Seminar 6

structured financial
produts
An Eyewitness Account

César Oreste Crousillat Velasco

Professor of Derivatives and Financial Risk Analysis
co.crousillatv@up.edu.pe
Millennium financial innovation
1. St. Johan Godric
2. Cosimo de’ Medici
3. Phillip II
4. Tulipmania: Sharing the Greed
5. James Watt and Mathew Boulton
6. Transcontinental railroad
7. J.P. Morgan
8. J. D. Rockefeller
9. Henry Ford
10. Warren Buffet
11. Robert Woodruff
12. Bill Gates and Cyberspace: The Materialized Future
13. George Soros – a global open society
14. Steve Jobs: Build the Unthinkable
 James Watt (1736 – 1819)
• Socio political situation
• Rule of Parliament
• GBP recognized as main world currency
• IR low cheap to fundto start industry
• 18th Century Birbingham English center of ore and coal (i.e.
raw materials)

 James Watt: great inventor – like Steve Wozniak, bad salesman – (unlike Steve
Jobs)
 Accredited of the father of the first industrial revolution
 Accomplishments
 Designed most efficient, portable, steam engine
 New metallurgic products (strong and resistance to high temperature)
 Separated Water condenser (needed low T) and cylinder (hot T for
steam
 I meant a declaration of independence from running water
 Pumping water from mines
 “proto assembly line” industry – textiles
 Prior steam engines -- Four story-houses, Very inefficient
 Matthew Boulton (1728 – 1809)
• Matthew Boulton: great visionary and salesman– like
Steve Jobs, also fairly good engineer
• Lunar Society – collection of inventors, entrepreneurs,
etc

 E.x. Darwin grandfather, Maria Edgeworrth (novelist), Joseph Presley

(discovered element Oxigen) and William Werschel *astronomer: found ice
in Mars poles and discoverexd planete Uranus)

 Accomplishments
 Largest business man in Birmingham
 Most prominent member of Lunar Society – enormous influence
 Visionaries – Realized that James Watt WAS great inventor – like Steve
Wozniak , bad salesman – ( unlike Steve Jobs)
 PUSHED WATT TO INVENT ROTARY MOTION
 Dreamt of building CAR powered by steam engine
(locomotive)
The Us Transnational Railroad
• Key growth is development in communications, processing data and
transportation of goods and services
• United the country – west coast (old Spanish), Mississippi basin (old
French) and East Coast (original 13 US colonies)

17 and 18 Century
East meets West
• Promontory summit, Utah – May 10, 1869

• Also British Isles, France and Germany

• NIR – New Issue Report
• Schedule to the Master Agreement
• Complex document
• ISDA
• Trade Confirm
• Trade Long Confirm
• Operating guidelines

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• International Swaps and Derivatives
Association
• Is a document agreed between two parties that sets out
standard terms that apply to all the transactions entered into
between those parties
• With ISDA, both parties at the time of trade a “confirm”
dealing with particular aspects of transaction is signed by
both parties
• If counterparty doesn’t have an ISDA in place, then “long
confirm “ is signed by both parties pending counterparty
signing ISDA within 60 – 90 days; else trade is unwind
• Outlines the terms agreed between two parties. ISDA itself is
standard, but it is accompanied by (1) customized schedule
and (2) sometimes, a credit support annex.
• Makes netting easier !!!!
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• Broker's written acknowledgment that they have completed a
trade.
• These can be in electronic or paper form, and record
information such as:
• Trade date
• Commission fees
• Price
• Settlement terms of the trade
• Options – European/American, strike, maturity, cash of physical
settlement
• Swaps, fixed coupon, spread over LIBOR, maturity
• Typically send a confirmation within one week of the trade's
completion. 9
• Document that specifies the terms of a swap that functions as
both an ISDA® Schedule and confirmation
• Parties to a derivatives transaction may use a long-form
confirmation if they wish to enter into a swap but have not
executed an ISDA Master Agreement (nor ISDA® Schedule)
• Supplements, forms a part of, and is subject to the terms of, a
standard form ISDA® Master Agreement
• The long-form confirmation lists
• Commercial terms of a transaction that would usually be
found in a transaction confirmation
• Relationship terms that would typically be found in an ISDA®
Schedule
• Used when don’t have an UMBRELLA agreement
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Part 5. Other Provisions

Definitions. Capitalised terms not defined herein bear the meaning ascribed to
them in [Schedule of Definitions/Trust Indenture].

