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More "for dummies"

Mortgage Backed Security
A Mortgage Backed Security is a type of asset backed security where the originator (often Fannie Mae, Freddie Mac, Lehman, Citi or one or two other major players) buys a bunch of “whole loans” (aka residential mortgages). The loans are placed in a big pool and payments on the loans (interest, capital, foreclosure recovery, etc) are pooled as the “income” part of the security. The MBS originators sell “shares” of the security to mutual funds, pension funds and other “buyers”.
Over the 00’s roughly 1 to 2 trillion dollars of MBS were created each year. However, an MBS is not as easy to price as other types of securities (such as commercial paper, munis or government bonds). The value of an MBS depends on the aggregate value of the loans. Each loan is valued based on:
• The size
• The interest rate
• The length of the loan
• The value of the property in the case of foreclosure
In addition, there are numerous costs for servicing the loans (actually gathering and tracking the payments), pushing for recovery in the case of default or foreclosure, selling the properties in the case of foreclosure and many others.
The risk on the security is also complicated because it depends on the individual risk of failure of each loan, plus aggregate risks. The risk factors include:
• The chance of default (borrower will simply stop paying)
• The chance of prepayment (borrower will pay early, reducing interest)
• The chance of delinquency (borrower will miss a payment)
• Average interest rate vs current interest rate (if interest rates go down, prepayment goes up as borrowers refinance. If interest rates go up, delinquency and default increase).
• Credit rating of the borrower
• Payment history of the borrower
The Lehman team, for example, had models that included upwards of 20 different variables which gave the risk of whether an individual loan, or pool of loans would fail. However, these models are only as good as the underlying data. Whole Loans were often bought based on just the size, rate and maturity. This created numerous opportunities for fraud and also more cost for “due diligence” in reviewing the loan packages. The feeling was that loan quality really didn’t matter all that much because the MBS market fed the CDO market and the CDO market was super hot. In other words, Lehman would turn over the loans so fast it wouldn’t matter how good or bad they were.
For further reading:
• http://en.wikipedia.org/wiki/Mortgage-backed_security

Collateralized Debt Obligation
Because an MBS can be made up of horrible quality loans, and no one would buy the MBS, banks came up with the idea of slicing up an MBS into “tranches”. Each tranche can be thought of as a bucket. As Lehman (or the MBS holder) receives money (interest, principal, whatever), they throw the money into the buckets in order of seniority. The first tranche gets all the money until the bucket is full. Then the second tranche gets money. The third tranche gets whatever is left. The belief was that, regardless of the underlying loan quality, enough money would come in to always fill the first tranche, and almost always fill the second tranche. The third tranche was riskiest, but was also priced accordingly (it was cheap and had a high interest rate).
A CDO basically let the rating agency give high ratings to part of an MBS even if the underlying assets were junk. The CDO also created nightmares of level 3 (hard to price or sell) assets for companies like Lehman who often simply kept the 3rd tranche.
For further reading:
• See if you can sneak into an Alvin Hall lecture. He explains this amazingly well.
• http://en.wikipedia.org/wiki/Collate...ebt_obligation

Credit Default Swap

A Credit Default Swap is a contract between two parties that can be thought of as insurance. The term insurance, however, has to be avoided because insurance is regulated whereas a CDS is a private contract and thus, unregulated. The seller of a CDS provides “insurance” against credit related default events on some particular object (security, company, whatever). The buyer pays the seller a premium and then only gets payment if a credit event occurs on the CDS object.

Take, for example, the numerous CDS contracts issued against Lehman. JP Morgan sold CDS protection to the Lehman customers who bought Lehman MBS and CDO products. If Lehman defaulted on payment, or went bankrupt, JP Morgan had to pay out the value of the CDS. Of course, a CDS is often much more complicated than this and can involve stock, debt or other considerations.
Most of the CDS’ that were called in over the fall were tied to either CDO or MBS products, or to the companies that issued the products. Imagine this chain of events, and you can see the leverage factor at play:
• Lehman issues an MBS for 10 Million.
• Lehman turns the MBS into a CDO and sells the first tranche to say… AIG. The second tranche goes to…call it “failed Euro Bank”.
• AIG buys a CDS from JP Morgan (counterparty to $58 trillion in swaps!) to protect against the CDO going bad.
• Failed Euro Bank buys a CDS from Citi (counterparty to $38 trillion in swaps!) to protect their part of the CDO.
• Hedge Fund “TBNL” buys a CDS against Lehman going bankrupt from BofA (counterparty to ANOTHER $38 trillion in swaps!).
We now have seven companies (Lehman, AIG, JP Morgan, Citi, Euro Bank, TBNL, BofA) all tied to the same underlying asset. Note that some of these companies (JP Morgan, Citi, BofA) are required to pay massive amounts if the MBS fails. AIG and Failed Euro Bank are also potentially in trouble, especially if JP Morgan, Citi or BofA can’t pay. Hedge Fund TBNL helps cause the problem because Hedge Fund TBNL has no exposure to the underlying asset and is simply betting that it will fail. Add a few dozen Hedge Funds doing the same thing and you suddenly have companies promising to pay 30 or 40 times (or more) of the underlying asset’s value if a credit event occurs.
Speculation exists that the government deal around Bear Sterns was actually to keep JP Morgan from having to pay out many trillions of dollars in CDS payments.
For further reading:
• http://en.wikipedia.org/wiki/Credit_default_swap
• http://asecondhandconjecture.com/ind...nd-nightmares/
• http://nickgogerty.typepad.com/desig...ment-risk.html