Chapter 20

Credit Derivatives and Collateralized Debt Obligations

The credit crisis of 2006 to 2011 represented one of the greatest episodes of financial hysteria seen since the Nikkei stock price index (which traded at 8,734.62 on June 25, 2012) reached an intraday peak of 38,957.44 on December 29, 1989. The introduction to this book summarizes much of this mass hysteria, and it is very difficult to resist the temptation to make this a “What were they thinking?” chapter when recounting the tens of billions of dollars lost in the credit markets during this period. As best we can, we will try to reemphasize some common risk management fallacies that we raised in the introduction to this book. We reprise those fallacies in this chapter with specific reference to credit default swaps (CDS) and collateralized debt obligations (CDOs) and how Wall Street responded to market participants who clung to these fallacies as if they were true:

  • “If it hasn’t happened to me yet, it won’t happen to me, even if it’s happened to someone else.”
Wall Street response: If everyone thinks home prices won’t go down, sell them 100 percent loan-to-value mortgage loans until they learn otherwise.
  • “Silo risk management allows my firm to choose the ‘best of breed’ risk model for our silo.”
Wall Street response: If the credit silo can’t model the value of securities whose default is tied to macroeconomic factors such as home prices, sell them mortgage-related CDOs.
  • “I don’t care what’s wrong with the ...

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