In 2007 a bank held what it believed were safe, highly rated bonds. Within two years the same bonds could barely be sold at any price, banks stopped lending to each other and economies slowed around the world. The cause was not one event but a chain: loans made to people who could not repay, packaged into securities that looked safe, sold to banks that were heavily borrowed.
The chain matters to a financial manager because the same weak links can appear again in a different form.
This topic covers the roots and effects of the global financial crisis, securitisation and collateralised debt obligations, dark pool trading, and collective investment schemes in Nigeria (unit trusts, real estate investment trusts and exchange traded funds). The syllabus for this chapter is current affairs: ICAN tells students to read quality business news. The previous topic covered dividend policy. The next covers technology tools.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic.
In 30 seconds
The financial crisis began with subprime mortgages sold to borrowers who could not repay. Banks securitised loans by selling them to a special purpose vehicle (SPV), which issued bonds backed by the repayments. Collateralised debt obligations (CDOs) split the risk into tranches: senior (lowest risk), junior and equity (first to lose).
When borrowers defaulted, losses spread up the tranches, fair values fell, highly geared banks neared negative equity, and the inter-bank market froze. Dark pools trade large blocks of shares anonymously and reveal them only afterwards. Collective investment schemes pool investors’ money under professional management: unit trusts, REITs and ETFs.
Key terms in plain English
| Term | What it means |
|---|---|
| Subprime mortgage | A home loan to a borrower with a weak chance of repaying |
| Securitisation | Turning future loan repayments into bonds that can be sold for cash today |
| Special purpose vehicle (SPV) | A separate entity that buys the loans and issues the bonds |
| CDO | A bond backed by a pool of debts, split into layers of risk |
| Tranche | One layer of a CDO, with its own risk and return |
| Dark pool | A private venue for large share trades that are not shown to the market beforehand |
| Collective investment scheme | An arrangement in which many investors pool money managed by someone else |
| Net asset value (NAV) | The value of a fund’s assets less its costs, per unit or share |
Syllabus check
This topic is in syllabus area A (the environment of financial management and emerging issues). It covers:
- the causes and effects of the financial crisis;
- new trading venues and instruments, and their regulation;
- collective investment schemes in Nigeria.
CAMA 2020 and emerging issues
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Securities such as CDOs are carried at fair value under IFRS |
| s. 385 | The directors’ report covers performance and risk | It should describe exposure to complex instruments |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors must understand what the company holds |
| s. 404(7) | The audit committee reviews policies and internal control | It reviews risk control over trading and investments |
Collective investment schemes and securities markets are governed by the Investments and Securities Act 2025, which replaced the 2007 Act.
The financial crisis
Roots
From the 1990s, lenders sold mortgages aggressively, often to people with no realistic chance of repaying. Property prices had risen steadily, so the property seemed to be good security. There are two views of why lenders entered this market. One is that government policy, over several US administrations, pushed lenders to extend home credit to people they would once have refused.
The other is that the expansion was a growth opportunity that lenders were happy to take.
Securitisation
Banks hold assets that give future cash flows (mortgages, cards, loans). In securitisation the bank transfers them to an SPV, which pays for them with cash raised by issuing bonds backed by the borrowers’ payments. Future receipts become cash today. A mortgage-backed security (MBS) is backed by mortgage receivables. ICAN notes that the SEC in Nigeria has promoted MBS as a way to address the housing deficit.
CDOs and tranches
Securitised sub-prime mortgages were packaged as CDOs, split into tranches. Senior tranches carry the lowest risk and return. Junior tranches pay higher coupons for more risk. The most junior is the equity tranche. A CDO pays investors in sequence from the cash collected. If it is not enough, the lower tranches lose first: the equity tranche loses its principal first, then the next level, and so on.
With high employment and rising property prices, investors expected all tranches to be safe.
How it collapsed
- CDOs could be traded only between banks and other financial institutions, so about a trillion dollars of sub-prime debt sat on bank balance sheets as supposedly low-risk securities.
- The US economy weakened, unemployment and interest rates rose, and sub-prime mortgages defaulted. Losses reached the junior tranches and then the senior ones.
- CDOs had to be shown at fair value, so values fell. Banks are highly geared, with typically less than 10% of assets covered by equity, so falling asset values pushed some towards negative equity.
- Holders tried to sell, found few buyers and prices fell further.
- Banks that were clean began to doubt other banks and stopped lending in the inter-bank market, so LIBOR rose and liquidity was threatened.
Impact on the real economy
Banks tightened lending, so credit became scarce and borrowing rates rose. Buyers could not get mortgages and property prices fell. Less building meant a smaller construction sector. Recession pushed more people to default, consumer confidence fell and strong economies slowed.
Dark pool trading
A large sell order on an open exchange is advertised to everyone and may itself move the price against the seller. A dark pool is a venue where large blocks trade between anonymous parties and are announced only after the trade. Estimates put dark pool trading at over 20% of share trades in the USA and UK.
