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05/09/2014 13:42 Unitec New Zealand 1

Weeks 8
What happened last time
Swaps
Today
Part 1:
Securitization and the Credit Crisis of 2007
Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis
http://www.jlem.com/articles/jlem/tumbling_tower_of_babel.pdf
Explaining the Credit Crunch
http://www.nber.org/digest/mar09/w14612.html
Subprime mortgage crisis
http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
Option Strategy Cheat Sheet
https://www.tradeking.com/education/video/how-choose-your-strategy-part-4-option-
strategy-cheat-sheet
The mathematical equation that caused the banks to crash
http://www.theguardian.com/science/2012/feb/12/black-scholes-equation-credit-crunch
THE INFORMATION CONTENT OF OPTION PRICES DURING THE FINANCIAL CRISIS
https://www.ecb.europa.eu/pub/pdf/other/art2_mb201102en_pp87-99en.pdf
Mortgage put options and real estate markets
http://xwhartonrealestate.merchantquest.net/research/papers/full/613.pdf
Some useful Links
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OTC Derivatives and Central Clearing: Can All Transactions Be Cleared?
https://www.moodys.com/microsites/crc2010/papers/hull_otc.pdf
The subprime credit crisis and contagion in financial markets
http://ac.els-cdn.com/S0304405X10000127/1-s2.0-S0304405X10000127-
main.pdf?_tid=31573f1a-3490-11e4-8ae0-
00000aab0f6c&acdnat=1409875643_64f6efa6387ba6efbae24054a83d7bd3
What Is Securitization?
https://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf
The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned?
http://www-2.rotman.utoronto.ca/~hull/downloadablepublications/CreditCrunch.pdf
Some useful Links
THE RISK-RELEVANCE OF SECURITIZATIONS DURING THE RECENT FINANCIAL CRISIS
https://www.bus.miami.edu/_assets/files/faculty-and-research/academic-
departments/accounting/seminars/Dushnat_Vyas_Miami_Nov2%20copy.pdf
Systematic Risk and Credit Ratings of Mortgage Securitizations
https://www.diw.de/documents/dokumentenarchiv/17/diw_01.c.373265.de/fin11_roesch_sch
eule.pdf
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Securitization
Derivatives such as forwards, futures, swaps and options are
concerned with transferring risk from one entity of the
economy to another. So far we examined the first 3
derivatives. Now we plan to look at securitization.
Securitization is the process of taking an illiquid asset, or
group of assets, and through financial engineering,
transforming them into a security. A typical example of
securitization is a mortgage-backed security (MBS), which is
a type of asset-backed security that is secured by a collection
of mortgages.
Traditionally banks have funded loans with deposits, so
securitization is a way that loans can increase much faster
than deposits.
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Asset Backed Security (Simplified)
Figure 8.1, page 196
Asset 1
Asset 2
Asset 3

Asset n
Principal:
$100 million
SPV
Senior Tranche
Principal: $80 million
Return = LIBOR + 60bp
Mezzanine Tranche
Principal:$15 million
Return = LIBOR+ 250bp
Equity Tranche
Principal: $5 million
Return =LIBOR+2,000bp
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The Waterfall (Figure 8.2, page 197)
Equity Tranche
Senior
Tranche
Mezzanine Tranche
Asset
Cash
Flows
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ABS CDOs or Mezz CDOs
(Simplified)
(Figure 8.3, page 198)
Assets Senior Tranche (80%)
AAA
Mezzanine Tranche (15%)
BBB
Equity Tranche (5%)
Not Rated
Senior Tranche (65%)
AAA
Mezzanine Tranche
(25%) BBB
Equity Tranche (10%)
Mezzanine tranches from
many ABSs are used to
create the ABS CDO ABSs
ABS CDO
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Losses to AAA Tranche of
ABS CDO (Table 8.1, page 199)
Losses on
Subprime
portfolios
Losses on
Mezzanine
Tranche of
ABS
Losses on
Equity
Tranche of
ABS CDO
Losses on
Mezzanine
Tranche of
ABS CDO
Losses on
Senior
Tranche of
ABS CDO
10% 33.3% 100% 93.3% 0%
13% 53.3% 100% 100% 28.2%
17% 80.0% 100% 100% 69.2%
20% 100% 100% 100% 100%
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U.S. Real Estate Prices, 1987 to 2012:
S&P/Case-Shiller Composite-10 Index,
(Figure 8.4, page 200)
0.00
50.00
100.00
150.00
200.00
250.00
Jan 87 Jan 90 Jan 93 Jan 96 Jan 99 Jan 02 Jan 05 Jan 08 Jan 11
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10
What happened
Starting in 2000, mortgage originators in the US relaxed their lending standards
and created large numbers of subprime first mortgages.
