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How Real Estate, Derivatives and excessive leverage caused the financial crisis

By Edited Aug 29, 2016 0 0


This paper aims to highlight an important factor that was instrumental in the current financial crisis - the extreme leverage that derivative instruments provide, and how Financial Institutions (mis)used this to increase their exposure. It also shows how artificial products are created, and how different instruments and their participants are inter-connected, which results in the collapse of the entire system even if any one in the chain fails.

Here we will limit our discussions primarily on derivatives instruments, as these are not commonly understood by all. Common investments like Equities, Fixed Income securities are not elaborated here, but these instruments are also play a significant role in the entire financial eco-system

The discussion is kept as simple as possible to ensure readers with minimal or no knowledge on the derivative products mentioned in this paper are able to understand and appreciate the scenario. However, regulars can also use this as a refresher to revisit how things are intertwined, and use this as a reminder for caution while dealing in the Financial Markets.

Readers are encouraged to read further into the various products highlighted in this note, and understand the complexities associated with each product. The illustrations in this note are very simple to enable easier understanding.

Also, in the backdrop, we must understand that at the root of this crisis were mortgages in general and sub-prime mortgages in specific. The euphoria that was prevalent in the Real Estate Market due to extraordinary demand created by new buyers resulting from easy availability of loans without requisite checks, and artificially increased prices due to this increased demand, led to the creation of a massive bubble, which when finally burst, sucked not only the US economy, but the Global economies as well into recession.

So what really happened?

Let us see how financial instruments and Financial Institutions played their part leading upto the crisis. Here, for simplicity’s sake, we shall look at only 3 entities, each playing a single role. However, in the real world, each entity would play multiple roles â€" being an investor at one time, an issuer at another, a protection buyer in one situation, and a protection seller at another.


Bank A â€" An Investment Bank

Real Estate Financiers (REF) - A financier, who specializes in lending for real estate purchases, lets say homeloans

Market Movers Inc (MMI) â€" An investment Bank.

Investors â€" Investment Banks, Asset Managers, Insurance Companies, Hedge Funds, Pension Funds, Very High Networth Individuals, etc.


The property market is booming. This is because the economy is doing well, interest rates are low and credit availability is easy. This results in more demand and continuous increase in property prices inducing more and more people to take loans and buy property.

Real Estate Financiers (REF) is in the business of lending money to borrowers for acquiring houses. Currently the Real estate market is at its peak, and everyone wants to buy a house or property to cash in. Because of high demand, there is extreme competition amongst various lenders to lend more, often circumventing safety norms. REF Managers are under intense pressure to perform better than their competitors, and face the heat from their bosses if they cannot generate more business in the booming period than their competitors. Hence they go all out to lend as much as they can. As they lend more, they need more funds which again come from the market as they borrow. Hence they borrow from the market and then resell to the retail borrowers.



Investment Bank (Bank A) pays a sum of USD 10 million and buys a Bond from an Issuer (REF) that pays 10% interest per annum (technically known as coupon). This coupon payment is received 4 times a year on 1st April, 1st July, 1st October and 1st January. Hence each coupon payout is for USD 250000 (10000000 *10%*3/12)

Now REF has 10 million dollars which it can invest in various activities (typically fund his business requirements). However, if he does not need it immediately, then he may deploy some or all of these funds into various Money Market Instruments (Overnight calls, Repos, etc), or deploy in any other instruments like equities, buy Fixed income securities, etc.

REF has received 10 million dollars, which it lends to various borrowers, and earns interest. From the interest thus earned, REF pays its interest obligation to Bank A. The properties against which home loans are issued by REF are mortgaged with itself, as security.

Instrument 2

Credit Default Swaps (CDS)

As the Investment Bank, Bank A, has taken an exposure on the issuer of Bonds i.e. REF by buying the bonds, there is a possibility that when the time to repay the bond, or payment of interest comes, REF may default in the payment. Hence to protect against the risk of default Bank A purchases an instrument known as a Credit Default Swap from another investment Bank (MMI). Bank A pays a stream of premium payments to MMI, who in turn promises to indemnify Bank A if REF defaults. Bank A buys protection by paying a regular premium, while MMI sells protection by receiving regular premiums, with the Bonds issued by REF as the Reference Asset.


Bank A

(Protection Buyer)

(Protection Seller)

Protects against default Risk of REF

Provides regular Premium to receive protection

Note: In case REF does default, MMI would have to make payment to Bank A for the losses suffered by Bank A (to the extent mutually agreed by MMI and Bank A).

