B8306: Capital Markets & Investments Class 9

Professor John Handley

FIXED INCOME III:

Risk Management

Class Outline

 Duration
 Credit Default Swaps
 The Financial Crisis of 2008
 Was David Bowie Responsible For The Financial Crisis ?

Reference

 BKM: 1.7, 16.1 – 16.2

OBJECTIVES FOR TODAY

 What is interest rate risk and why is it important ?

 What is duration and how is it used ?

 What is a Credit Default Swap ?

 Is U.S. government debt really risk-free ?

 How important was credit risk in the 2008 Financial Crisis ?

 What is the most important lesson from the 2008 Financial Crisis ?

… at least the way I see it anyway 

 What’s David Bowie got to do with finance ?

2
1. DURATION

Duration is a key idea used in the management of interest rate risk

What Is Interest Rate Risk ?

We know that …

 yields (interest rates) in the future are uncertain and are likely to change

 changes in yields (interest rates) cause bond prices to change and cause
reinvestment rates to change

… which means the return on most bonds is uncertain (irrespective of whether

you plan to hold the bond to maturity or sell it beforehand)

… collectively, this uncertainty exposes investors and borrowers in bond

markets to interest rate risk

Which type of bond is (sometimes) free of interest rate risk ?

3
You face similar issues if you deal with a bank …

Is a fixed rate mortgage better than an adjustable (variable) rate mortgage ?

Interest rate risk creates an opportunity for some but is a cause of concern for others

How Volatile Have Risk-free Interest Rates Been In The Past ?

Source: Federal Reserve Board at https://www.federalreserve.gov/releases/h15/data.htm

4
Are All Bonds Equally Affected By Changes in Yields ?

Holding all other factors constant …

 the prices of longer term bonds are more sensitive to changes in yields than
shorter term bonds

 the prices of lower coupon bonds are more sensitive to changes in yield than
higher coupon bonds

… which suggests we need take account of both the coupon rate and the
maturity of a bond when looking at its sensitivity to interest rates

Two common (and related) measures of the sensitivity of the price of a bond to a
change in yields are the modified duration of the bond and the dollar duration of
the bond

… both of which are based on the duration of the bond

5
2. DURATION

What Is The Duration of A Bond ?

Although maturity is the traditional measure of a bond's lifetime, it is inadequate

for many bonds since it represents the timing of only the last cash flow on the bond

For example, consider the promised cash flows on the following three bonds …

End of year 0 1 2 3

Bond A 98 1 1
Bond B 1 1 98
Bond C 0 0 100

Do you think of these bonds as being 3-year bonds ?

Duration (also called “Macaulay Duration”) is an alternative measure of a bond’s

lifetime that takes account of the entire pattern of the cash flows on the bond

6
Specifically, the duration of a bond is equal to the weighted average timing of all
the cash flows on the bond

Consider an 𝑛𝑛 year bond with a current price of 𝑃𝑃0 , a current YTM of 𝑦𝑦 per annum
𝑝𝑝
and promised cash flows of 𝐶𝐶𝑡𝑡 at the end of year 𝑡𝑡 …

End of year 0 1 2 … 𝑛𝑛

𝑝𝑝 𝑝𝑝 𝑝𝑝
cash flows 𝐶𝐶1 𝐶𝐶2 𝐶𝐶𝑛𝑛
price 𝑃𝑃0

Then the duration of the bond, measured in years, is then …

𝑛𝑛

𝐷𝐷 = 𝑤𝑤1 ×1 + 𝑤𝑤2 ×2 + ⋯ + 𝑤𝑤𝑛𝑛 ×𝑛𝑛 = � 𝑤𝑤𝑡𝑡 ×𝑡𝑡

𝑡𝑡=1

… where 𝑡𝑡 is the timing of each cash flow and the corresponding weight is
𝑝𝑝
𝐶𝐶𝑡𝑡 �(1+𝑦𝑦)𝑡𝑡
𝑤𝑤𝑡𝑡 =
𝑃𝑃0
7
Example 1 (continued)

Reconsider the 4-year corporate bond with promised cash flows of …

End of year 0 1 2 3 4

𝑝𝑝
𝐶𝐶𝑡𝑡 5,000 5,000 5,000 105,000

and a current price of $90,063.62 based on the current YTM of 8% per annum.

