Misplaced Pages

#192807

89-400: Since 1995, Trimaran and its successor entities have invested approximately $ 1.6 billion of equity in fifty-nine companies through transactions totaling more than $ 10 billion in total value. In addition, Trimaran's debt business has managed approximately $ 1.5 billion of leveraged loans across four collateralized loan obligation vehicles. Since 2006, one of its co-founders, Andrew Heyer, lead

178-537: A CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets. The CDO is "sliced" into sections known as "tranches" , which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and

267-468: A CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual. Separate special purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as " CDO-Squared ", "CDOs of CDOs" or " synthetic CDOs ". In

356-569: A CDO—usually a special purpose entity—is typically a corporation established outside the United States to avoid being subject to U.S. federal income taxation on its global income. These corporations must restrict their activities to avoid U.S. tax liabilities; corporations that are deemed to engage in trade or business in the U.S. will be subject to federal taxation. Foreign corporations that only invest in and hold portfolios of U.S. stock and debt securities are not. Investing, unlike trading or dealing,

445-449: A business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% if the stock declines 20%.; also in this case the involved subject might be unable to refund the incurred significant total loss. Risk may depend on the volatility in value of collateral assets. Brokers may demand additional funds when the value of securities held declines. Banks may decline to renew mortgages when

534-481: A former team from Drexel Burnham Lambert, does not signal an end to Trimaran, which will continue on as an independent entity. Bloom and Kehler had founded the PE firm in 1995. The jump back to corporate credit is not big leap for Bloom and Kehler. At Trimaran, the pair also oversaw Trimaran Advisors, which invests in below investment-grade corporate debt. David Millison, also a Drexel alum, had managed those funds for Trimaran as

623-539: A global CDO market of over US$ 1.5 trillion. CDO was the fastest-growing sector of the structured finance market between 2003 and 2006; the number of CDO tranches issued in 2006 (9,278) was almost twice the number of tranches issued in 2005 (4,706). CDOs, like mortgage-backed securities, were financed with debt, enhancing their profits but also enhancing losses if the market reversed course. Subprime mortgages had been financed by mortgage-backed securities (MBS). Like CDOs, MBSs were structured into tranches, but issuers of

712-491: A larger increase in operating profit . Hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions. Before the 1980s, quantitative limits on bank leverage were rare. Banks in most countries had a reserve requirement , a fraction of deposits that was required to be held in liquid form, generally precious metals or government notes or deposits. This does not limit leverage. A capital requirement

801-515: A limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan . Leveraging enables gains to be multiplied. On the other hand, losses are also multiplied, and there is a risk that leveraging will result in a loss if financing costs exceed the income from the asset, or the value of the asset falls. Leverage can arise in a number of situations. Securities like options and futures are effectively leveraged bets between parties where

890-571: A loan in Bakersfield, California, where "a Mexican strawberry picker with an income of $ 14,000 and no English was lent every penny he needed to buy a house of $ 724,000". As two-year " teaser" mortgage rates —common with those that made home purchases like this possible—expired, mortgage payments skyrocketed. Refinancing to lower mortgage payment was no longer available since it depended on rising home prices. Mezzanine tranches started to lose value in 2007; by mid year AA tranches were worth only 70 cents on

979-425: A low-risk money-market fund, he or she might have the same volatility and expected return as an investor in an unlevered low-risk equity-index fund. Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels. So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment

SECTION 10

#1732901493193

1068-470: A major leveraged finance business in the U.K. In the aggregate, these businesses had several hundred employees in the United States, Canada and the U.K. In 1997, the CIBC Argosy Merchant funds backed Gary Winnick and his telecom venture, Global Crossing , which embarked on a project to build optical fiber cable connections under the ocean between Europe and North America. Bloom, Heyer and Kehler,

1157-466: A merchant ship, or a fleet of such ships and caravelle , a small, highly maneuverable, two- or three-masted ship. Trimaran Capital Partners was founded in 2000 by former Drexel Burnham Lambert and CIBC World Markets investment bankers Jay Bloom, Andrew Heyer, and Dean Kehler. The firm traces its roots back to the 1995 creation of the CIBC Argosy Merchant funds, a series of merchant banking investment funds managed on behalf of CIBC , and before that to