The concern is that prices in the dark are unknown to the exchange, which weakens the exchange’s price as a signal and could harm investors who trade there. The regulatory response has been that the US SEC proposed fuller disclosure by dark pools and their users, and the European Commission was studying the effect on pricing.
Collective investment schemes in Nigeria
A collective investment scheme (CIS) lets investors pool money managed by a third party. The Investments and Securities Act defines it as an arrangement in which participants pool resources to share profits or income arising from the management of the money or property solely from the effort of a third party. Three types:
- Unit trusts: money from many investors is pooled to buy a portfolio of shares, bonds and money market instruments. Professional managers run it at low cost and holders get diversification.
- Real estate investment trusts (REITs): manage income-producing property such as homes, shopping malls and business centres. A REIT must distribute most of its profit as dividends and may be a trust or a listed company. ICAN names Skye Shelter Fund Plc and Union Homes as listed REITs, so check what is listed now.
- Exchange traded funds (ETFs): a collection of securities that tracks an index, traded on a stock exchange like a share. Net asset value is the value of the securities plus dividends and interest, less management and operating expenses, divided by the number of units issued.
The rules in more depth
Why securitisation can hide risk
Once a loan is packaged and resold, the buyer cannot see the individual borrowers. Ratings can give false comfort, and risk is passed on without disappearing.
Why tranches protect senior holders only up to a point
Losses go to the lowest tranche first. When defaults are widespread, they pass through the junior layers and reach the senior ones.
Why high gearing makes banks fragile
With equity below 10% of assets, a fall of more than 10% in asset values removes all of the equity.
Why a freeze in inter-bank lending spreads the problem
Banks rely on each other for short-term funds. When trust goes, even sound banks struggle to raise cash.
Effect on analysis
When you are asked about a new instrument, say who holds the risk, how it is valued and what happens in a downturn.
Worked examples
Example 1: losses through tranches. A CDO holds ₦200m of mortgages. Tranches: senior ₦140m, junior ₦40m, equity ₦20m. Defaults cause losses of ₦50m.
- The equity tranche loses first: ₦20m (all of it).
- The junior tranche takes the next ₦30m of the loss, leaving ₦10m of its ₦40m.
- The senior tranche loses nothing.
- If losses were ₦100m, the senior tranche would also lose: 100 − 20 − 40 = ₦40m.
Example 2: gearing and negative equity. A bank has assets of ₦500bn and equity of ₦40bn (8%). Fair values of its securities fall so that assets fall by 12%.
- Loss = 500 × 12% = ₦60bn.
- Equity = 40 − 60 = −₦20bn, which is negative equity.
- Liabilities of ₦460bn now exceed assets of ₦440bn.
Example 3: the dark pool motive. A fund wants to sell 5m shares at ₦20 (₦100m). On an open exchange the visible order may push the price down 2%.
- Cost of the price move.
2% × ₦100m = ₦2m. - In a dark pool the order is hidden until it is done, so the fund may avoid most of that cost.
- The trade-off is that the price is not visible to the wider market.
Example 4: ETF net asset value. An ETF holds securities worth ₦520m. It earns ₦12m of dividends and interest and has ₦4m of expenses. It has 50m units.
- NAV = (520 + 12 − 4) ÷ 50 = 528 ÷ 50 = ₦10.56 per unit.
- An ETF trades on the exchange, so its market price may differ slightly from NAV.
How to score full marks
- Tell the story in order: loans, securitisation, tranches, defaults, fair value, gearing, freeze.
- Use numbers to show how losses move through tranches.
- Link to the real economy: credit, property, jobs.
- Name the benefit and the risk of any new venue or instrument.
- Link to Nigeria: MBS, REITs, unit trusts.
- Give a current example where you can.
Common mistakes in the exam
- Describing the crisis as a single event.
- Saying senior tranches never lose.
- Forgetting fair value accounting and gearing.
- Defining a dark pool as illegal.
- Confusing a unit trust with an ETF.
- Quoting out-of-date figures for Nigerian schemes.
Quick revision
- Sub-prime loans, securitisation by an SPV, CDOs in tranches.
- Losses hit equity first, then junior, then senior.
- Fair value and high gearing pushed banks to negative equity; inter-bank lending froze.
- Dark pool: anonymous large trades, announced afterwards.
- CIS: unit trusts, REITs, ETFs.
- CAMA 2020: ss. 377(1), 378, 385, 308, 404(7).
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A sub-prime mortgage is a loan to a borrower who:
- Is very likely to repay
- Has a weak chance of repaying
- Is a bank
- Is a government
Show the answer
B. They were sold aggressively.
Question 2. In securitisation, the bank transfers loans to:
- A central bank
- A special purpose vehicle
- A stock exchange
- A tax office
Show the answer
B. The SPV issues bonds backed by the repayments.
Question 3. In a CDO, which tranche loses first?