The current duration of the bond is 3.7065 years as calculated below …

𝑝𝑝 𝑝𝑝 𝑝𝑝
𝑡𝑡 𝐶𝐶𝑡𝑡 𝐶𝐶𝑡𝑡 ⁄(1 + 𝑦𝑦)𝑡𝑡 𝐶𝐶𝑡𝑡 ⁄(1 + 𝑦𝑦)𝑡𝑡 𝑤𝑤𝑡𝑡 ×𝑡𝑡
𝑤𝑤𝑡𝑡 =
𝑃𝑃0

1 5,000 4,629.63 0.0514 0.0514

2 5,000 4,286.69 0.0476 0.0952
3 5,000 3,969.16 0.0441 0.1322
4 105,000 77,178.13 0.8569 3.4277

Sum 90,063.62 1.0000 3.7065

8
What Is The Modified Duration of A Bond ?

Making a slight adjustment to the duration of a bond gives the modified duration
of the bond …

∗
𝐷𝐷
𝐷𝐷 =
1 + 𝑦𝑦

… where 𝑦𝑦 is the current YTM of the bond.

Why Do We Need Two Duration Measures ?

They measure different things …

 duration is a measure of the timing of the cash flows on the bond

 modified duration is a measure of the sensitivity of the price of the bond to

changes in yields
9
One can show that the approximate change in the price of a bond due to a small
change in yield is:

∆𝑃𝑃 ≈ −𝐷𝐷 ∗ 𝑃𝑃0 ∆𝑦𝑦

… where 𝑃𝑃0 is the current price of the bond (that is, before the change in yield),
𝑦𝑦 is the current YTM and ∆𝑦𝑦 is the change in YTM – where both 𝑦𝑦 and ∆𝑦𝑦 are
expressed in decimals

Extension Note: The mathematical foundation for the above is to regard P as a function of y and then calculate a first
1 𝑑𝑑𝑃𝑃0
order Taylor Series expansion for ∆P. For calculus-minded students one can show that 𝐷𝐷 ∗ = − .
𝑃𝑃0 𝑑𝑑𝑑𝑑

If we choose ∆𝑦𝑦 = 0.01 and substitute into the above and rearrange we get:

∆𝑃𝑃
𝐷𝐷 ∗ ≈ − ×100
𝑃𝑃0

… this means that modified duration can be interpreted as the approximate %

change in the price of a bond if yields change by 1%
10
What Is The Dollar Value Duration of A Bond ?

A related concept is the Dollar Value Duration of a bond:

𝐷𝐷 ∗
𝐷𝐷𝐷𝐷01 = ×𝑃𝑃
100 0

… this can be interpreted as the approximate $ change in the price of a bond if

yields change by 1%

Example 1 (continued)

How sensitive is the price of the 4-year corporate bond to a change in yield ?

We have …
𝐷𝐷 3.7065
𝐷𝐷 ∗ = = = 3.4320
1 + 𝑦𝑦 1.08

𝐷𝐷 ∗ 3.4320
𝐷𝐷𝐷𝐷01 = ×𝑃𝑃 = ×90,063.62 = 3,090.95
100 0 100
11
 … which means a 1% change in yield will

 change the price of the bond by approximately 3.4320%

 change the price of the bond by approximately $3,090.95

Let’s check …

The current price is $90,063.62 based on the current YTM of 8% per annum.

Assume yields immediately increase from 8.0 % to 8.5%. We can use modified
duration to estimate the impact of the change in yield on the price of the bond and
compare this to the actual price of the bond at the new yield.

