So we all always hear that the reason the i-banks dove face first into CDOs cubed was because they were leveraged 30 to 1 or some other ridiculous number. Recently I've realized I don't actually know exactly where that number comes from. Is it just debt/equity? Does it include long term debt and short term debt? Hope you can shed some light on it
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Kinda funny that everyone claims to be a master of finance, but this post got no responses, and probably 20 bullshit responses did. I guess thats how this site works.
If you know the answer please let me know
Most of the 30 to 1 levered CDOs they're talking about were synthetic CDOs or CDO squared. Synthetic CDOs use the selling CDS for the AAA traunch instead of actually securitizing it with loans. Therefore, very little capital is required to get returns on the mortgages of up to like 95% of the total structure. I know that's a terrible description, but I hope that kind of helps. In other words, the CDO is long 10% subprime mortgages for lower traunches and and 90% long the AAA traunch through the selling of CDS.
THat makes sense for the CDOs, but we always hear about the banks themselves having been leveraged. Is that a measure of all the CDOS they had, or is it a measure of the short term debt they have to their equity?
These are my opinions stitched together from course work, newspapers, word of mouth, etc. I do not claim any mastery in finance. I am only an undergrad becoming another SA like the rest of you.
Increase leverage = Increase the spread between cash flows expected during good times and expected during down times (a.k.a. amplify volatility of cash flows in relation to market performance)
In the upturn, leverage allowed firms to borrow easily and place increasingly larger one-side bets not fully hedged (expected the market to steer in one direction due to past indicators)
Firms were securitizing products whose underlying assets were EXPECTED to increase simply because the past few years indicated skyrocketing asset prices. Only a few questioned what would happen to the value of these securitized products if the underlying assets were to fall rather than increase.
Lending to certain individuals with specific risk metrics allowed these firms to dump the loans to Fannie/Freddie because they were "pre-approved". A recent paper submitted by an NYU professor shows that loans made to individuals with greater risk than the specified standards defaulted less than the loans dumped to Fannie/Freddie which were of higher quality. In other words, as long as the individuals met the quantitative risk metrics, no further due diligence was done because they knew they could get the loan off of their balance sheet and give it to Fannie/Freddie.
In the good times, securitizing these exotic securities were bringing in the money. Firms borrowed (leveraged themselves) to increase lending so that they can pool more of these mortgages/loans and use some financial alchemy to create AAA rated debt from a pool of sub-investment grade debt. (A little bit of what Eaglespread was describing - best understood through diagrams - google it)
Bubble bursted. Underlying asset prices began to DECLINE. Firms that borrowed to lend more already lent that capital out. They now had mortgages/loans that they were going to pool, securitize and sell (like in the good times). Unfortunately, with declining asset prices, the securitized products were dramatically falling in value and increasingly difficult to valuate because of this "slicing and dicing" - financial alchemy.
Firms are stuck with these toxic assets, which they are unable to sell. Accounting standards required firms to valuate these assets at market value, and the red ink began dripping. They are no longer able to pay back the debt they've incurred. (Question: Was it short term or long term debt?)
To put it very simple, leverage for banks in this case simply means that for each dollar of capital they have, they lend or bear other financial assets 30 times more...
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