As mentioned previously, a CDS is a popular type of an unfunded credit derivative. This alone, may not have been a large problem. It was the combination of a number of factors, including something known as a collateralized debt obligation (hereinafter CDO). A CDO is generally defined as “an investment-grade security backed by a pool of bonds, loans and other assets.”[i] It is thought of as a type of asset-backed security (hereinafter ABS) that derives its value from a set of underlying assets.
Beginning in 2003 and continuing through 2006, the new CDOs backed by asset-backed and mortgage-backed securities grew increasingly exposed to subprime mortgage bonds. As individuals began to default at an increasing rate, the CDOs backed by these subprime mortgage bonds were downgraded in their rating and suffered large losses. This effect is commonly referred to as the “subprime mortgage crisis” because it signaled a beginning of the general downturn of the credit market. This downward trend has, in effect, limited the amount of mortgage credit that was generally available to homeowners. During this period, CDOs began to and continued purchasing portions of mortgage bonds that were much riskier but still had investment-grade ratings (we will revisit this in a subsequent section).
The CDO issuers were able to turn their risky mortgages and bonds into investment-grade “paper” by combining it with other assets. They then were able to sell these CDOs to investors on the open market. CDOs were attractive to buyers because they were investment-grade, and a higher rate of return then other “securities.” However, even while these CDOs were rated at investment grade, there is always some risk associated and that is where CDSs came into play.
CDSs were marketed by AIG’s Financial Products (hereinafter AIGFP) division in London as a form of “insurance” that would protect the holder of the CDO in the event of default. The man credited with inventing this use of the CDS is Joseph Cassano, a man who worked for Mike Milken (otherwise known as the Junk Bond King) in the Eighties. In theory, there is nothing wrong with using CDSs in this manner.
This method of using CDSs was designed so that investors who held CDOs would pay a premium to AIGFP, and in exchange, AIGFP agreed to cover the loss if the mortgage-backed CDO defaulted. This effectively moved the risk off of the table for investors holding a large amount of mortgage-backed CDOs, creating a boom in the market.
Remember however, that the seller of the CDS does not have to actually demonstrate that it can pay out on the guarantee. This allows sellers of CDSs to sell countless amounts of CDSs without having a single real asset to honor the obligation. Also, neither party actually holds the underlying loan, thereby allowing the CDS seller to sell “protection” to multiple parties for the same underlying mortgage.
As long as the probability of a default on the underlying security remained relatively unlikely, all parties involved could continue to collect high amounts of money. This was a win-win situation, until defaults became increasingly more common and AIG was expected to “payout” on the insurance.
And what did we expect when lending institutions were permitted to merge with commercial banks as a result of the Gramm-Leach-Bliley Act, making lending money in a predatory manner increasingly more common. Even individuals who had no income, no job, and no assets were permitted to borrow money and were actually expected not to default. NINJA[ii] loans became increasingly more accessible to borrowers, who then had the money to purchase a home they actually could not afford. What did we really expect to happen? We bet big, rolled the dice, and lost it all.
[ii] http://www.investopedia.com/terms/n/ninja-loan.asp “A slang term for a loan extended to a borrower with "no income, no job and no assets". Whereas most lenders require the borrower to show a stable stream of income or sufficient collateral, a NINJA loan ignores the verification process.”