1246-416: A niche raising high yield debt. In April 1995, CIBC's investment banking subsidiary, then known as CIBC Wood Gundy announced the acquisition of The Argosy Group, The acquisition of Argosy marked an aggressive push by CIBC into the U.S. investment banking business. Prior to that point, CIBC had never done a junk bond deal. Argosy's three major principals had worked on some of the biggest junk bond deals of

1335-666: A number of leveraged buyouts including Reddy Ice (with Bear Stearns Merchant Banking ), Norcraft (with Saunders Karp & Megrue ) Trimaran made a series of investments in 2004 including: jewellery retailer Fortunoff , specialty apparel retailer Urban Brands ( Ashley Stewart clothing) and auto parts manufacturer Accuride Corporation . In 2005, Trimaran would add Charlie Brown Steakhouse, which would later acquire Bugaboo Creek Steak House in 2007. Trimaran would also make investments in Jefferson National and Broadview Networks among others. Trimaran initially attempted to raise

1424-819: A result of these developments, the CIBC implemented a strategy to reallocate resources and capital away from the riskier CIBC World Markets division in favor of its retail operations. As part of this reallocation, and in an effort to reduce conflicts between the bank's principal investments and its financial sponsor clients, the Trimaran operations would subsequently spinout completely from CIBC World Markets. Trimaran Capital Partners became independent of CIBC in February 2006 Although Trimaran had made some investments in telecom and internet startups in 2000 and had also made investments in companies such as Iasis Healthcare and Village Voice Media ,

1513-457: A setback when rating agencies "were forced to downgrade hundreds" of the securities, but sales of CDOs grew—from $ 69 billion in 2000 to around $ 500 billion in 2006. From 2004 through 2007, $ 1.4 trillion worth of CDOs were issued. Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured housing loans, to student loans and credit card debt. The diversification of borrowers in these "multisector CDOs"

1602-451: A spinout of a portion of its team to form Mistral Equity Partners In 2008, the two remaining managing partners entered into a venture with Nelson Peltz ’s Trian to create a new debt-focused business development company . The firm is named for the trimaran , a multi-hulled boat consisting of a main hull and two smaller outrigger hulls. The firm's principals had used nautical terms to describe their predecessor entities including argosy ,

1691-411: A third, $ 1.25 billion fund in 2004, but existing limited partners expressed dissatisfaction with the fact that the firm had not fully invested its existing fund and had yet to produce sufficient realizations to merit a new commitment. Although Trimaran is still in operation managing its existing investment funds, the key professionals in the firm have embarked on a number of different ventures. Following

1780-402: Is off-balance sheet , so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The notional amount of the swap does count for notional leverage, so notional leverage is 2 to 1. The swap removes most of the economic risk of the treasury bond, so economic leverage is near zero. There are several ways to define operating leverage, the most common. is: Financial leverage

1869-420: Is a fraction of assets that is required to be funded in the form of equity or equity-like securities. Although these two are often confused, they are in fact opposite. A reserve requirement is a fraction of certain liabilities (from the right hand side of the balance sheet) that must be held as a certain kind of asset (from the left hand side of the balance sheet). A capital requirement is a fraction of assets (from

SECTION 20

#1732901493193

1958-424: Is always riskier than an unlevered one. In fact, many highly levered hedge funds have less return volatility than unlevered bond funds, and normally heavily indebted low-risk public utilities are usually less risky stocks than unlevered high-risk technology companies. The term leverage is used differently in investments and corporate finance , and has multiple definitions in each field. Accounting leverage

2047-454: Is finding buyers for the riskier pieces at the bottom of the pile. The way mortgage securities are structured, if you cannot find buyers for the lower-rated slices, the rest of the pool cannot be sold. To deal with the problem, investment bankers "recycled" the mezzanine tranches, selling them to underwriters making more structured securities—CDOs. Though the pool that made up the CDO collateral might be overwhelmingly mezzanine tranches, most of

2136-405: Is named after a lever in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the smaller amounts of money needed for borrowing into large amounts of profit. However, the technique also involves the high risk of not being able to pay back a large loan. Normally, a lender will set a limit on how much risk it is prepared to take and will set

2225-438: Is not considered to be a trade or business, regardless of its volume or frequency. In addition, a safe harbor protects CDO issuers that do trade actively in securities, even though trading in securities technically is a business, provided the issuer's activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar businesses. CDOs are generally taxable as debt instruments except for

2314-407: Is that the underlying leveraged asset is the same as the unleveraged one. If a company borrows money to modernize, add to its product line or expand internationally, the extra trading profit from the additional diversification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures (high risk) and puts the rest in