Bond price before the change (at 𝑦𝑦 = 0.08) 𝑃𝑃0 = $90,063.62

Change in yield ∆𝑦𝑦 = +0.005
Estimated change in bond price ∆𝑃𝑃 ≈ −𝐷𝐷 ∗ 𝑃𝑃0 ∆𝑦𝑦 = −$1,545.48
Estimated bond price after the change 𝑃𝑃0 + ∆𝑃𝑃 = $88,518.14
Actual bond price after the change (at 𝑦𝑦 = 0.085) 𝑃𝑃0𝑛𝑛𝑛𝑛𝑛𝑛 = $88,535.41
Approximation error −$17.27
12
Extension Note: The above formula for modified duration implicitly assumes that the cash flows on the bond are fixed
and changes in yield arise only from parallel shifts in the yield curve.

Why Do We Get An Error ?

Modified duration implicitly assumes the price-yield relationship is linear when

in fact the price-yield relationship is curved. This means modified duration …

• is a local measure of the sensitivity of the price of a bond to a change in yield

– which means the smaller the change in yield the better the estimated
change in price

• always underestimates the price of the bond after the change in yield

Why Should We Bother Using Modified Duration to Estimate a Price Change ?

We can use our bond pricing formula to calculate the actual price of a bond
following a change in yield – but modified duration is still useful …

• as a simple measure of the sensitivity of the price of a bond to future changes

in yields
13
• when we want a single summary measure of the sensitivity of a portfolio of
bonds to future changes in interest rates (yields)

This means modified duration is an important tool for both hedging and speculative
purposes.

How Do You Use Duration For Speculative Purposes ?

We know that modified duration of a bond is a function of the duration of a bond

which in turn is a function of the bond’s maturity and coupon rate

If you wish to take a view on the future direction of interest rates then modified
duration can help in choosing which bonds to buy or sell.

If you think interest rates are going to fall would you be better to …
A – buy a 1-year bond now
B – sell a 1-year bond now
C – buy a 10-year bond now
D – sell a 10-year bond now
14
Can We Get a Better Estimate ?

The convexity of a bond is a measure of the curvature of the relationship between

the price of the bond and its yield.

One can show that a (better) approximation for the change in the price of a bond
due to a small change in yield is:

1
∆𝑃𝑃 ≈ −𝐷𝐷 ∗ 𝑃𝑃0 ∆𝑦𝑦 + 𝜅𝜅𝑃𝑃0 (Δ𝑦𝑦)2
2

… where the current convexity of the bond, measured in years, is:

𝑛𝑛
1
𝜅𝜅 = � 𝑤𝑤𝑡𝑡 ×𝑡𝑡×(𝑡𝑡 + 1)
(1 + 𝑦𝑦) 2
𝑡𝑡=1

𝑝𝑝
𝐶𝐶𝑡𝑡 �(1+𝑦𝑦)𝑡𝑡
… where 𝑤𝑤𝑡𝑡 =
𝑃𝑃0

Extension Note: Mathematically, this is a second order Taylor Series expansion for ∆P. For calculus-minded students
1 𝑑𝑑 2 𝑃𝑃0
one can show that 𝜅𝜅 = .
𝑃𝑃0 𝑑𝑑𝑦𝑦 2
15
This is still an approximation with most (but not all) of the change in price
explained by the bond's modified duration and convexity.

Convexity is a desirable feature of bonds

… all else equal, a higher convexity bond gives you bigger price increases when
yields fall and smaller price decreases when yields rise

Extension Note: (Bonds with Semi-Annual Cash flows): We have so far assumed that the bond pays annual cash flows
at the end of each year 𝑡𝑡 = 1,2, . . , 𝑛𝑛. If instead the bond pays semi-annual cash flows then we need to use the
following amended formulae for duration, modified duration and convexity:

𝑖𝑖 𝐷𝐷 1 𝑖𝑖 𝑖𝑖+1
𝐷𝐷 = ∑2𝑛𝑛
𝑖𝑖=1 𝑤𝑤𝑖𝑖 × 𝐷𝐷∗ = 𝑦𝑦 𝜅𝜅 = 𝑦𝑦 2
∑2𝑛𝑛
𝑖𝑖=1 𝑤𝑤𝑖𝑖 × ×
2 1+ �1+ � 2 2
2 2
𝑝𝑝 𝑦𝑦 𝑖𝑖
𝐶𝐶𝑖𝑖 ��1+ �
where 𝑤𝑤𝑖𝑖 = 2
and the cash flows are paid at the end of each semi-annual period 𝑖𝑖 = 1,2, . . ,2𝑛𝑛.
𝑃𝑃0

