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Leverage

  • Thread starter samuel_von_gudmange
  • Start date
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samuel_von_gudmange

Member
Hey,

Recently, I've heard the word "leverage" used in the context of securitisation a few times, and I don't understand what is meant by it?

On page 32 of the actuary in the "Blow-by-blow" account of the credit crunch, at the end of the second paragraph, it says ""Primary securitisation and second and third-order repackaging leveraged these assets.".

I thought that if someone invested borrowed money (along with their own money) in an asset, then they would be said to have taken a leveraged position in that asset.

I feel like I'm missing the obvious, but I don't see how this ties in with securitisation. The only thing I can think of is that it's something to do with the equity tranche of securitisations.

Thanks,



Sam
 
Thanks Cymro,

The article on riskglossary is a good explanation but doesn't specifically mention securitisation.

Leverage can refer to any way of gaining greater exposure to the returns and their variability on an assets.

I can see how call options achieve this. Replicating portfolios were covered in CT8, and I think the replicating portfolio for a call option involved holding a negative amout of the risk-free asset, which is like leverage in the sense of borrowing money to invest in the underlying.

I think I can see why investing in equity tranches are a more high-risk way of gaining exposure to the underlying assets, rather than just holding the underlying assets themselves. But would the senior tranches offer correspondingly lower-risk exposure to the same assets?

Is this what is meant by leverage in the case of securitisation?
 
Much of this crappy debt was bought up by hedge funds or off balance sheet vehicles which borrowed short term to pay for these assets. Hence the leverage.
 
Thanks Cardano,

So there's leverage in a really straightforward sense going on.

Does anyone else think that the quote from the article seems to be saying that the act of securitisation "leveraged" the underlying assets?

There's another quote on the second page of the article in the middle column "... this made the system more robust and thus allowed for leverage to be extended beyond historic norms ...".

The article does seem to be saying that something about securitisation is producing leveraged exposure.

Or is it just saying that the act of securitisation allows investors to gain leveraged exposure to asset classes where this would not previously have been possible?

As you can tell, I don't really understand that article. It might even mean that by securitising some of it's assets and selling on exposure to them, the bank is increasing it's own leverage - though I don't see how ths could be, because the holders of the asset-backed-securities are not entitled to anything from the bank other than the future cashflows underlying the security.



Sam
 
I think that if the securitisation was split into various tranches, then those who bought the riskier tranches would have a leveraged position (even if they did not actual borrowing to buy the tranche).

This is because the risky tranche's return would magnify the returns on the underlying. For eg, say the securitisation was split 50/50 and the underlying payment were to decrease by 10%, then the bottom half would get the full 50% of a payment with the risky half getting 40% (ie a drop of 20%).

Another way you could think of it is that those who bought the risky tranche "borrows" from those with the safe tranche - which may be much more akin to a bond than the underlying.

Sam, just read your bit about the bank increasing its own leverage. Essentially as above except that it is common that the issuer keeps the riskiest tranche for themselves.
 
There was also potential on the upside, since the tranches would have been priced for a modelled default rate and those holding the most risky equity tranch would have gained handsomely if the default rates had been overestimated. This is the reason why the banks retained these tranches and further leveraged them through investment vehicles off balance sheet

Unfortunately most investment bankers are under 45 and therefore have trouble remembering the 1970's let alone the 1930's and the idea of actually pricing in a reasonable probability of systematic default didn't even occur to them
 
This is the reason why the banks retained these tranches and further leveraged them through investment vehicles off balance shee
Click to expand...

So this mean that the company's investment vehicles borrowed money which they used to invest in the equity tranches?

Sorry if this is just the same question again. Just making sure I understand it.

Thanks,



Sam
 
samuel_von_gudmange said:
So this mean that the company's investment vehicles borrowed money which they used to invest in the equity tranches?

Sorry if this is just the same question again. Just making sure I understand it.

Thanks,



Sam
Click to expand...

Yes basically. If you think back to June 07 it was the failure two such Hedge funds owned by Bear Stearns that started this cascade of events.

http://www.larouchepub.com/other/2007/3427mbs_cdo_crash.html

The idea generally was to sell the supposedly low risk higher tranches to pension funds and the like.
 
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