2403-417: Is total assets divided by the total assets minus total liabilities . Under Basel III , banks are expected to maintain a leverage ratio in excess of 3%. The ratio is defined as Here the exposure is defined broadly and includes off-balance sheet items and derivative "add-ons", whereas Tier 1 capital is limited to the banks "core capital". See Basel III § Leverage ratio Notional leverage

2492-415: Is total notional amount of assets plus total notional amount of liabilities divided by equity. Economic leverage is volatility of equity divided by volatility of an unlevered investment in the same assets. For example, assume a party buys $ 100 of a 10-year fixed-rate treasury bond and enters into a fixed-for-floating 10-year interest rate swap to convert the payments to floating rate. The derivative

2581-481: Is usually defined as: For outsiders, it is hard to calculate operating leverage as fixed and variable costs are usually not disclosed. In an attempt to estimate operating leverage, one can use the percentage change in operating income for a one-percent change in revenue. The product of the two is called total leverage, and estimates the percentage change in net income for a one-percent change in revenue. There are several variants of each of these definitions, and

2670-513: The Basel I standard. Basel I categorized assets into five risk buckets, and mandated minimum capital requirements for each. This limits accounting leverage. If a bank is required to hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to 1. While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for all off-balance sheet risks (there

2759-471: The Community Reinvestment Act was enacted to address historical discrimination in lending, such as ' redlining '. The Act encouraged commercial banks and savings associations (Savings and loan banks) to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods (who might earlier have been thought of as too risky for home loans). In 1977,

Trimaran Capital Partners - Misplaced Pages Continue

2848-554: The Great Recession . Gretchen Morgenson described the securities as "a sort of secret refuse heap for toxic mortgages [that] created even more demand for bad loans from wanton lenders." CDOs prolonged the mania, vastly amplifying the losses that investors would suffer and ballooning the amounts of taxpayer money that would be required to rescue companies like Citigroup and the American International Group." ... In

2937-548: The IMF 's former chief economist Raghuram Rajan warned that rather than reducing risk through diversification, CDOs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely. During and after the crisis, criticism of the CDO market was more vocal. According to the radio documentary "Giant Pool of Money", it was the strong demand for MBS and CDO that drove down home lending standards. Mortgages were needed for collateral and by approximately 2003,

3026-550: The 1970s, private companies began mortgage asset securitization by creating private mortgage pools. In 1974, the Equal Credit Opportunity Act in the United States imposed heavy sanctions for financial institutions found guilty of discrimination on the basis of race, color, religion, national origin, sex, marital status, or age This led to a more open policy of giving loans (sometimes subprime) by banks, guaranteed in most cases by Fannie Mae and Freddie Mac. In 1977,

3115-593: The 1980s while at Drexel Burnham Lambert. The 52 Argosy employees that CIBC acquired would constitute the core of what would become CIBC's High Yield Group and the CIBC Argosy Merchant Banking funds that were responsible for, among other things, the $ 2 billion windfall that CIBC would earn from its early investments in Global Crossing . The Argosy principals also managed two collateralized debt obligation vehicles known as Caravelle Funds I and II. With

3204-430: The 1990 founding of the boutique investment banking firm The Argosy Group. The Argosy Group was a New York-based boutique investment bank founded in February 1990, and is Trimaran's earliest predecessor. Founded as a 9-person advisory firm by Bloom, Heyer, and Kehler, Argosy was one of several private equities and investment banking firms to spring up in the wake of the collapse of Drexel Burnham Lambert . Before Drexel,

3293-505: The 2007–2009 subprime mortgage crisis . In 1970, the US government-backed mortgage guarantor Ginnie Mae created the first MBS ( mortgage-backed security ), based on FHA and VA mortgages. It guaranteed these MBSs. This would be the precursor to CDOs that would be created two decades later. In 1971, Freddie Mac issued its first Mortgage Participation Certificate. This was the first mortgage-backed security made of ordinary mortgages. All through

3382-522: The High Yield Group at CIBC World Markets had grown to more than 120 and had raised more than $ 80 billion of high yield debt. Following the crash of the dot-com bubble and the shutdown of the high yield markets in late 2000, CIBC World Markets began to suffer a series of setbacks. In July 2001, the Wall Street Journal profiled CIBC World Markets, chronicling the rapid decline of the bank from