Extension Note: Immunization is the bond portfolio management strategy which uses duration for hedging (that is, risk
management) purposes. Specifically, one seeks to hedge (or “protect”) the current value of a bond portfolio (or the
total future value of a bond portfolio) against interest rate risk – a portfolio with zero interest rate risk is said to be
"immunized". This is particularly important for pension funds who need to choose which assets to hold now to meet
their schedule of expected pension liabilities in the future. Other techniques used to manage interest rate risk include
interest rate swaps (to manage an exposure to fixed v. floating interest rates), basis swaps (to manage an exposure to
different floating interest rates) and forward rate agreements (to lock in a future interest rate on an investment or a
borrowing).

16
3. CREDIT DEFAULT SWAPS

Credit Default Swaps are a key tool used in the management of credit risk

What is a Credit Default Swap (CDS) ?

A CDS is a derivative security whose value is determined by the value of an

underlying bond (or portfolio of bonds)

You can think of a CDS as a being like an insurance contract against default …

At the start of each quarter …

$
CDS CDS
CDS spread
Buyer Seller

But if the issuer defaults on the underlying bond during the life of the CDS …
$
CDS CDS
loss from default
Buyer Seller

17
CDS allow bond investors to hedge the credit risk of a bond

… if a bond defaults, then the payout on the CDS can be used to make good the
loss on the bond

CDS allow other investors to speculate on the credit risk of the bond

… you can buy or sell a CDS without buying or selling the underlying bond

… the price of the CDS reflects the likelihood of payout

What Would You Do Now If You Thought The Bond Market

Was Going To Crash ?

A – Short Bonds

B – Buy CDS

18
Is Sovereign Debt Risk-Free ?
Prices are expressed in basis points
1
1 basis point = th of 1% or 0.01%
100

The CDS spread is the per annum cost

(in thousands of USD) to “insure”
USD10 million of the sovereign’s
5-year debt against default

19.80
… it currently costs %×
100
10,000,000 = $19,800 per annum to
insure $10 million of 5-year Japanese
debt against default

Source: http://www.worldgovernmentbonds.com/sovereign-cds/

19
What Is The U.S. Debt Ceiling ?

“The debt limit is the total amount of money that the United States government is authorized to
borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military
salaries, interest on the national debt, tax refunds, and other payments. The debt limit does not authorize
new spending commitments. It simply allows the government to finance existing legal obligations that
Congresses and presidents of both parties have made in the past. Failing to increase the debt limit
would have catastrophic economic consequences. It would cause the government to default on its legal
obligations – an unprecedented event in American history.”

Source: U.S. Department of the Treasury: https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-

service/debt-limit

“If the current $14.29 trillion debt ceiling is not raised, the Obama administration says the government
would ultimately have to default on its debt; without borrowing, it would not be able to pay both the
government's daily bills and the investors whose bonds have come due.”

– New York Times, 20 July 2011

“A cornerstone of the global financial system was shaken Friday when officials at ratings firm Standard
& Poor's said U.S. Treasury debt no longer deserved to be considered among the safest investments in the
world. S&P removed for the first time the triple-A rating the U.S. has held for 70 years, saying the
budget deal recently brokered in Washington didn't do enough to address the gloomy outlook for
America's finances”.
– Wall Street Journal, 6 August 2011
20
Source: https://www.bloomberg.com/politics/articles/2017-05-21/credit-arbiters-say-u-s-resilient-as-politics-cloud-debt-debate

