The Art of Credit Derivatives: Demystifying the Black Swan

23

Dynamic Credit Portfolio Management

Ignorance more frequently begets confidence than does knowledge: it is those who know little, and not those who know much, who so positively assert that this or that problem will never be solved by science.

Charles Darwin

23.1 INTRODUCTION

At the heart of the crisis that started in the June 2007 are the loan securitization markets - that is, the securitization markets for commercial and residential mortgage loans, credit card receivables, leveraged loans, and so on. Broadly, the securitization of loan assets has become a key part of the business model of many large financial institutions. Ultimately, it has enabled institutions to transform very illiquid assets into marketable instruments that can be sold into the market. This has led to an interplay between the financial institutions that, on the one hand, shed loans via securitization and, on the other hand, took securitization products on their books.

It should be clear by now that pooling credit assets, and investment in the securitization products - specifically high-grade CDO tranches - represent relatively strong exposure to systemic risk. The correlation among the collateral, the negative convexity, introduced by tranching, and the huge leverage within these products or investment strategies reinforces the strength of the exposure to the systemic risk. Additionally, as shown in Chapter 13, within a portfolio context the dependencies between the securitizaton notes may become, much ...