3471-485: The Wall Street clients in hopes of getting hired by them for a multiple increase in pay. ... Their [the rating agencies] failure to recognize that mortgage underwriting standards had decayed or to account for the possibility that real estate prices could decline completely undermined the ratings agencies' models and undercut their ability to estimate losses that these securities might generate." Michael Lewis also pronounced

3560-762: The acquisition of Argosy in 1995 and Oppenheimer & Co. in 1997, the center of gravity of CIBC's investment banking operations began to shift toward the United States. CIBC's High Yield Group began to develop a reputation for financing complex leveraged buyout transactions and worked closely with several of the leading private equity firms. CIBC provided financing for many of the leading private equity firms of this period including: Apollo Management , Hicks Muse , Kohlberg Kravis Roberts & Co. , Thomas H. Lee Partners , and Willis Stein & Partners . Bloom, Heyer and Kehler took on increasing responsibilities within CIBC World Markets. Ultimately, as Vice Chairmen of

3649-405: The bank and co-heads of Leveraged Finance, the three Argosy founders had responsibilities for leveraged loan and high-yield sales, trading and research, debt private placements, restructuring advisory and financial sponsor coverage. They were also responsible for the creation and management of multiple special situations investment funds and collateralized debt obligation funds, and the creation of

Trimaran Capital Partners - Misplaced Pages Continue

3738-533: The bank's profits in 2000. Trimaran was founded in 2000, effectively on the back of the success of the Global Crossing investment. In April 2001, Trimaran closed on a $ 1 billion fund with capital provided primarily by CIBC. The investment banking operations of CIBC World Markets reached their peak in 1999 and 2000, when the bank cracked the top ten of U.S. issuers of high yield bonds and the top twenty in mergers and acquisitions advisory. From 1995 through 2000,

3827-422: The basic principle is the same. A CDO is a type of asset-backed security . To create a CDO, a corporate entity is constructed to hold assets as collateral backing packages of cash flows which are sold to investors. A sequence in constructing a CDO is: A common analogy compares the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) to water flowing into cups of

3916-405: The bulk of its capital from its $ 1 billion 2001-vintage private equity fund was uninvested after its first year and a half. From the end of 2002 through mid-2005, Trimaran actively pursued new investments. In December 2002, Trimaran partnered with Kohlberg Kravis Roberts & Co. to purchase the transmission business subsidiary, ITC Transmission , from DTE Energy . In 2003, Trimaran completed

4005-476: The bushes for money for the larger fund. Fundraising for both is slated to start later this year, according to a source close to Trimaran. Without Heyer, Trimaran was never successfully raised. Mistral formed a partnership with the Schottenstein family , which has acquired well-known retailers such as American Eagle Outfitters , DSW Shoe Warehouse and Filene's Basement . The family made an equity commitment to

4094-457: The cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk . As an example,

4183-563: The chief investment officer. He is not expected to be joining Bloom and Kehler in the new venture. Bloom and Kehler have been paired off for much of their respective careers. Prior to Trimaran, both Bloom and Kehler had served as co-heads of the CIBC Argosy Merchant Banking Funds, the PE arm of CIBC World Markets. Leveraged loan In finance , leverage, also known as gearing, is any technique involving borrowing funds to buy an investment . Financial leverage

4272-594: The diversified consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs. According to the Financial Crisis Inquiry Report , "the CDO became the engine that powered the mortgage supply chain", promoting an increase in demand for mortgage-backed securities without which lenders would have "had less reason to push so hard to make" non-prime loans. CDOs not only bought crucial tranches of subprime mortgage-backed securities, they provided cash for

4361-530: The dollar. By October triple-A tranches had started to fall. Regional diversification notwithstanding, the mortgage backed securities turned out to be highly correlated. Big CDO arrangers like Citigroup , Merrill Lynch and UBS experienced some of the biggest losses, as did financial guaranteers such as AIG , Ambac , MBIA . An early indicator of the crisis came in July 2007 when rating agencies made unprecedented mass downgrades of mortgage-related securities (by

4450-523: The early 2000s, the debt underpinning CDOs was generally diversified, but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this had changed. CDO collateral became dominated by high risk ( BBB or A ) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages . These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to

4539-469: The end of 2008 91% of CDO securities were downgraded ), and two highly leveraged Bear Stearns hedge funds holding MBSs and CDOs collapsed. Investors were informed by Bear Stearns that they would get little if any of their money back. In October and November the CEOs of Merrill Lynch and Citigroup resigned after reporting multibillion-dollar losses and CDO downgrades. As the global market for CDOs dried up

