Hedge funds and investment banks packaged home loans into complex financial products like CDOs and sold them to investors seeking higher yields. As interest rates fell and home prices rose, more risky loans were originated and securitized. When the housing market collapsed in 2007-2008, the value of these securities plummeted due to high correlations within loan pools that rating models and investors failed to properly account for. Some hedge funds like Magnetar profited by taking positions that benefited from this mispricing, while others like Peloton suffered large losses after being overly exposed to subprime mortgage-backed assets. The crisis exposed flaws in how risk was assessed and allocated within structured products.
2. 2007-2008 financial crisisLowest Interest rate in forty yearsMany home loans were sold to major investment banks Investment banks – Securitized into CDO’s and sold to investors.
4. CDO Securities backed by a pool of fixed income assetsConsists of CLO’s, CBO’s and RMBSProvide liquidity as traded daily on secondary marketPay slightly higher interest rate than corporate bonds
5. CDO is complex and costly processEnables a bank to design loans to homeowners to make more loans as bank can sell loan to third partyBank can originate more loans and feesMany CDO’s became liquid due to size, investor breadth and rating agency coverage
8. Waterfall Portfolio of 300 mn(BBB)240 mn of AAA, paying LIBOR +54bp {5.7 mn}After deduction of expenses & hedging cost7.3 mnAnnual Cash flow of 12.7 mn @ 4.2526 mn of AA, paying LIBOR +79 bp{1 mn}14 mn tranche of equity {return of 40%}In case of 3 mn loss20 mn of BBB, paying LIBOR +275 bp{0.6 mn}5.4 mn2.4 mnIf reinvestedReserve AccountIf notEquity holders
9. LBO (Leveraged Buyout)The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring companyThe purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital
11. Junk BondA bond rated 'BB' or lower because of its high default risk.These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues.
13. Rating AgenciesHelp bringing liquidity to CDO market as per following reasons :Analyzed each tranche of a CDO and assign ratings accordinglyUsed historical models to predict risk Limited ManpowerHad to allocate risk to appropriate tranche and understand correlation of loans
17. MagnetarFounded in 2005Magnetar Capital-Return 25% in 2007 Considered its return as one brilliant strategy Strategy-certain tranches of CDO(collaterlized debt obligations) were unsystematically mispriced Unaffected with the subprime market held up or collapsed
18. Magnetar Structured Finance Arbitrage TradeMade profit –By equity tranche of CDO’s and derivative CDO instrument relatively mispricedBought less risky CDO equity and credit default swaps(CDS) protection on tranchesPerformed its own calculation of Risk for each tranche and compared that with the return that the tranche offered
19. Magnetar Structured Finance Arbitrage TradeResults showed –Two classes of securities had very similar risks but significantly different yieldsBought CDS on mezzanine tranche and long position on Equity
20. PelotonFounded in 2005Top performer in hedge funds in 2007Became bankrupt after one month of getting two prestigious awards-at Black tie euro hedge ceremony
21. Peloton Fall StrategyShorted the US housing market before subprime crisis and was profitedMisunderstood the subprime crisisWent long for AAA-rated securities backed by Alt-A mortgage loansUBS downgraded its Alt-A backed securitiesMarket went down leading to margin callsNo support from investors and banks due to conflicts in views
23. Leveraged ProfitThe investors purchased the senior tranche of CDO yielding LIBOR +50 bpsBy leveraging by 25x earned a return commensurate with equity tranche or LIBOR +1250bps.
24. Bank Debt & Cov-lite LoansFueled by leveraged buyout boomCorporate bank debt allowed companies to operate with no maintained or interest coverage ratioLBO firms demanded loose termsLenders passed on the weak cov-lite loansInvestors analyzed at summary level
25. Bank Debt & Cov-lite LoansRating agencies gave false sense of securityBank loan and leveraged securities prices fellInvestors believed that the default rates would hit higher level that in 1930s and would stay there till maturity
26. Covenant - lite LoansThe current cov-lite loans were traded heavilyWas thought to have limited near term default as companies ran until cashlessThe Cov-Lite were traded heavily as compared to Cov-heavy loansThe nominal coupons were less on cov-lite as compared to cov-heavy loans
27. Default Rate and Recovery Rate Discount Rate to justify Cov-Lite Valuations
28. Arbitrage – Bank loans and BondsYield on secured cov-lit bank loans and compare it with unsecured bonds of same companyIf yields are close, trading opportunity existMore risk the company wider spread gets
29. Arbitrage – Bank loans and BondsDifference of recovery rate on various securitiesDefault rates were identical because issued by same companyBank debt had pressure of selling as held in large by investors. Whereas, bonds did not