Instrument 3

Collateralized Debt Obligations (CDO):

Bank A is receiving continuous interest payments from REF resulting from the Bond transaction. Bank A now repackages this interest and sells in the market i.e. they create a new security based on the Assets (Bonds) that they own, repackage it and sell to investors in the form of CDOs, at a slightly lower interest rate â€" thus they recover a large portion of their funds that they invested with REF through sale of the CDOs, and from the interest stream that comes from REF, Bank A can pay interest to the investors who bought the CDOs (and make a spread in between). Once this is done Bank A again has funds to repeat the whole process, i.e. again buy new bonds, repackage and sell to investors.

Bank A


Pays 10M and receives 250000 per quarter@ 10% pa

Bank A repackages and creates new CDO and sells with coupon @ 9% p.a.


(buy the repackaged security and get Interest @ 9% p.a.)

Instrument 4

Mortgage Backed Securities (MBS)

REF who has lent out money to borrowers as home loans has a pool of Mortgages and a stream of interest receipts that borrowers pay to it.

REF securitizes the Mortgages that it holds and issues them to investors i.e. through a securitization process, REF converts the physical mortgages into securities (which are backed by the mortgaged property). These securities are sold to investors as MBS. Investors buy such securities and receive an interest from REF. The interest payable to investors of MBS may be less than what REF is getting from its borrowers.


Borrowers with Mortgages

REF Provided Loans and receive s Interest

REF securitizesand creates new MBS and sells with coupon @ 7% p.a.


(buy the securitized mortgages and get Interest @ 7% p.a.

Now REF realizes more money from the sale of these securities, and also makes a spread between the interest rate it receives from its Borrowers and the interest that it pays to its investors. The additional money could be used for further lending, to create more mortgage pools and reselling.

By doing so, REF not only raises more money for its operations, but also transfers the credit risk arising from the mortgages to the investors. Further, since it has more money to lend now, it tries hard to attract more borrowers, often lending to persons who may not have a good credit rating and thus not eligible to borrow.

Instrument 5

Interest Only Strips (IO):

REFs home loan borrowers


Investors (buy IO Strips)



IO Strip


A derivative of the MBS that REF can issue is an IO security, whereby interest is paid to investors based on the current value of the loan collateral. High prepayment by borrowers can lead to lower returns to the investor than the actual amounts invested

Thus REF could issue IO Strips to Investors, who would get interest on their investments. The interest payments are based on the outstanding principal of the borrowers of REF. If the borrowers prepay faster, then the Principal component reduces, and hence this leads to reduction in interest payments to the investors.

Instrument 6

Principal Only Strips (PO)

Another variant of the MBS that REF can issue is a PO strip. PO strips are created by separating the principal payments from the interest payments collected from a pool of mortgage pass-through securities. The principal payments are combined, regardless of whether principal is paid early or at final maturity.

PO strips are priced and traded at a discount from par value, like zero-coupon issues, rising to par at maturity. PO strips can have high yields if prepayments are accelerated (and interest rates decline), but can have returns much lower than expected if interest rates begin rising. At worst, the return to the investor may never reach the purchase price, resulting in a loss

REFs home loan borrowers


Investors (buy PO Strips)



PO Strip


REF could issue PO Strips as well to investors. Based on the repayments by the borrowers of REF, REF would repay the investors. If the borrowers repay faster than expected (prepay), then the investors who have bought the PO strips would benefit as they would get their principal much faster, and vice versa.

IO Strips and PO Strips are two sides of the same coin, whereby PO Strip holders benefit with faster repayments, while IO strip holders benefit with slower repayments.

So where is the problem?

All seems to be fine till now. Everyone seems to be gaining, and it seems to be a win-win for all parties involved â€" Bank A can lend and earn interest, REF gets funds which it lends, MMI provides protection and gets premium, each of these parties resell their assets and increase their incomes, and finally the Investors have access to a wide variety of products to invest in and increase their returns.

So where is the problem, you may ask. Let us analyze this now.

Practically at each level, the funds released could (and would!) be deployed back into some instrument available in the marketplace â€" either as real estate, or any conventional instruments like equities, bonds, government securities; or unconventional exotic derivatives. Hence the bubble keeps building.

We have seen how a simple transaction involving a Bond multiplied into numerous other transactions linked directly or indirectly to the original bond transaction.