SECTION 50

#1732901493193

4628-588: The equity layer tranches were paid last in the sequence and there was not sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers. Ultimately the challenge is in accurately quantifying the risk and return characteristics of these constructs. Since the introduction of David Li's 2001 model, there have been material advances in techniques that more accurately model dynamics for these complex securities. CDO refers to several different types of products. The primary classifications are as follows: The issuer of

4717-570: The failure of Trimaran to raise its third fund, in March 2007, Andrew Heyer, one of the three founders of Trimaran, left the firm to launch a new buyout firm. Mistral Equity Partners was founded with a team from Trimaran to make investments in the consumer and retail industries. Mistral successfully raised an approximately $ 300 million fund Trimaran Capital Partners III has a preliminary target range of $ 700 million to $ 1 billion. Trimaran plans to raise an interim $ 300 million to make deals happen while beating

4806-527: The financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above. Collateralized debt obligation A collateralized debt obligation ( CDO ) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets,

4895-481: The first quarter of 2008 alone, credit rating agencies announced 4,485 downgrades of CDOs. At least some analysts complained the agencies over-relied on computer models with imprecise inputs, failed to account adequately for large risks (like a nationwide collapse of housing values), and assumed the risk of the low rated tranches that made up CDOs would be diluted when in fact the mortgage risks were highly correlated, and when one mortgage defaulted, many did, affected by

4984-472: The heads of the CIBC Argosy Merchant funds and all former Drexel bankers, were former associates of Winnick from his days in the 1980s as a salesman at Drexel Burnham Lambert under Michael Milken . They were also instrumental in providing Global Crossing with $ 35 million in equity financing before the company went public. CIBC would ultimately realize a gain estimated to be $ 2 billion from its relatively small equity investment in Global Crossing, making it one of

5073-584: The initial funding of the securities. Between 2003 and 2007, Wall Street issued almost $ 700 billion in CDOs that included mortgage-backed securities as collateral. Despite this loss of diversification, CDO tranches were given the same proportion of high ratings by rating agencies on the grounds that mortgages were diversified by region and so "uncorrelated" —though those ratings were lowered after mortgage holders began to default. The rise of "ratings arbitrage"—i.e., pooling low-rated tranches to make CDOs—helped push sales of CDOs to about $ 500 billion in 2006, with

5162-428: The investment bank Salomon Brothers created a "private label" MBS (mortgage backed security)—one that did not involve government-sponsored enterprise (GSE) mortgages. However, it failed in the marketplace. Subsequently, Lewis Ranieri ( Salomon ) and Larry Fink ( First Boston ) invented the idea of securitization ; different mortgages were pooled together and this pool was then sliced into tranches , each of which

5251-412: The investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities , enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated. The issuer of the CDO, typically an investment bank, earns a commission at

5340-413: The investors where senior tranches were filled first and overflowing cash flowed to junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranche investors face the losses first. The risk and return for a CDO investor depends both on how the tranches are defined, and on the underlying assets. In particular,

5429-452: The left hand side of the balance sheet) that must be held as a certain kind of liability or equity (from the right hand side of the balance sheet). Before the 1980s, regulators typically imposed judgmental capital requirements, a bank was supposed to be "adequately capitalized," but these were not objective rules. National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to

SECTION 60

#1732901493193

5518-750: The low-rated slices Wall Street couldn't sell on its own." Other factors explaining the popularity of CDOs include: In the summer of 2006, the Case–Shiller index of house prices peaked. In California, home prices had more than doubled since 2000 and median house prices in Los Angeles had risen to ten times the median annual income. To entice those with low and moderate income to sign up for mortgages, down payments and income documentation were often dispensed with and interest and principal payments were often deferred upon request. Journalist Michael Lewis gave as an example of unsustainable underwriting practices

5607-425: The most profitable investments by a financial institution in the 1990s. The investment is also thought to have personally generated millions of dollars for Bloom, Heyer and Kehler. CIBC's investment in Global Crossing provided a considerable boost for its investment banking operations in the U.S. and for Bloom, Heyer and Kehler. In fact, CIBC's gain on its investment in Global Crossing would represent more than 20% of

