.
« Reply #13 on: September 19, 2016, 10:59:08 AM »
Quick question, the two major 'losers' after the dust settled were those whose funds depleted and never recovered (particularly pension funds that were directly vested in the CDOs) and taxpayers who had to give over capital to banks and businesses in order to keep things running.  Is this correct or was there some other group that I am missing out on?

Yes, I'd say that your assessment is mostly accurate. I would also argue that anyone who was in the banking industry who wasn't in the .01% also took a bath - the banks have continued downsizing since 2008. Some of this was divesting since subsequent regulations like Dodd-Frank didn't allow banks to speculate (as much) as they had. But overall, the industry has shrunk.

NorCal

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Re: 2008 Crash and CDO locations in the market.
« Reply #14 on: September 21, 2016, 11:06:29 PM »
CDO is a generic term for collateralized debt.  A CDO isn't fundamentally good or bad.  It isn't something you should strive to stay away from.  The issue is whether their risk is priced appropriately.

If you own pretty much any type of non-government fixed income fund, it probably has some CDO's underlying it.  Most bond funds have some mortgages, auto loans, or credit card debt in them.  Some of it is incredibly safe.  Some of it is incredibly risky.

A bigger part of the 2008 carnage was driven by Credit Default Swaps, which are a whole different can of worms.

I wouldn't worry too much about it.  The next crisis will be about some entirely different excess or stupidity. 

TexasRunner

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Re: 2008 Crash and CDO locations in the market.
« Reply #15 on: September 22, 2016, 07:53:38 AM »
CDO is a generic term for collateralized debt.  A CDO isn't fundamentally good or bad.  It isn't something you should strive to stay away from.  The issue is whether their risk is priced appropriately.

If you own pretty much any type of non-government fixed income fund, it probably has some CDO's underlying it.  Most bond funds have some mortgages, auto loans, or credit card debt in them.  Some of it is incredibly safe.  Some of it is incredibly risky.

A bigger part of the 2008 carnage was driven by Credit Default Swaps, which are a whole different can of worms.


Ya, I agree.  It was more of an understanding thing (I didn't see how the 'string' of financials carried along).

I wouldn't worry too much about it.  The next crisis will be about some entirely different excess or stupidity.

Care to take a guess of what and inform us?...  :D

NorCal

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Re: 2008 Crash and CDO locations in the market.
« Reply #16 on: September 22, 2016, 10:46:21 PM »

I wouldn't worry too much about it.  The next crisis will be about some entirely different excess or stupidity.

Care to take a guess of what and inform us?...  :D
[/quote]

I have a few guesses on what it might be.  More likely than not, it will be something completely expected:

1. A major eurozone financial crisis.  It will happen someday.  I just don't know how it will happen or when.

2. Slowing growth among the major tech companies.  Google, Amazon, Apple, etc. trade at pretty high valuations, which imply fast growth.  They're getting to the point where it's harder to grow (see Apple this year) because of their sheer size.  I think they still have good growth in them (ex Apple) but they can't continue growing at the same rate forever.  Due to their size and valuations, they make up a large percentage of the major indexes.  A simple slowing of growth could trigger a stock market correction with broad impact.  This would somewhat rhyme with the 2000/2001 recession.  This is probably a few years away at the earliest (if not much longer).

3.  A major internet or power outage.  If the power or internet goes out for a significant period of time, that would be a recession.

4.  War.  It will happen again in our lifetime.  Based on historical patterns, I wouldn't be surprised to see a major conflict sometime in 2020's or 2030's.  I hope it doesn't happen, but it wouldn't surprise me.

5.  A major increase in the cost-of-capital or another disruption in the credit markets.  The cost of capital (think interest rates) will go up someday.  A LOT of businesses have learned to survive and thrive on cheap capital.  These businesses will have major issues with more expensive money.  Many will fail if the cost of capital truly increases.  This one is guaranteed to happen someday, although most economists don't see likely catalysts in the near or medium term.  I'd guess sometime in the 2020's, once baby boomers start becoming net sellers of assets.

6. Most Likely  Something entirely unexpected

MustacheAndaHalf

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Re: 2008 Crash and CDO locations in the market.
« Reply #17 on: September 22, 2016, 11:30:56 PM »
So the cross-trading was the issue?  As in Company A had 20$ collateral into Company B's CDO, and Company B only had 5$.  When Company A goes bankrupt and defaults on Company B's over-leveraged CDO, then Company B subsequently goes under.  Is this accurate?
No, I think the first layer of mortgages and CDOs could have crashed without taking the global financial market down with it.  Oh, and see "The Big Short" - very entertaining and some really good insight.  So my take:

First layer, CDOs that only own mortgages.  Some overlap, so leveraged damage, but survivable.
Second layer, synthetic CDOs contain other CDOs.  Now the leverage is out of control, and could bring down a company.  Lots of confusion is possible as well.
Third layer, "credit default swaps".  It's like getting 0.00001% interest (I made up this number) on a bond that only pays out if company A goes under.  These swaps are leveraged, and are very dangerous for the very rare event of a solid company going under.  Say company A is a $25 billion company, but out in the market is $1 trillion in credit default swaps against company A going under - because it's unthinkable.

So the mortgages default, nobody is that concerned.  Rating agencies don't have the real picture.
The first layer of CDOs stop paying - they default, and the damage begins spreading...
The synthetic CDOs, which contain other CDOs, follow next and now the damage is reaching billions.  It's enough to tilt company A into bankruptcy when it can't make good on it's obligations.
Now the market realizes that the credit default swaps for company A, which are guaranteed by company B, C, and D... are a multiple of company A's value.  If every credit default contract is honored, many big financial companies will go under trying to honor their contracts.

I would say the multiplied leverage of CDOs, synthetic CDOs and credit default swaps brought down the market.  That's also why you heard the Fed say it had to intervene.  If any company failed, the whole credit default swap market comes tumbling down.