23 Pages Posted: 23 Oct 2008 Last revised: 20 Nov 2008
Date Written: October 17, 2008
This paper briefly introduces the theory of leveraged returns and risk aversion, which created both a supply and demand for leveraged structured products. The paper describes three applications in structured finance: Constant Proportional Debt Obligations (CPDOs) used financial leverage to increase returns on consumer mortgage and other loan receivables; Auction Rate Securities (ARS) used monthly note auctions to determine rates for even safer underlying student loan collateral; and Structured Investment Vehicles (SIVs) implemented a term-structure arbitrage to lower funding costs for typical consumer mortgage and other assets at the expense of liquidity risk. There are three common themes in each of the product categories. First, investments books' dismissal of leverage on the grounds of practical borrowing costs is correct in all but a financial bubble. There is no reason that a lender would lend at a risk-free rate if the risk premium on the use of funds was high enough to enable an arbitrage. Second, therefore, the initial application to increasing leverage has to take place in a benign market environment with a safe underlying collateral or investment type. Third, once the arbitrage is in place and risk has been dismissed, there inevitably comes a push to increase the risk of the underlying collateral to heighten profits. Of course, when risk manifests - as it inevitably does - dramatic losses follow.
Keywords: SIV, ARM, ARS, CPDO, Structured Finance. Structured Investment Vehicle, Auction Rate Market, Auction Rate Securitiy, Constant Proportional Debt Obligation
JEL Classification: G28, G32, E44, E58
Suggested Citation: Suggested Citation