5696-472: The new Mistral fund, and Jay Schottenstein assumed a part-time advisory role with the firm. Trimaran Partners, Jay Bloom and Dean Kehler, co-founders and managing partners of the private equity firm, have reportedly struck out on a venture with the Nelson Peltz-led hedge fund Trian Partners , investing in distressed corporate bonds, bank loans, and possible loan-to-own opportunities. The move, reuniting

5785-781: The new issue pipeline for CDOs slowed significantly, and what CDO issuance there was usually in the form of collateralized loan obligations backed by middle-market or leveraged bank loans, rather than home mortgage ABS. The CDO collapse hurt mortgage credit available to homeowners since the bigger MBS market depended on CDO purchases of mezzanine tranches. While non-prime mortgage defaults affected all securities backed by mortgages, CDOs were especially hard hit. More than half—$ 300 billion worth—of tranches issued in 2005, 2006, and 2007 rated most safe (triple-A) by rating agencies, were either downgraded to junk status or lost principal by 2009. In comparison, only small fractions of triple-A tranches of Alt-A or subprime mortgage-backed securities suffered

5874-537: The other hand, almost half of Lehman's balance sheet consisted of closely offsetting positions and very-low-risk assets, such as regulatory deposits. The company emphasized "net leverage", which excluded these assets. On that basis, Lehman held $ 373 billion of "net assets" and a "net leverage ratio" of 16.1. While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face bankruptcy or default during

5963-448: The peaks of Wall Street's league table rankings. At the same time, the High Yield Group was restructured with the original Argosy Group founders focusing their responsibilities on their new Trimaran Capital Partners fund and the older CIBC Argosy Merchant funds. Bloom, Heyer and Kehler were succeeded by managing directors Edward Levy and Bruce Spohler, who had worked previously at Argosy and Drexel, together with Bill Phoenix. By 2002, as

6052-417: The pooling and tranching activities on every level of the derivation. Others pointed out the risk of undoing the connection between borrowers and lenders—removing the lender's incentive to only pick borrowers who were creditworthy—inherent in all securitization. According to economist Mark Zandi : "As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility

6141-513: The principal is implicitly borrowed and lent at interest rates of very short treasury bills. Equity owners of businesses leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result. Businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in revenue will result in

6230-453: The problems with Basel I, it seems likely that some hybrid of accounting and notional leverage will be used, and the leverage limits will be imposed in addition to, not instead of, Basel II economic leverage limits. The financial crisis of 2007–2008 , like many previous financial crises, was blamed in part on excessive leverage. Consumers in the United States and many other developed countries had high levels of debt relative to their wages and

6319-401: The ratings agencies were chronically behind on developments in the financial markets and they could barely keep up with the new instruments springing from the brains of Wall Street's rocket scientists. Fitch, Moody's, and S&P paid their analysts far less than the big brokerage firms did and, not surprisingly wound up employing people who were often looking to befriend, accommodate, and impress

6408-417: The risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunitistic. The poor performance of many banks during the financial crisis of 2007–2009 led to calls to reimpose leverage limits, by which most people meant accounting leverage limits, if they understood the distinction at all. However, in view of

6497-542: The same fate. (See the Impaired Securities chart.) Collateralized debt obligations also made up over half ($ 542 billion) of the nearly trillion dollars in losses suffered by financial institutions from 2007 to early 2009. Prior to the crisis, a few academics, analysts and investors such as Warren Buffett (who famously disparaged CDOs and other derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" ), and

6586-455: The same financial events. They were strongly criticized by economist Joseph Stiglitz , among others. Stiglitz considered the agencies "one of the key culprits" of the crisis that "performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies." According to Morgenson, the agencies had pretended to transform "dross into gold." "As usual,

6675-433: The securities had difficulty selling the more lower level/lower-rated "mezzanine" tranches—the tranches rated somewhere from AA to BB. Because most traditional mortgage investors are risk-averse, either because of the restrictions of their investment charters or business practices, they are interested in buying the higher-rated segments of the loan stack; as a result, those slices are easiest to sell. The more challenging task

6764-466: The supply of mortgages originated at traditional lending standards had been exhausted. The head of banking supervision and regulation at the Federal Reserve, Patrick Parkinson, termed "the whole concept of ABS CDOs", an "abomination". In December 2007, journalists Carrick Mollenkamp and Serena Ng wrote of a CDO called Norma created by Merrill Lynch at the behest of Illinois hedge fund, Magnetar. It