“The way in which the U.S. finds itself in these periodic impasses is not a positive feature of the country’s
fiscal management [says a Moody’s senior analyst] …Yet our fundamental assumption is that even
though the politics around raising the debt limit can be noisy, messy and complex, the U.S. has a track
record of always managing to get it done”
– Bloomberg, 22 May 2017
21
“On December 9, 2017, the outstanding debt subject to limit was at the statutory debt limit. The
following business day, Secretary Steven Mnuchin notified Congress of [the use of extraordinary
measures] …
– U.S. Department of The Treasury, 27 July 2018

The debt ceiling was suspended in Feb 2018 and again in Aug 2019 for a further
two years …

Source: Federal Reserve Bank of St Louis at https://fred.stlouisfed.org/series/GFDEBTN

22
4. THE FINANCIAL CRISIS OF 2008

Imagine it is January 2008. There are currently five “big” U.S. Investment Banks:

What are the odds that shortly there will be only two ?
23
The Crisis in a Nutshell …

“In the fall of 2008, the credit squeeze, which had emerged a little more than a year before,
ballooned into Wall Street’s biggest crisis since the Great Depression. As hundreds of
billions in mortgage-related investments went bad, mighty investment banks that once ruled
high finance have crumbled or reinvented themselves as humdrum commercial banks. The
nation’s largest insurance company and largest savings and loan both were seized by the
government. The channels of credit, the arteries of the global financial system, have been
constricted, cutting off crucial funds to consumers and businesses small and large”

– New York Times, 2009

Here is the timeline …

24
 2001 2007 2008 2009

Oct 08
$700B
Mar 08
Stimulus
Fed brokers
sale of Bear
Feb 09
Housing Stearns to
$780B
bubble JP Morgan
Stimulus
bursts

U.S. Govt 7 Sep 08

encourages Treasury seizes
home Fannie Mae &
ownership Freddie Mac 17 Sep 08
AIG bailed
Jun 07 out
Fed drops Two Bear 14 Sep 08
interest rates Stearns Merrill 15 Sep 08
to fend off Hedge Lynch sold Lehman
recession Funds to BoA files for
collapse bankruptcy
protection

25
Many factors contributed to the Financial Crisis including explosive growth in the
use of sub-prime mortgages and securitization

What Is Securitization ?

The promised cash flows generated by a pool of one set of bonds (or from some
other dedicated source) is exclusively used to service the promised cash flows on
a second set of bonds

Securitization was not a new concept … it had been used for decades by the federal
agencies (Fannie Mae & Freddie Mac) to efficiently allocate the risks associated
with mortgage lending across a wide investor base and thereby increase the supply
of capital to the housing market
Extension Note: Specifically, the federal agencies provided liquidity to mortgage lenders by purchasing the loans they
made using funds raised by issuing debt securities (MBS) to other investors.

What changed in the lead-up to the crisis was the quality of the loans being
securitized and who was doing the securitization …

26
A typical “private-label” securitization is as follows …
 A mortgage originator such as a bank has a large portfolio of low quality sub-prime mortgages. Rather than
keeping them on its balance sheet, it decides to sell them to a Special Purpose Vehicle

 The SPV issues new securities – called mortgage backed securities (MBS) – to investors, supported by the cash
flows generated by the underlying “mortgage pool”. Pooling of the mortgages reduces the exposure of the SPV
investors to any single mortgage borrower. The new securities are split into sets of securities of differing seniority,
called tranches.

 The credit risk associated with the mortgage pool is allocated to investors based on seniority of – the senior tranche
(about 75% of the total principal value of the securities issued) gets paid first and only if fully paid, does the
mezzanine tranche (20%) then get paid and only if fully paid does the unrated/residual tranche (5%) then get paid.

 If the SPV starts to experience losses due to defaults in the underlying mortgage pool, then the losses are borne by
the unrated tranche first, then the mezzanine and lastly (if at all) by the senior tranche.

 The senior tranche is usually rated AAA and the mezzanine tranche is usually rated BBB.

 MBS mezzanine tranches were often difficult to sell to investors. So a second level of securitization was used to
transform a large portfolio of MBS mezzanine tranches (from different securitizations) into new securities called
Collateralized Debt Obligations (CDO) – which were similarly split into tranches of differing seniority.