This way a chain is created which consists of multiple participants dealing in various products, and as is said, the strength of the chain is as strong as the strength of the weakest link.

As a background note, let us once again remind ourselves why the property market was booming. This was because when the economy was doing well, interest rates were quite low and credit availability was easy, which resulted in more people taking loans and buying property (houses). This increased demand forced the prices to go up. As prices were increasing and everyone wanted to lend to everyone else, credit was available easily and cheaply, poor credit scores were ignored, and more and more people jumped onto this bandwagon, further driving the prices northwards. To add to this, loans were given to borrowers who typically should not have qualified for the loan given (known as sub-prime loans i.e. the credit worthiness of the borrowers was not prime). Often property was appraised at much higher value then it actually was to enable higher credit. When this finally came to light, the sub-prime bubble burst and prices of real estate nose dived. There was no credit available in the markets, and the valuations of existing homes dropped by as much as 50% and even more in many cases.

So, coming back to our discussion, now when this burgeoning market stopped its growth, demand for homes and real estate slumped. Thus REF could not deploy all the funds that it had and hence could not generate the required interest receipts to fund the interest payment to Bank A. REF may keep honoring its interest payment for some time using its accumulated profits or reserves, but eventually it may have to default, as there are no more flows or residual funds which can be used for the interest payments. To make things worse, because of the real estate market slump, property prices also start coming down. Hence investors, who had borrowed money and invested in high priced houses, now find that the value of their house is less than what they owe to the lender REF, and hence they start defaulting on the principal and interest repayments. Beyond a certain level, REF would not be able to sustain this and would have to fall (i.e. declare itself as a defaulter and/ or file for bankruptcy)

With this default, The USD 10 million that Bank A has invested in the bonds of REF is at risk. But as Bank A has taken a CDS, MMI would now have to make this USD 10 million payment to Bank A.

There are 4 possibilities here:

1. MMI has provided similar protection to many others, and there have been multiple defaults - In such a case, it is possible that because of the many defaults MMI had to honor, it is now exhausted financially and cannot honor its commitment to Bank A

2. MMI has provided similar protection to many others, and there have been multiple defaults, but MMI honors its commitment to Bank A - In such a situation, some other protection buyer will not get his loss protected, as MMI has used its finances to honor Bank A’s commitment, which would lead to the fall of such other protection buyer. We will ignore this scenario to take our discussion forward.

3. MMI has no other protection liability â€" This would be a rare possibility, but possible only if MMI is too small to provide multiple protections, and hence it itself could fall if it honors its commitment to MMI.

4. MMI is financially strong and can manage all its commitments - For arguments’ sake, we will ignore this possibility (which is also practical as we have seen in the current crisis, most protection sellers took a major hit)

Hence looking at scenarios 1 and 3, it is most likely that MMI cannot honor its commitment and Bank A will stand to lose the USD 10 million that it lent to REF.

Given this, there could be 2 possibilities with Bank A

1. It is financially strong and can take this hit of USD 10 million

2. It is financially not as strong (maybe because of other hits as well), and cannot take this loss of USD 10 Million.

In both the scenarios, the investors who have bought the CDOs from Bank A would suffer â€" they may lose their invested amount and the interest (because CDO as a product is designed to transfer the risk from the issuer to the Investor).

Add to this the Default of Bank A, which triggers its own Tsunami as it would have multiple associations with various other participants (for example, Bank A may have provided protection to some one else, it could have sold bonds, issued equity, have commitments in the Forex markets, have exposures in the Forwards and Futures markets.) All such transactions have the possibility to fail, and counterparts may likely lose money because of this default, compounding the negative sentiment and defaults in the market.

Similarly, the investors who have bought the MBS from MMI will also suffer.

Hence this creates a chain reaction. Collapse of any one participant leads to a chain of collapses in the entire market-place. There is a compounding effect. When one participant falls, various counterparts also stand to lose. Negative sentiment and pessimism rule, which leads to more gloom in the markets, pressuring prices to fall further. This works like fuel to accelerate the vicious depression in the market, and indeed in the economy. Defaults increase, funds dry up and this keeps compounding, dragging more and more entities and investors into the black hole of crisis and bankruptcy.

Amongst all this chaos, the funds that the Financial Institutions may have deployed in the Equities and bonds markets would be sought back, by selling their holdings. This triggers another avalanche in these markets and prices fall further.


Bank A





Bank c

Bank E

Share Holder/Investor

Share Holder/Investor

Share Holder/Investor

Stock/Bond market

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