6853-653: The three bankers had all worked together at Shearson Lehman Brothers . Kehler and Bloom had worked together previously at Lehman Brothers Kuhn Loeb and were joined by Heyer when Lehman was acquired by Shearson/American Express . The Argosy team had been involved in many of the most prominent high yield financings of the preceding two decades, for companies including RJR Nabisco , Beatrice Foods , and Storer Communications . The Argosy Group focused on debt underwriting, private placements, sales and trading, proprietary special situation investing, and restructuring advisory assignments for highly leveraged companies. Argosy created

6942-437: The time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDOs became entirely worthless, as

7031-506: The tranches (70 to 80% ) of the CDO were rated not BBB, A−, etc., but triple A. The minority of the tranches that were mezzanine were often bought up by other CDOs, concentrating the lower rated tranches still further. (See the chart on "The Theory of How the Financial System Created AAA-rated Assets out of Subprime Mortgages".) As journalist Gretchen Morgenson put it, CDOs became "the perfect dumping ground for

7120-525: The transformation of BBB tranches into 80% triple A CDOs as "dishonest", "artificial" and the result of "fat fees" paid to rating agencies by Goldman Sachs and other Wall Street firms. However, if the collateral had been sufficient, those ratings would have been correct, according to the FDIC. Synthetic CDOs were criticized in particular, because of the difficulties to judge (and price) the risk inherent in that kind of securities correctly. That adverse effect roots in

7209-575: The true accounting leverage was higher: it had been understated due to dubious accounting treatments including the so-called repo 105 (allowed by Ernst & Young ). Banks' notional leverage was more than twice as high, due to off-balance sheet transactions. At the end of 2007, Lehman had $ 738 billion of notional derivatives in addition to the assets above, plus significant off-balance sheet exposures to special purpose entities, structured investment vehicles and conduits, plus various lending commitments, contractual payments and contingent obligations. On

7298-402: The underlying asset value decline is mild or temporary the debt-financing may be only short-term, and thus due for immediate repayment. The risk can be mitigated by negotiating the terms of leverage, by maintaining unused capacity for additional borrowing, and by leveraging only liquid assets which may rapidly be converted to cash. There is an implicit assumption in that account, however, which

7387-530: The value of collateral assets. When home prices fell, and debt interest rates reset higher, and business laid off employees, borrowers could no longer afford debt payments, and lenders could not recover their principal by selling collateral. Financial institutions were highly levered. Lehman Brothers , for example, in its last annual financial statements, showed accounting leverage of 31.4 times ($ 691 billion in assets divided by $ 22 billion in stockholders' equity). Bankruptcy examiner Anton R. Valukas determined that

7476-502: The value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called-in. This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices. It means that as market price falls, leverage goes up in relation to the revised equity value, multiplying losses as prices continue to go down. This can lead to rapid ruin, for even if

7565-557: Was a clumsy provisions for derivatives, but not for certain other off-balance sheet exposures) and it encouraged banks to pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to solid companies or ones near bankruptcy, and the requirement for government loans was zero). Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate

7654-434: Was a selling point, as it meant that if there was a downturn in one industry like aircraft manufacturing and their loans defaulted, other industries like manufactured housing might be unaffected. Another selling point was that CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. In 2005, as the CDO market continued to grow, subprime mortgages began to replace

7743-440: Was a tailor-made bet on subprime mortgages that went "too far." Janet Tavakoli, a Chicago consultant who specializes in CDOs, said Norma "is a tangled hairball of risk." When it came to market in March 2007, "any savvy investor would have thrown this...in the trash bin." According to journalists Bethany McLean and Joe Nocera, no securities became "more pervasive – or [did] more damage than collateralized debt obligations" to create

7832-610: Was then sold separately to different investors. Many of these tranches were in turn bundled together, earning them the name CDO (Collateralized debt obligation). The first CDOs to be issued by a private bank were seen in 1987 by the bankers at the now-defunct Drexel Burnham Lambert Inc. for the also now-defunct Imperial Savings Association. During the 1990s the collateral of CDOs was generally corporate and emerging market bonds and bank loans. After 1998 "multi-sector" CDOs were developed by Prudential Securities, but CDOs remained fairly obscure until after 2000. In 2002 and 2003 CDOs had

7921-488: Was undermined." Zandi and others also criticized lack of regulation. "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards." CDOs vary in structure and underlying assets, but

#192807