Let’s discuss the current sub-prime mess and review some important concepts in the CFA Level I exam.

IKB Deutsche Industriebank AG, a German bank once endorsed by Moody’s, has just received bailout from the German regulators with a safety net of about €3.5 billion. This is because IKB’s affiliate, Rhineland Funding Capital, is in a financial crisis. The reason is that Rhineland is holding €14 billion debts, most of them are Collateralized debt obligation (CDO)

CDO is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even be another CDO). It means that if the debt issuer cannot pay Rhineland the interest or principles as scheduled (which means the debt is default), Rhineland can claim those debts (e.g. the business loans).

Some of these CDO’s are backed by Mortgage Backed Security (MSB).

Mortgage-Backed Security (MBS) is backed by a pool of mortgage. The mortgage payment also provides cash flow to the debt.

So, how did Rhineland find the money to buy the CDO’s? Rhineland did so by issuing commercial papers. Since commercial papers have lower interest rate than CDO, Rhineland earns the differences and became a very profitable vehicle of IKB.

Commercial Paper is a short-term security. It is discounted like the T-Bill with full payment at maturity. Commercial papers are issued by large corporations. And they are usually considered to be low risk, so, it is also at lower rate, with is about the LIBOR for Rhineland’s commercial paper.

So this is how the cash flows:

US investors, such as Oakland City, bought commercial papers from Rhineland, which had very good credits. And Rhineland is paying them at a rate of LIBOR for the money. Rhineland then used the money to buy debts (CDO’s) from other US issuers. These debts have higher risk and pay higher interest rate to Rhineland and many are back by MBS’s. So, Rhineland earns profits.

Last few years, the US banks provides more mortgage to homeowners with weak credits (e.g. some even allow the homeowners to have zero down payment) in order to accelerate their businesses. These are called sub-prime mortgages. However, the abilities of these homeowners to pay the mortgage are generally weak. As a result, when

 there is a slight economic downturn or increase in interest rate, these homeowners have to give up their houses to the bank. But since the housing price has been dropping, the banks are not able to get back the entire mortgage through house auctions. So, they won’t be able to pay the MBS they have issued! And since some CDO’s have MBS as backing, these CDO’s will be default too.

As a results, CDO’s market price drops. At the same time Rhineland has to pay back the money to their commercial paper holders as it is of shorter terms. But Rhineland cannot do so because the price of the CDO’s it’s holding is dropping. And they cannot issue more commercial paper neither because everyone has concerns about the sub-prime mortgage and they believe that, since Rhineland is holding so much CDO’s backed by sub-prime mortgage, the default risk of their commercial papers is high. So, Rhineland is in financial crisis.

Since IKB has to back its affiliate, Rhineland, by providing funds to cover the loss, IKB is in financial crisis, too. If the government does not give IKM bailout, chain effects will continue and may make the whole German financial market collapse.

Similarly, many other funds and investment banks in the world have engaged in the CDO’s or MBS’s involving sub-prime mortgages.  If this is not properly addressed, a world wide financial turmoil will occur.