- Senior
- Junior
- Equity
- All together
Show the answer
C. The most junior tranche is the equity tranche.
Question 4. Falling fair values pushed banks towards negative equity because they were:
- Highly geared
- Debt free
- Government owned
- Small
Show the answer
A. Equity was under 10% of assets.
Question 5. A dark pool trade is:
- Shown to all before it happens
- Anonymous and announced afterwards
- Illegal in all cases
- Only for small orders
Show the answer
B. It is for large blocks.
Question 6. A REIT mainly manages:
- Bonds
- Income-generating property
- Currencies
- Loans to banks
Show the answer
B. It must distribute most of its profit.
Question 7. An exchange traded fund:
- Tracks an index and trades on an exchange
- Is a bank deposit
- Is a private loan
- Cannot be sold
Show the answer
A. A hybrid of a share and a fund.
Question 8. The main protection a senior tranche has is that:
- It loses last
- It pays the highest return
- It is government backed
- It cannot default
Show the answer
A. But it can still lose in a severe downturn.
Question 9. A unit trust gives investors:
- Diversification under professional management
- A fixed bank rate
- A seat on the board
- Tax exemption
Show the answer
A. The fund holds a portfolio of securities.
Question 10. Which section of CAMA 2020 requires the statements to follow IFRS?
- Section 378
- Section 400
- Section 405
- Section 409
Show the answer
A. Fair value is required for such securities.
Written questions
Question 11 (10 marks). (a) Explain what is meant by securitisation. (4 marks) (b) Describe how a CDO is divided into tranches and how losses are shared. (6 marks)
Question 12 (20 marks). Atlas Bank holds a CDO of ₦200m: senior ₦140m, junior ₦40m and equity ₦20m. Defaults cause losses of ₦50m. The bank has assets of ₦500bn and equity of ₦40bn. Fair values of its securities fall so that assets drop by 12%. (a) Calculate how the ₦50m of losses is shared across the tranches. (5 marks) (b) Calculate the bank’s equity after the fall in assets and comment.
(5 marks) (c) Explain how the problem spread to the inter-bank market and the real economy. (6 marks) (d) Explain what a dark pool is and why a fund might use one. (4 marks)
Question 13 (10 marks). (a) Describe unit trusts, REITs and exchange traded funds. (6 marks) (b) An ETF holds securities worth ₦520m, earns ₦12m of income, has ₦4m of expenses and has 50m units. Calculate the net asset value per unit. (4 marks)
Model answers
Show the model answer to Question 11
(a) Securitisation (4 marks). The bank transfers interest-bearing assets such as mortgages to a special purpose vehicle. (1.5) The SPV pays with cash raised by issuing bonds backed by the borrowers’ payments. (1.5) Future receipts become cash today. (1)
(b) Tranches (6 marks). The CDO is split into senior, junior and equity tranches. (2) Senior carries the lowest risk and return. Junior pays a higher coupon for more risk. (2) Losses go to the equity tranche first, then the junior, then the senior. (2)
Show the model answer to Question 12
(a) Tranches (5 marks). Equity loses ₦20m, all of its value. (2) The junior tranche loses ₦30m of ₦40m. (2) The senior tranche loses nothing. (1)
(b) Equity (5 marks).
- Loss = 500 × 12% = ₦60bn. (2)
- Equity = 40 − 60 = −₦20bn. (2)
- Negative equity means liabilities exceed assets, so the bank is insolvent on a fair value basis. (1)
(c) Spread (6 marks). Banks doubted each other’s credit and stopped lending in the inter-bank market, so LIBOR rose and liquidity was threatened. (3) Banks tightened lending, credit became scarce, mortgages were hard to get, property prices and building fell, and recession followed. (3)
(d) Dark pool (4 marks). A venue where large blocks of shares trade anonymously and are announced only after the trade. (2) A fund uses it to avoid moving the price against itself with a visible large order. (2)
Show the model answer to Question 13
(a) Schemes (6 marks). A unit trust pools money from investors into a portfolio of shares, bonds and money market instruments run by professional managers, giving diversification. (2) A REIT manages income-generating property and must distribute most of its profit as dividend; it may be a trust or listed company. (2) An ETF is a collection of securities that tracks an index and trades on an exchange. (2)
(b) NAV (4 marks).
- (520 + 12 − 4) = 528. (2)
- 528 ÷ 50 = ₦10.56 per unit. (2)
Pathfinder on Financial crisis, CDOs, dark pools and CIS
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic. ICAN says to follow business news and the examinations directorate for current issues. Worked examples 1 to 4 show the calculations.
Revise first: Worked examples
Questions ask you to trace how losses spread from loans to banks and the economy. See the section on the financial crisis.
Revise first: The financial crisis
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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