the most for borrowers whose risks were highest.”
However, we now know fromhindsight that this theory was only feasible in the short-run. Even though, financialinstitutions proceeded making substantial “artificial” profit throughout this bubble period through CDOs, in which banks offloaded risks by creating products/bundlingtogether a diversified portfolio of various types of loans, i.e. sub-prime mortgages,corporate bonds, and then slicing these portfolios into different tranches. UsingMoody’s rating definitions, “AAA are judged to be of the highest quality, withminimal credit risk” with “C being the lowest rated class and typically in default, withlittle prospect for recovery of principal or interest”.
However, this property bubblewas incomprehensively burst as the US sub-prime crisis hit in 2007. As Reinhart andRogoff (2008) put it, “unfortunately that innovation (securitization) also made theresulting instruments extremely non-transparent and illiquid in the face of fallinghouse prices.”
Some of the resulting instruments Reinhart and Rogoff speak about used by banksthroughout the property bubble included CDSs and Repurchase Agreements (Repos).CDS are a credit structured product which act as insurance to the buyers in case of thetrance defaulting, i.e. the risk of default is transferred from the holder of the fixedincome security to the seller of the swap. Brunnermeier (2009) clarifies, “the buyer of these contracts pays a periodic fixed fee in exchange for a contingent payment in theevent of credit default.”
This was a very risky investment on the behalf on the seller as we saw in the downfall of Lehman Brothers and AIG, when these institutionsdidn’t have the required capital requirement (adequate leverage) on their balancesheets to deal with the liquidity spiral. These downfalls resulted from the amount of defaulting toxic liquidity held on their CDS books, which triggering large payments tothose who had bought these swaps. As a result “the prices paid for CDS that offered protection against defaults of the remaining banks soared, as each bank tried to protectitself against counterparty credit risk.”
We have witnessed that this was a secondmajor contributory factor to the previous financial crisis. What's more, we can nowsee that this existing risk management technique is not fit for purpose, as the seller of CDS must have a highly leveraged balance sheet so as to be able to pay out in the caseof wide-scale default and also, the nature of the CDO technique is that “outsourcingthe funding side of an originator’ balance sheet undermines its incentive to monitor
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