Collateralized Debt Obligations: Embedded Options, Misguided Forecasts
Options are behind some of the biggest losses that companies have suffered since the 1990s. Nick Leeson famously brought down Baring Brothers bank in 1995, a British financial institution that had been in existence since 1762. It is true that Leeson precipitated this collapse mostly by trading stock index futures on Japan’s Nikkei 225 index. But by using options as well, Leeson was able to temporarily hide the losses he was amassing on his Japanese stock market wager. What he did was sell (i.e. write) options on the Nikkei 225 index and used the proceeds to meet the margin calls on his losing futures positions. Options were also implicated in a $269 million loss taken in 1991 by Allied-Lyons, a British food and drinks company. Its treasury department drifted from hedging FX exposure with options into outright speculative bets on the volatility of currencies. It created these bets by simultaneously writing puts and calls. Though these option trading disasters were publicized in the financial press, options did not gain political significance until Collateralized Debt Obligations (CDOs) came asunder in the sub-prime mortgage crisis of 2007-2008. These derivative instruments were at the center of the subprime mortgage crisis.
The name of this security may not suggest it, but CDOs contain options as one of their essential ingredients. A CDO is made up of a collection of loans or mortgages that are divided up into various tranches. These are defined by their priority over the cash flows—that is, the repayments of the debt—generated by the loans and mortgages. The senior tranche is the first to receive its share of the payments made by borrowers. Usually, next in line to receive their contracted amount is the mezzanine tranche. If there are any monies still left after the other cohorts have collected, then the equity tranche is assigned the residual. Because it has first rights over the cash flows, the senior tranche is the least risky. For this reason, it is offered the lowest return. The mezzanine tranche is somewhat riskier given its later position in the sequence of payments. So in exchange, it is granted the prospect of a somewhat higher return than the senior portion. Given their status as final claimants, the equity tranche holders are exposed to the greatest hazard. But they also have the chance to garner the greatest return of all the CDO investors.
By parceling out the expected cash flows into various tranches, CDOs come to embody a series of option positions. The senior tranche is effectively equivalent to being long a bond, made up of the loan and mortgage assets, and simultaneously short a series of call options on the bond. Each of these options can be viewed as being cash-settled. Not only that, each of the options can be viewed as expiring around the time a periodic payment is to be made to the CDO investors. These calls carry a relatively low strike price. The option strike is effectively set at level representing a slight premium to the value the bond will have immediately after a periodic payment is set. What happens, then, is this: every time funds are distributed on the CDO, the senior tranche holders can be conceived as first receiving all of the money, owing to their long bond position. Moreover, they can be seen as having to make a cash settlement on the call options they have written. Suppose there is $7 available to be immediately disbursed, and that the set of future cash flows are worth $100. Prior to payment, the bond will be worth $107. The senior tranche holders can be conceived as having written a call with a strike price of, say, $102. Just before payment, the call expires and the senior tranche must pay $5 ($107 - $102) to those long that option. But it keeps the remaining $2 ($7 received minus $5 to defray the option). Notice that the senior tranche keeps this $2 even if the payments about to be made were $5, $3, or $2, wherein the bond would have been worth $105, $103, and $102, respectively. This is because the strike price is close to the post-payment value of the bond.
Breaking a CDO down like this allows us to see where exactly matters went awry in the sub-prime mortgage arena. What especially brought the financial system under stress in 2008 was the senior tranche of CDOs. This tranche contained individually high-risk mortgages that were nevertheless seen as safe fixed-income investments by the insurance companies, pension funds, and banks which purchased them. Corroborating this judgment were the bond-rating agencies that graded CDO tranches. When a bevy of financial institutions had to write down their CDO assets and slash the ratings on them, derivatives came under assault as a species of financial alchemy. The scientific and mathematical veneer of derivatives, so the charge went, deluded even sophisticated investors into thinking a dicey package of housing loans could be magically transformed into a triple-A-rated rated security. But once it is recognized that the senior tranches are equal to being long a bond plus short a call on that same bond, it becomes plain that the losses were owing to a drop in the bond position as opposed to the option. By itself, a short call trade is a bearish bet on the underlying security. However, the gains are limited to the premium received in writing the option. Because of this cap, the short call position cannot fully hedge against a fall in the bond’s price. Neither is the reduction of risk achieved by the CDO’s derivative element mere hocus-pocus. In the jargon of the options world, that element is part of a covered call writing strategy. This is commonly used by conservative investors to lower the break-even point on a stock at the price of constraining their returns on an appreciation of the shares (Fig. 6.10).
What covered call writing, and hence senior tranches of CDOs, cannot defend against are mammoth declines in the value of the underlying asset. Underestimating the probability of such an extreme event is essentially what led to the downfall of the CDO sector in 2007-2008. Crucial to that miscalculation, as Peter J. Wallison has well observed, is that both Fannie Mae and Freddie Mac failed to disclose how many sub-prime mortgages they actually had. Since they held a huge portfolio of such mortgages, that lack
Fig. 6.10 Payoff profile of a covered call write strategy versus purchase of underlying asset
of forthrightness made it difficult for traders and investors to gauge how precarious the entire housing market stood. It was more of a knowledge problem than it was a financial instrument design flaw.