• Portfolios of CDO mezzanine tranches were also difficult to sell so they too were securitized to create new
securities called CDO-squared (CDO2)

• Portfolios of CDS on MBS were also securitized to create securities called Synthetic CDOs.
Extension Note: In practice, there was normally more than one mezzanine tranche of different seniorities: AA, A, to BB.
If non-mortgage assets are securitized, the security is called an asset backed security (ABS).
27
What Was Securitized ?

The banks who originated the sub-prime mortgages did not want them on their
balance sheet.

So, these were pooled and securitized and used to service new securities called
mortgage-backed-securities (MBS) …

On Set-up …

sub-prime
mortgages MBS
Investors
Bank SPV
$ $ 

$ fee

Investment
Bank
28
Over Time …

“insurance”
AAA
CDS MBS
tranche
$

Pool of
repayments BBB
sub-prime
$ SPV $ MBS
mortgages
tranche

$
Residual
MBS
tranche

The AAA MBS tranches were marketed as securities with low-risk-high-return and
so were easy to sell to investors… but not so the BBB MBS tranches.
29
So, these were pooled and securitized and used to service new securities called
collateralized debt obligations (CDO) …

AAA
CDO
tranche
$

Pool of
payments BBB
BBB MBS
$ SPV $ CDO
tranches
tranche

$
Residual
CDO
tranche
The AAA CDO tranches were marketed as securities with low-risk-high-return and
so were easy to sell to investors… but not so the BBB CDO tranches.
30
So, these were pooled and securitized and used to service another level of new
collateralized debt obligations called CDO-squared (CDO2) …

AAA
CDO2
tranche
$

Pool of
payments BBB
BBB CDO
$ SPV $ CDO2
tranches
tranche

$
Residual
CDO2
tranche
The AAA CDO2 tranches were marketed as securities with low-risk-high-return
and so were easy to sell to investors …
31
Just How Safe Was the Senior MBS Tranche ?

The structure incorporated the following protection to investors …

 over-capitalized mortgage pool

 if a borrower defaulted on the mortgage then the house could be sold to reduce
the loss on a default

 payments from the SPV were backed by a CDS written by a high credit quality
firm such as AIG (American International Group – which was one of the largest
insurance companies in the U.S)

 AAA credit rating

Surely, the CDS alone would have been enough

to eliminate the credit risk exposure faced by the senior tranche investors ?
with the pool of sub-prime mortgages and “follow the money” …

32
And there was still more …

The CDS on the AAA MBS were pooled and securitized and used to service new
securities called synthetic collateralized debt obligations (Synthetic CDO) …

What Is The Fundamental Problem Here ?

What Do You Think Happened When The Housing Bubble Burst ?

33
What Happened to Prices ?

Source: Daniel, K., 2009, Anatomy of a Crisis, CFA Institute Conference proceedings Quarterly, September.

• The ABX BBB- Index measures the price of sub-prime mortgages

• The CMBX-AAA measures the credit spread on the MBS AAA tranches (left
axis)

• The CDX-IG measures CDS spreads on investment-grade bonds (left axis)

34
Who Was To Blame ?

Everyone is happy so long as the borrower continues to make the promised payments
to the investor(s). But we had multiple failures in the system …

1. U.S. Government – a noble but flawed policy

2. (Some) Borrowers – sadly borrowed beyond their means

3. Rating Agencies – there were flaws in their credit models

… actual defaults on the underlying sub-prime loans were not only high but
highly correlated

… homes could be sold to reduce the loss on a default but recovery rates on
the loans that defaulted were low due to weak asset markets at the time

How Many U.S. Corporations Were Rated AAA At The Time ?

