What are the roles of the originator and investment banks

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Reading Questions

1. In your own words, describe the process of securitization. You may use Lecture 6 and our textbook as references. The points below should help you to answer this:

a. What are the roles of the originator and investment banks in securitization?

b. Describe the role of the credit rating agencies in securitization.

c. In securitization, how can the originator finance via the structured products with credit ratings higher than its own?

d. Explain the "waterfall cash flow" structure of CDO. Discuss also the risk/return and liquidity aspects in this waterfall cash flow structure.

2. Discuss the CDO strategy deployed by Magnetar during 2007. The following points should help you to answer this:
a. Figure 3 in [M2013] illustrates the so-called "Magnetar trade". How did Magnetar use the Credit Default Swap (CDS) protection in the trade? In your own words, explain each scenario in Figure 3. On page 517 of our textbook [S2013], why did David Stowell say "The strategy would only lose money if the equity got wiped out while the mezzanine tranche stayed intact"?

b. In [NM2008], why did the authors say "Mortgage analysts note that Magnetar's trading strategy wasn't all luck - it would have benefited whether subprime market held up or collapsed."? Use your answer in part a) to illustrate the concept of relative trade.

c. In [EB2010], authors criticized Magnetar for "building CDOs to fail". What are their major criticisms? How did the Investment Banks get involved in the Magnetar trade?

You may use your answer in part a) as illustration.

3. Discuss the trading strategy of Peloton. The following questions should help you to answer this:
a. Using [E2008] and [BMZ2008], describe the directional trade deployed by Peloton.
How was Peloton's directional trade in 2007 different from its strategy in early 2008?

b. In comparison with [Z2008], how was it different from John Paulson's strategy? More specifically, how did John Paulson benefit from the use of CDS protection?

c. In [BMZ2008], why did Ron Beller, the chief of Peloton say "Peloton failed not because it made the wrong investments but because his bankers didn't stick with him when the prices of those investments were temporarily out of whack"? Use your knowledge on margin call in Lecture 7 to explain the liquidity crisis faced by Peloton. What role did UBS play in this case?

4. Answer the following questions on the global financial crisis (2007-2008):
a. How did the process of securitization play a critical part in causing the global financial crisis (2007-2008)? What led to the proliferations of these structured products?

b. Describe the principal-agent problems that existed in the mortgage securitization market that led to the global financial crisis. In particular, explain the principal-agent problems among the key players in the process of securitizations. How did the hedge funds contribute to these principle-agent problems? You may use your answers in Questions 2 and 3 for illustration.

c. Revisiting each of the divisions/business areas of an investment bank individually (covered in Lectures 1-8), describe the impact of the global financial crisis (2007- 2008) on each of these divisions/business areas individually.

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