Having worked in Financial Risk Management for the last 4 years at a large bank, I was in a unique position to analyse the technical causes behind the current so-called “credit crisis”.

Financial Risk Management involves the use of ‘pricing models’ to estimate potential future values of financial instruments. These models calculate the risk of an instrument based on the number of variables, and with interest based products, the most important variable used is the ‘mean time to default’.

The “mean time to default” is basically the credit rating. So as long as these CDOs had a credit rating of ‘AAA’, the model would assume that the mean time to default of about 8 years, whereas a subprime mortgage debtor has a mean time to default that is closer to 3/4 years, which would be a credit rating of B or CCC.
(I’m simplifying, more information here http://www.blaha.net/Finance%20Corporate%20Debt%20Ratings.php)

Now not all of the mortgages in the CDO were subprime, as these types of instruments are generally made up of tranches of different mortgages on the bank’s mortgage book. So the risk on the whole of the CDO was definitely not B, but it certainly wasn’t AAA either.

The real crunch here though is that the credit rating determines the coupon (interest) rate. AAA assets have a very low yield, because their risk is virtually non existent. B assets have a high risk, and so investors expect a much higher yield to cover the risk (this is known as the risk premium).

So the banks were selling BBB instruments (CDOs) at AAA risk premiums, and making the spread between them. Given that there is often a large (up to 100 basis points) spread between those two I can see why the banks were keen on this practice. Lend at 600 and borrow at 500? Where can I get me some of THAT action !! ??

Given the massive profitability of this fraud for banks, one has to question the role of Moody’s/S&P in all of this in their rating the CDO paper as ‘AAA’. No doubt they will claim they were duped by financial whiz kid quants at the banks, but I think only the American taxpayer would be silly enough to believe that story.

On that final note, the Rest Of The World ™ would like to extend a big ‘Thank You’ to the American taxpayer for volunteering to pay for our investment mistakes in your financial system. We could have done our due diligence on your mortgage backed derivatives ourselves and found them overpriced for the risk, but instead we decided to buy them anyway, and now you have agreed to pay the risk premium through your taxes.

THANK YOU, and remember not to vote!

Actually both CMs were in the USA and I believe the third is as well, but the credit crisis is going into ” real” business more than the media thinks.