Collateralized debt obligations and the 2007–2008 financial crisis Jakub Vondrácekˇ December 17, 2020 Table of contents 1 2007 – 2008 Financial crisis 2 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 2007–2008 Financial crisis What happened? Excessive risk taking by banks US housing bubble collapse and subsequent subprime mortgage crisis Bank failures Lehmann brothers bankruptcy Goldman Sachs paid $ 550 million to settle fraud charges after allegedly anticipating the crisis and selling toxic assets to clients 47 bankers served jail time $2 trillion loss from the global economy $ trillions in bailouts and stimulus Regulation (Dodd-Frank act, Basel III) Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 The housing bubble 1997 Asian crisis and 1998 Russian crisis led to a significant inflow of funds to the US, which led to easily available credit and a subsequent construction boom and debt-financed consumer spending Banks began giving out more loans at better terms (even to very risky customers), this led to the skyrocketing of housing prices Instruments to invest in the housing market Mortgage backed securities Collateralized debt obligations (CDO) Keyword: subprime Ratings: AAA, AA, A, BBB, BB, B, CCC, CC, C, D (S&P) Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Collateralized debt obligations CDO squared CDO’s backed by tranches from other CDO’s Synthetic CDO CDO’s backed by other derivatives e.g. credit default swaps Around 2000, CDO’s were generally well diversified, but in 2007, the CDO’s became dominated by high risk tranches from other asset backed securities Many banks insured CDO’s using e.g. credit default swaps and the market for this kind of insurance grew very quickly Rising default rates of the underlying security (mortgage) led to steep decline in price of many CDO’s and was a large contributor to the financial crisis Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Pricing of CDO’s CDO’s are generally very complicated derivatives and their pricing is a very difficult task Li Model - David X. Li (industry standard before the crisis), based on Gaussian copulas Duffie and Garleanu model Hull model Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Movie recommendations The Big Short (Ryan Gosling, Steve Carell, Christian Bale, Brad Pitt), CSFD 75%. Margin Call (Kevin Spacey, Zachary Quinto), CSFD 71%. Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020 Thank you for your attention! References https://www.khanacademy.org/economics-finance-domain/ core-finance/derivative-securities https://en.wikipedia.org/wiki/Collateralized_debt_obligation https://www.investopedia.com/ask/answers/040815/ are-all-mortgage-backed-securities-mbs-also-collateralized-debt-obligations-cdo. asp Jakub Vondrácekˇ Collateralized debt obligations 17th December 2020.