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Collateral damage: Sizing and assessing the subprime CDO crisis

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  • Larry Cordell
  • Yilin Huang
  • Meredith Williams
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    Abstract

    This paper conducts an in-depth analysis of structured finance asset-backed securities collateralized debt obligations (SF ABS CDOs), the subset of CDOs that traded on the ABS CDO desks at the major investment banks and were a major contributor to the global financial panic of August 2007. Despite their importance, we have yet to determine the exact size and composition of the SF ABS CDO market or get a good sense of the write-downs these CDOs will generate. In this paper the authors identify these SF ABS CDOs with data from Intex©, the source data and valuation software for the universe of publicly traded ABS/MBS securities and SF ABS CDOs. They estimate that 727 publicly traded SF ABS CDOs were issued between 1999 and 2007, totaling $641 billion. Once identified, they describe how and why multisector structured finance CDOs became subprime CDOs, and show why they were so susceptible to catastrophic losses. The authors then track the flows of subprime bonds into CDOs to document the enormous cross-referencing of subprime securities into CDOs. They calculate that $201 billion of the underlying collateral of these CDOs was referenced by synthetic credit default swaps (CDSs) and show how some 5,500 BBB-rated subprime bonds were placed or referenced into these CDOs some 37,000 times, transforming $64 billion of BBB subprime bonds into $140 billion of CDO assets. For the valuation exercise, the authors estimate that total write-downs on SF ABS CDOs will be $420 billion, 65 percent of original issuance balance, with over 70 percent of these losses having already been incurred. They then extend the work of Barnett-Hart (2009) to analyze the determinants of expected losses on the deals and AAA bonds and examine the performance of the dealers, collateral managers, and rating agencies. Finally, the authors discuss the implications of their findings for the “subprime CDO crisis” and discuss the many areas for future work.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-30.

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    Date of creation: 2011
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    Handle: RePEc:fip:fedpwp:11-30

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    Related research

    Keywords: Debt ; Securities ; Asset-backed financing ; Banks and banking;

    This paper has been announced in the following NEP Reports:

    References

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    1. Gary B. Gorton, 2009. "Information, Liquidity, and the (Ongoing) Panic of 2007," NBER Working Papers 14649, National Bureau of Economic Research, Inc.
    2. William Lang & Julapa Jagtiani, 2010. "The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance," Atlantic Economic Journal, International Atlantic Economic Society, vol. 38(2), pages 123-144, June.
    3. Efraim Benmelech & Jennifer Dlugosz, 2009. "The Alchemy of CDO Credit Ratings," NBER Working Papers 14878, National Bureau of Economic Research, Inc.
    4. Efraim Benmelech & Jennifer Dlugosz, 2010. "The Credit Rating Crisis," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 161-207 National Bureau of Economic Research, Inc.
    5. Joshua Coval & Jakub Jurek & Erik Stafford, 2009. "The Economics of Structured Finance," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 3-25, Winter.
    6. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (U.S.).
    7. Daniel M. Covitz & Nellie Liang & Gustavo A. Suarez, 2009. "The evolution of a financial crisis: panic in the asset-backed commercial paper market," Finance and Economics Discussion Series 2009-36, Board of Governors of the Federal Reserve System (U.S.).
    8. Atif Mian & Amir Sufi, 2008. "The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis," NBER Working Papers 13936, National Bureau of Economic Research, Inc.
    9. Larry Cordell & Michael Hopkins & Yilin Huang, 2011. "The trust preferred CDO market: from start to (expected) finish," Working Papers 11-22, Federal Reserve Bank of Philadelphia.
    10. Yuliya Demyanyk & Otto Van Hemert, 2011. "Understanding the Subprime Mortgage Crisis," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 1848-1880.
    11. Lang, William W. & Jagtiani, Julapa, 2010. "The Mortgage Financial Crises: The Role of Credit Risk Management and Corporate Governance," Working Papers 10-12, University of Pennsylvania, Wharton School, Weiss Center.
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    Cited by:
    1. Wojtowicz, Marcin, 2014. "CDOs and the financial crisis: Credit ratings and fair premia," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 1-13.

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