Nevertheless, the implosion of CDOs predictably led to calls for greater regulation of derivatives. Many of the demands were met with the 2010 passage of the Dodd-Frank Act. Given the knowledge problem faced not only by derivatives traders but also by anyone trying to assess risk, it is hard to fathom how strengthening regulation is going to help avoid a future CDO-type implosion. For this to work, government bureaucrats will need to possess a better mode of predicting future asset prices than what the markets unimpeded can do on their own. To say to an investor, after all, that a derivative is not suitable for them or that they are liable to wreak havoc on the financial system is to say that your own forecast is better than theirs. Markets do have the advantage of quickly assimilating the wide diversity of insights and opinions of the investing crowd.
Let us engage in a historical thought experiment. In the mid-2000s, regulators could have stopped CDOs from proliferating. Regulators could have kept CDOs out of the portfolios of socially critical players like pension funds and insurance companies. But officials would have had to gauge that the probability of a housing collapse was greater than what the market was calculating. In making this estimate, officials would have also had to adjust for the extent to which the government’s actions may have been clouding the market’s calculations. That means they would have to take into account the Fed’s low interest rates policy. This is not to mention the numerous laws and inducements that the government had adopted to encourage people to buy houses. Nobody of influence in government did any of this. Going forward, can we expect this to be different? Can the government be counted upon to regularly engage individuals with the necessary forecasting skills to consistently outperform the market’s outlook? Can the government regularly secure people capable of mustering the courage to go against the prevailing view? No doubt, the state might occasionally be able to employ individuals having a unique discernment and intuitive knack for the markets. But it is never prudent to build laws and regulations whose efficacy depends so heavily on the rare virtues of those enforcing them. For that is to effectively rely on luck. Besides, such individuals are likely to be hired away by financial institutions. The private sector is very willing and more able to pay individuals with unusual predictive talents.
Perhaps one might think that regulators can be equipped with the latest quantitative-statistical models. But if the recent financial crisis has taught us anything, it is that the success of mathematics in the natural sciences cannot be replicated in our understanding of the human things. People do not display the regularity of behavior that planets do. Unlike planets, too, people learn from their experience. Doing so, they change in ways that prevents scientific observers from making anything more than statistically informed guesses about what a group of people are going to do based on they have done before. Nor should it be forgotten that causal factors impinging on human affairs are extremely variegated and complex. This often makes it difficult to uncover previous instances similar in all decisive respects to the subsequent phenomena one is trying to explain and predict. I will grant that the imposing mathematical edifice surrounding derivatives has done much to impart an excessive confidence among market professionals. Too many have become convinced of their oracular powers in the belief that the path of human activity can be mapped out. Too many have succumbed to the delusion that what Niccolo Machiavelli called fortuna has been conquered by quantitative modeling.
Yet such fallacies are not simply a phenomena of the financial markets. As Alexis de Tocqueville observed over a century and a half ago, democracies can be gullible to applications of science that promise to make people more materially affluent. Precisely because science has so conspicuously lived up to this promise, anything seemingly embodying its characteristic elements will engender sentiments of awe and respect among democratic peoples. This includes the cavalcade of equations put forward to explain the pricing of derivatives. It even extends to subject matter beyond the realm of physical nature to human affairs, where the success of scientists have been limited. More than any other realm of human existence, financial markets corroborate David Hume’s famous philosophical point about the rational tenuousness of induction—namely, that it is ultimately a matter of faith to think that the future will be like the past. Still, we do well to recall the relative success of prediction markets in foreseeing everything from elections, sporting outcomes, movie box office receipts, and court cases. The price system of the market, not the policymaking apparatus of the state, is the best means we have available to confront the abyss of the future.
-  Laurent L. Jacque, Global Derivative Debacles. From Theory to Malpractice (Singapore:World Scientific, 2010), 161-168.
-  Laurent L. Jacque, Global Derivative Debacles, 115-121.
-  In writing the call, to whom does the senior tranche sell that option? The answer is the nextmezzanine tranche. These in turn sell calls with a higher strike price to the equity tranche. Inthe end, the equity tranche holders are left with the riskiest situation, a simple long call position at the highest possible strike price, $105 in my illustration.
-  Peter J. Wallison, Hidden in Plain Sight: What Really Caused the World'’s Worst FinancialCrisis and Why It Could Happen Again (New York: Encounter Book, 2015), Chap. 10.
-  Niccolo Machiavelli, The Prince, trans. Harvey C. Mansfield, Jr. (Chicago: University ofChicago Press, 1985), Chap. 25.
-  Tocqueville, Alexis de Democracy in America pp.459-465.
-  David Hume, A Treatise ofHuman Nature, ed. Peter Nidditch (Oxford: Oxford University
-  For an overview of the efficacy, promise, and limits of prediction markets, see my“Prediction markets: The practical and normative possibilities for the social production ofknowledge”. Episteme 6, no. 1 (2009), 91-106. For a more recent overview of predictionmarkets, see Erik Snowberg, Justin Wolfers, and Eric Zitzewitz. “Prediction Markets forEconomic Forecasting”, Centre for Economic Policy Research Discussion Papers, No. D9059(July 2012), www.cepr.org/active/publications/discussion_papers/dp.php?dpno=9059