Subprime Mortgage Crisis - a Case Study on Morgan Stanley

4048 Words Mar 10th, 2010 17 Pages
1. Introduction
The US Subprime Mortgage Crisis in 2007 has had a severe impact on the global financial system. The collapses of Bear Stearns and Lehman Brothers, the acquisition of Merrill Lynch by the Bank of America and the conversion of Morgan Stanley and Goldman Sachs into bank-holding companies have all resulted from this subprime crisis that shocked the world and directly triggered the greatest global financial crisis since the Great Depression.
The underlying factors leading to the crisis were in fact the new inventions in the US housing market – the subprime mortgage lending and securitization technology that significantly magnified the impact of the default risk of these loans on the whole financial system.
This report, hence,
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In our case of subprime mortgage lending, MBSs promise a very high rate of return due to the inherent default risk of the subprime mortgages.
2. Collateralized Debt Obligations
CDO represents a re-securitization in which a pool is created from tranches of already issued securitizations such as MBSs. Since the credit ratings of MBSswere low due to the high default risk of their underlying subprime mortgages, MBSs often appeared unattractive to investors and fund managers. However, by slicing up the MBS into several tranches of bonds with different maturities and credit risk, investment banks were able to increase the saleability of these once unattractive, low-rating MBSs by forming a new portfolio of securities with higher ratings.
CDO tranching appeals to a wider range of investors as they can match each investor’ credit risk preference with the appropriate tranche. A typical CDO structure can be split into three main slices called senior (low risk), mezzanine (middle risk) and equity (high risk) tranches as shown.
Figure 2: A typical CDO tranching structure

The division of CDO into various different tranches indicates the sequential allocation of the underlying assets’ default risk. And since higher risks generate higher returns, the equity tranche will receive the highestreturn to compensate for taking on the highest default risk, as compared to the senior or mezzanine
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