1. Running Head: EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 1
Exotic Instruments and 2007-2009 Financial Crisis
Ronald Newton
Jun 15, 2015
Professor: Richard Cofer

2. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 2
Exotic Instruments and 2007-2009 Financial Crisis
The acronyms would make a government bureaucrat smile: AIG, CDS, CMO, IO, MBS, and PO.
All played into the financial crisis of 2007 to 2008 that was a “meltdown of the U.S. and international
credit markets” (Brigham & Ehrhardt, 2005, p. 885). Reinhart and Rogoff called financial crisis of 2007
to 2008 the first major financial crisis of the twenty-first century and name as among its causes “esoteric
instruments, unaware regulators, and skittish investors” (2008, p. 339).
The indirect effects of the financial crisis included the loss of some 8.7 million U.S. jobs in two
years (Kurtz, 2014, para. 6). The unemployment rate more than doubled and for a period exceeded 10%.
As of mid-2014, employers had brought back all except 113,000 of these jobs (2014, para. 1).
This paper will take a brief look at some of the exotic financial instruments used during the
crisis and explain what they are, how investment bankers and investors used them, their risks, and how
their use contributed to the crisis.
CMO
Investment bankers classify CMO (collateralized mortgage obligations) bonds as MBS
(mortgage-backed securities) because mortgages purchased and held by a trustee underlay the CMOs’
value. Gorton and Metrick tell us the financial crisis of 2007 - 2007, like other U.S. financial crises
preceding it, came after a credit boom. In the U.S., this credit boom was from “an increase in the
issuance of asset-backed securities, particularly mortgage-backed securities” (2012, p. 130). Looming
large among the MBSs were CMOs.
HowCMOs Work
CMOs came into existence to help provide a safe investment or investment flexibility and choice
for investors not attracted to mortgage pass-through securities where there is direct ownership in a pool of
mortgages (The Building Blocks of CMOs:Mortgage Loans & Mortgage Pass-Throughs, n.d.). The
issuer of a CMO acquires mortgages or mortgage pass-through securities and uses them as collateral
(backing). The issuer offers different classes or tranches (French for “slices”) of securities with varying
investment objectives. The issuer’s managers attempt to meet the stated investment objectives by
directing the principal and interest from the collateral into the different tranches (The Building Blocks of
CMOs: Mortgage Loans & Mortgage Pass-Throughs,n.d.). Figure 2 provides an example of the cash
flows of a CMO with three tranches.
Their Use in the Financial Crisis
As bonds, CMOs attracted investors interested in more return than available in traditional banking
or money market funds. The desire for CMOs created a market for mortgages that helped feed the
upstream desire to originate more mortgages. Some of this desire to increase the number of mortgage
originations lead to less strict credit policy and in some instances virtually no credit policy. The

3. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 3
mortgagers created record numbers of loans to persons whose credit was so poor the originators charged
higher interest rates because of the higher risk. These loans are the ones the financial crisis of 2007 –
2009 indelibly etched into the minds as subprime loans, but according to Mayer and Pence’s (2008)
Federal Reserve paper, subprime loans never exceeded 20% of the total loan originations for any given
year. Amazingly, Figure 1 portrays how the number of subprime mortgage loan originations almost
quintupled in size from 2001 to 2005, but interestingly decrease significantly in 2006 before many
realized there was a financial crisis in the making.
Issuers of CMOs could have kept subprime mortgages out of their collateral, but they did not. At
the height of their inclusion, Mayer and Pence’s believed some mortgage pools contained mostly
subprime mortgages with only a “handful of near-prime or prime loans” (2008, p. 4).
An investor who purchased CMOs was at risk because the cash inflows from principle and
interest can changes due to loan prepayment due to early payoff, sale or refinancing, and default. CMOs
with a high percentage of subprime loans exacerbated default risk.
POs
Financial managers consider POs (principal-only) and IOs (interest-only) structured notes as they
derive their value from another debt obligation. An IO is the natural consequence of a PO and vice-versa
since when an issuer creates either,the input needed for the other is the remaining component of the
stream of income from a mortgage pass-through security or tranche in a CMO.
HowPOs Work
POs are a form of zero coupon bond and issuers sell them at a deep discount and promise a set
total payment. The objective is for investors to receive the full face value of the bond from payment and
prepayments of mortgages.
Their Use in the Financial Crisis
Investors could use PO as a bet on refinancing of mortgages and a hedge against losses on CMOs
due to prepayment. If, for example, an investor held a CMO with interest in a tranche where inflows
began ten years into the future might purchase a PO based on a tranche with inflows from years seven to
nine. If prepayments occur earlier in the PO, the yield increases and helps offset the decreased yield of
the CMO that receives lower cash inflows.
POs are highly susceptible to mortgage default risk and defaults decrease the yield on the
investment. Decreasing mortgage interest rates help spur refinancing resulting in prepayments that
increase the value of a PO as they are retired earlier.
IOs

4. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 4
IOs are the complements of the POs mentioned above. IOs derive their value from the present
value of the expected interest payment stream. For mortgages, the payment stream for interest is largest
in the early years and declines with the passage of time.
HowIOs Work
As a complement to POs,IOs are similar as the investor receives claim to some portion of a
tranche of (interest) payments starting at some date and for a specified duration. Unlike with POs the
issuer of an IO does not promise any given total payment.
IOs are countercyclical to interest rates for normal bonds: A decrease in interest rates causes a
decrease instead of an increase in their value. Brigham and Ehrhardt (2005, pp. 912-3) support this
conclusion with the rationale decreasing interest rates result in mortgagees refinancing and this results in
the termination of their interest payments. The lack of the inflowing interest payments cause a decrease
in the value of the IO. Conversely, increasing interest rates prolong the period during which interest
payment inflows occur and possibly increase the value of the IO (2005, p. 913).
Their Use in the Financial Crisis
Investors could use IOs as a hedge against the decreasing interest rates and the resulting
refinancing of mortgages. If interest rates increased significantly, IO investors should benefit from the
lack of refinancing and receive more of their interest payments thus increasing the yield of their
investment.
However,as with the CMO bonds and POs,IOs did not provide a hedge against mortgage default
risk. To lure risk averse investor to these exotic instruments, protection against default of the bonds due
to mortgage defaults or any other reason came in the form CDS.
CDS
A CDS (credit-default swaps) are “called swaps but are actually more like insurance” according
to Brigham and Ehrhardt (2005, p. 922). Cecchetti and Scheonholtz say the purchasers of the credit
derivatives “make payments—like insurance premiums—to the seller” (2005, pp. 225). CDS allow
lenders to protect themselves from borrower default risk.
HowCDS Work
An investor purchases a CDS and makes payments to a counterparty to guard against a specific
bond defaulting. Should the bond default, the counterparty pays the investor the previously agreed upon
amount. Both counterparties post collateral against their inability to pay. When we consider the risk of a
bond defaulting over a set period of time (its term to maturity), it makes sense the uninterested observer
would consider them an insurance product.
Their Use in the Financial Crisis

5. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 5
CDS underpinned the ability of MBS issuers to create their risky products since for they provided
protection should adverse changes in the mortgage-based cash flows have caused MBS to default.
Investors purchased CDS to protect them from the same risk. Speculators entered the market looking to
reap a profit should the subprime MBSs default. Traded in the over the counter market, CDS made it
difficult to determine the counterparty so ascertain counterparty risk due to such things as financial
weakness or excessive sales would have been near impossible.
In their discussion of CDS, Cecchetti and Scheonholtz (2005, pp. 225-6) estimated $58 trillion
CDS were outstanding at the end of 2007 and placed American International Group (AIG’s) exposure at
“several hundred billion dollars” in September of 2008.
The Crisis and the Exotics
MBS issuers used securitization to move the loan-specific risk that borrowers will default or fail
to repay their loans from the originators to themselves and CDS sellers. While originators and mortgage
service companies may have excellent information on the mortgagees, MBS issuers and purchasers had
little information on which to gauge default risk, yet held most of it.
Simkovic (2013) wrote of how loan quality was level or increasing from the start of the century to
2003 but decreased rapidly from the following year to 2007. Housing prices reached their peak in 2005
and their decline shortly thereafter triggered large losses in MBS (Mishkin, 2011, p. 50). During the first
half of 2007, problems in the subprime market became increasingly visible and included the failure of
severalsubprime originators (Gorton & Metrick, 2012, p. 130). Figure 3 represents well the rapid onset
of problems in the subprime market.
Their Financial Crisis Major Timeline (Gorton & Metrick, 2013, p. 131) shows how by August of
2007, the problems with the mortgage markets had gone international and resulted in runs on
Countrywide (a significant subprime lender) and Northern Rock in the U.K.
During the next 12 months, Gorton and Metrick, (2013, p. 131) enumerated the following major
financial events: (1) JP Morgan Chase buys Bear Stearns; (2) U.S. government takes over Fannie Mae and
Freddie Mac; (3) Lehman Brothers files for bankruptcy; and (4) the AIGborrows $85 billion from the
Federal Reserve. AIGwas at risk of failure because it had set aside virtually no collateral for the CDS it
sold and the purchasers were seeking payment to protect them from defaulting on MBS. Many other
banks faced a similar situation.
By the end of 2008, the financial crisis was fully international in nature with five countries and
the European Central Bank cutting interest rates to prop up the world economy. In October 2008, the
U.S. Treasury found the financial crisis dire enough it invested in nine major banks.
Concluding Thoughts

6. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 6
During my graduate academic studies, the financial crisis of 2007 - 2008 was a frequent topic in
the finance courses. Researchershave explained well how the mortgage markets came to a position
where the failure of portion of it precipitated the breakdown in credit and later world financial markets.
This paper discussed two major instruments, MBS and CDS, whose use and abuse played a major
part on setting the stage for the crisis. The lack of risky MBS based tranches composed primarily of
subprime mortgages would have decreased the need for trillions of dollars of CDS protection. The
inability to issue MBS of subprime loans would have, among other things, decreased the number of
subprime loans; lowered the revenue of originators and servicers of loans; and decreased the income of
securitizers and investors.
The word “abuse” was not used lightly in the paragraph above. The desire for higher returns or
income resulted in CDS use as insurance where “insurers” failed to establish proper reserves and limit
their exposure. Securitizers used the CDS to sell MBS to investors who were unaware of the real content
of the MBS or the counterparty risk of the “insurers.”
Although, it would take considerable research and analysis, to prove it, it would seem proper risk
management by securitizers of MBS and strict adherence to the intent of CDS would have prevented, in
its entirety, the financial crisis of 2007 - 2008.

7. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 7
References
Brigham, E. F., & Ehrhardt, M. C. (2005). Financial management: Theory and practice (13th ed.).
Mason, OH: Thomson/South-Western.
The Building Blocks of CMOs: Mortgage Loans & Mortgage Pass-Throughs. (n.d.). Retrieved June 13,
2015, from http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=17&id=26
Cecchetti, S. G., & Scheonholtz, K. L. (2011). Money, banking, and financial markets (3rd ed.). Boston:
McGraw-Hill/Irwin
Collateralized Mortgage Obligation - Risk Encyclopedia. (n.d.). Retrieved June 13, 2015, from
http://www.riskencyclopedia.com/articles/collateralized_mortgage_obligation/
Frame, S., Lehnert, A., & Prescott,N. (2008, August 27). A snapshot of mortgage conditions with an
emphasis on subprime mortgage. Retrieved June 14, 2015, from
www.federalreserveonline.org/pdf/mf_knowledge_snapshot-082708.pdf
Gorton, G., & Metrick A. (2012, March). Getting Up to Speed on the Financial Crisis: A One-Weekend-
Reader's Guide. Journal of Economic Literature, 50(1), 128-150. Retrieved from
http://www.jstor.org.stmary.idm.oclc.org/stable/23269974
Kurtz, A. (2014, June 4). U.S. soon to recover all the jobs lost in the financial crisis. Retrieved from
http://money.cnn.com/2014/06/04/news/economy/jobs-report-recovery/
Mayer, C.,& Pence,K. (2008). Subprime Mortgages: What, Where, and to Whom? Retrieved from
http://www.federalreserve.gov/pubs/feds/2008/200829/200829pap.pdf
Mishkin, F. S. (2011). Over the cliff: From the subprime to the global financial crisis. The Journal of
Economic Perspectives,25(1), 49-70. Retrieved from
http://www.jstor.org.stmary.idm.oclc.org/stable/23049438.
Reinhart, C.M. & Rogoff, K.S. (2008). Is the 2007 US sub-prime financial crisis so different? An
international historical comparison. The American Economic Review, (98)2, Papers and
Proceedings of the One Hundred Twentieth Annual Meeting of the American Economic
Association (May, 2008), 339-344. Retrieved from http://www.jstor.org/stable/29730044.
Simkovic, M. (2013, March 1). Competition and Crisis in Mortgage Securitization. Indiana Law
Journal, 88(1). Retrieved from http://www.repository.law.indiana.edu/ilj/vol88/iss1/4

8. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 8
Figure 1
Sub-prime Originations by Year using LoanPerformance (LP) Definition
Source: Subprime Mortgages: What, Where,and to Whom? Mayer and Pence,2008.

9. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS 9
Figure 2
Cash Flows ofa Three Tranche CMO
The segregation of cash flows into three sequential pay tranches is illustrated. All three participate in
interest payments, but principal payments flow exclusively to the A bonds until they are retired. After
that, all principal payments flow to the B bonds until they are retired. Finally, all principal payments flow
to the C bonds until they are retired.
Note: Sourced from Collateralized Mortgage Obligation - Risk Encyclopedia.

10. EXOTIC INSTRUMENTS AND 2007-2009 FINANCIAL CRISIS
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Figure 3
Subprime Mortgage Serious Delinquency & Foreclosure Start Rates 1998:Q1 to 2008:Q1
Source: A snapshot of mortgage conditions with an emphasis on subprime mortgage, Frame, Lehnert, &
Prescott,2008, p. 7.
Original source: Mortgage Banker’s association.
Notes: Foreclosures started is the percentage rate of loans for which a foreclosure was initiated. Serious
delinquencies are loans 90+ days past due plus those in foreclosure.