How Many MBS, CDO, CDO2 Were Rated AAA At The Time ?
And Where Were The Promised Cash Flows Ultimately Coming From ?
35
4. Banks – moral hazard
… securitization allowed the original mortgage lender to pass on the credit
risk of the loan to someone else

5. Investment Banks – flawed incentive structures

6. Regulators – too slow to act

7. (Some) CDS sellers – under-capitalized

… the CDS were sold by high credit quality firms but this did not eliminate
the credit risk faced by the AAA MBS investors

8. (Some) Investors – lack of a reality check

9. Leverage – just too much of it ☹

Warning: This clip from the movie – The Big Short – contains some bad language

https://www.youtube.com/watch?v=EEXTqtH-Oo4

36
The Aftermath …

“After such a panic as has, the past year, swept over the country, it becomes a kind of
melancholy pleasure to look over the field and find that there are not quite so many dead
and wounded lying about as was anticipated. It was a fearful storm while it lasted … the
result of an attempt to do too much with too little capital.”
July 1874
and …

“It has not been simply the falling out of reckless traders – not the end of an ordinarily
wild speculation in which the failure is usually the result of individual indiscretion and
rashness … but it is more a result of a wrong financial system”.
July 1876
– Two editorials quoted in Giesecke, Longstaff, Schaefer and Strebulaev 1

Key Takeaway
Never Get Complacent About Risk
especially when times are good

1
An earlier working paper version of: Giesecke, K, F.A. Longstaff, S. Schaefer and I. Strebulaev, 2011, Corporate Bond Default Risk: A
150-Year Perspective, Journal of Financial Economics.
37
Is It Over ?

There is still a residual economic problem in the U.S. (even before Covid-19) …

The Fed has raised its benchmark rate twice this year, to a range between 1 and 1.25 percent.
Investors expect the Fed to raise the benchmark rate for a third time at its final meeting of the
year, in mid-December. The Fed kept rates unusually low for years after the 2008
financial crisis to encourage borrowing and risk-taking; it is gradually raising rates to
reduce that stimulus as the economy recovers.
– New York Times, 26 September 2017

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5. WAS DAVID BOWIE RESPONSIBLE FOR THE FINANCIAL CRISIS?

David Bowie
U.K. rock legend with a string of international hits over an extended period of time
including … Space Oddity, Life on Mars?, Heroes, Young Americans, Modern
Love, Ashes to Ashes

Not only was he a clever musician but also a clever businessman. Over the years,
he kept control of his copyrights and master recordings and then did something new
in 1997 …

Record master &

publishing Bowie Bonds
rights
Investors
SPV
$ $55m


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What Are Bowie Bonds ?

• Security type … ABS –Entertainment Royalties

• Issue Price … $55 million
• Method ... Private Placement
• Coupon … 7.9% per annum payable monthly
• Maturity … 10 years

“Moody's Investors Service has assigned an A3 rating to the [JTEC] music royalty
securitization. This rating is based on the historical performance of the assets, which are record
master and publishing rights on compositions written and recorded by the musical artist David
Bowie … The assets sold into the transaction will generate revenues on both royalty payments
earned for the sale of record albums as well as publishing rights.”

– Moody’s, 13 Feb 1997

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 “Accurate sales forecasts for newly
released albums are extremely difficult to
make. Even popular acts with large fan
bases can have disappointing sales …

Future sales of “seasoned” albums are

more predictable. Most of an album’s
sales occur during the first two years
after its release …

The albums in the Bowie transaction

were very well seasoned and Moody’s
viewed the potential future volatility of
the album sales as being relatively low
risk”

– Moody’s Approach to Rating Music Royalty and Intellectual Property-Backed Transactions, 2 July 1999

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“When Moody's recently announced it had put Bowie Bonds on its watch list for a possible
downgrade, you could hear the I-told-you-so's across Wall Street. But before you write off
aging rockers, it's worth noting that the bonds, which are based on David Bowie's future
earnings, have yielded a steady 8% a year since they were issued in 1997--and the Thin White
Duke has never missed a payment. Even if he is downgraded from his A3 rating, he'll still be
investment grade.”

– Fortune Magazine, 16 June 2003

And Then Comes This Headline in the British Press …

“David Bowie's 'back catalogue bonds' may have started the credit crunch

He’s always been a trendsetter. But could David Bowie have caused the latest fad
sweeping the nation – the credit crunch? …”
– Daily Mirror, 12 January 2009

It’s a long bow to draw but ….

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