This, combined with very low interest rates, increased the demand for real
estate and prices rose.
To continue to attract first time buyers and keep prices increasing they relaxed
lending standards further
Features of the market: 100% mortgages, ARMs, teaser rates, NINJAs, liar
loans, non-recourse borrowing
Mortgages were packaged in financial products and sold to investors
Banks found it profitable to invest in the AAA rated tranches because the
promised return was significantly higher than the cost of funds and capital
requirements were low
In 2007 the bubble burst. Some borrowers could not afford their payments
when the teaser rates ended. Others had negative equity and recognized that
it was optimal for them to exercise their put options (i.e. put the house to the
bank for the amount outstanding on the mortgage)
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Foreclosures increased supply and caused U.S. real estate
prices to fall. Products, created from the mortgages, that were
previously thought to be safe began to be viewed as risky
There was a flight to quality and credit spreads increased to
very high levels
Many banks incurred huge losses
What happened
What is Contagion?
https://www.youtube.com/watch?v=5iP3LIUm9FU
Is Financial Contagion Coming?
https://www.youtube.com/watch?v=La1axfWAIP8
The Wall Street Financial Meltdown - Part 6 The Contagion Goes Global - Financial Crisis
https://www.youtube.com/watch?v=cM2mPRiwjSo
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What Many Market
Participants Did Not Realize
Default correlation goes up in stressed market
conditions
Recovery rates are less in stressed market conditions
A tranche with a certain rating cannot be equated
with a bond with the same rating. For example, the
BBB tranches used to create ABS CDOs were
typically about 1% wide and had all or nothing loss
distributions (quite different from BBB bond)
This is quite different from the loss distribution for a
BBB bond from a BBB bond
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05/09/2014 13:42 Unitec New Zealand 5
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Regulatory Arbitrage
The regulatory capital banks were required to keep for
the tranches created from mortgages was less than that
for the mortgages themselves
Regulatory
Arbitrage
The regulatory
capital banks were
required to keep
for the tranches
created from
mortgages was
less than that for
the mortgages
themselves
Incentives
The crisis highlighted what are referred to
as agency costs:
Mortgage originators (Their prime
interest was in in originating mortgages
that could be securitized)
Valuers (They were under pressure to
provide high valuations so that the loan-
to-value ratios looked good)
Traders (They were focused on the next
end-of year bonus and not worried
about any longer term problems in the
market)
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15
The Aftermath
A huge amount of new regulation including:
Banks required to hold more capital
Banks required to satisfy liquidity ratios
CCPs for OTC derivatives
Bonuses subject to more scrutiny
Limits to proprietary trading
Securitisation after the credit crunch: is it right for your business?
http://www.pwc.com/en_GX/gx/structured-finance/pdf/securitisation-credit-crunch.pdf
Overdose: The Next Financial Crisis
https://www.youtube.com/watch?v=4ECi6WJpbzE
[49] George Magnus: The next economic crisis has already begun
https://www.youtube.com/watch?v=Mc1GXs550Uo
Preparing For The Next Financial Crisis
https://www.youtube.com/watch?v=TDubCwqdRZg
The Financial Crisis: What Happened? (Or, the Next Financial Crisis)
https://www.youtube.com/watch?v=8D2xhq7X5aQ