Obligations. Section 2(a)(iii) is amended by the deletion of the words "or

Potential Event of Default".

Additional Representations of Party A and Party B. The Agreement is amended by

the insertion of the following as Section 3(g):

"Relationship Between Parties. Each party will be deemed to represent to the

other party on the date on which it enters into a Transaction that (absent a
written agreement between the parties that expressly imposes affirmative
obligations to the contrary for that Transaction):

Other provisions may be included - escrow provision (for example, in the form
set out in the ISDA User's Guide to the 1992 Master Agreements), partial
invalidity (or severability), exclusion of partnership.
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Why take subprime mortgage?
o Borrow cheap IR and refinance in 2 years
o If in 2-y, home gained then have equity. Refi 30-y fixed
o No FICO required – measurement of credit score, ranges
between 300 and 850
o Subprime FICO < 600 (though varies with time)
o 2002 to restart economy, Congress order GNMA, Freddie MAC
to lend cheap
o IR teaser rates
o IO only for 2 years
o ARM
o Second mortgage, thus initial payment is zero dollars
o Other incentives
o Originators got percent of extra IR
o Flipping home – buy 2, 3, 4 homes…
o Target population
o Old people
o Single women
o Immigrants
Moments in the history of subprime
• Deregulation in the 1980s: Banks close branches in low-income neighborhoods. Enter
a new type of lender not identified with the population.

• Recession of 1991: It increases delinquency in credit cards. Most affected group are
recently divorced women. Between 1981 and 1999, the number of women declaring
bankruptcy increased by 838%, reaching half a million women.

• No alternative: "This new population of consumers with credit problems presents ...
a new opportunity: to sell subprime loans backed by housing as a way to consolidate
and pay off debt on credit cards" Run while you still can: Subprime demand and
predatory lending in rural areas, March 2004, HUD

• Opportunity: With subprime, banks replace bad debt with debt secured by the home
of the borrower. Fix the rate to the cost of funding plus 8% to 12% looks good for
those who have debts with rates of 20% to 29%.
• Main generator of jobs: According to economy.com,
• 43% of new jobs-700 thousand-are related to the
housing bubble from 2000 to 2004.
• In that period, the rest of the economy lost 400,000
jobs.

• Prices out of reach: "In 42 of 325 metropolitan areas,

housing prices are so high that during the first
quarter the average income could not buy a house
whose price corresponds to the average according to
traditional mortgage standards ... During In the last
12 months, the appreciation of the housing price was
greater than the increase in family income in 38 of the
50 states plus the District of Columbia. “
Bear Stearns 2005 Report
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• Disproportionate growth: HEL market grew from US
$ 34 billion in 1980 to US $ 340 billion in 1995 to US
$ 475 billion in 2006
• Predatory practices are not new:
• In the 1990s, practices such as focusing on
minority groups, low-income and elderly families
• Offering "toxic" products such as negative
amortization and "teaser rates",
• As well as inflating commissions by exploiting
ignorance, become commonplace. of the buyer.

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Review: Typical CDO Structure

ASSETS LIABILITIES
Cashflows
Many Aaa/AAA
Senior
C = 6.0 %
Assets
($70)
SPV (rating ≈ B)
Baa/ BBB
(Trust) ($ 100) Mezzanine
Equity
($20) C = 8.0 %

Yield = 9%
Equity ($10) Residual cash flows
Unrated
IRR > 20%

Assets could be: bonds, bank loans,

emerging market debt, project finance
loans, mid-market loans, TRUPs, etc.
Simple Characteristics -- CDO
• CDO = Collateral Debt Obligation
• Default probability by credit rating
• Correlation between default probabilities
• Loss severity
• IR flow waterfall
• Capital redemption waterfall
• Portfolio asset limits
• Legal documents governing SPV operation

Mortgage SPV Notes IR Capital

Waterfall Waterfal
$100 M
$100 M $700 M
$100 M Loan Indenture Investment AAA
$100 M Management Agreement LIBOR
$100 M Risk measure mode LIBOR + 75 bps + 75 bps
$100 M Sets Limits
$100 M Interest Set complaints $250 M
$100 M Governs IR waterfall BB
$100 M Amortizing Govens Redemption waterfall LIBOR + 250 bps
$100 M Mortagage $50 M Equity + Excess/Deficit

$1,000 M
Subprime market
MBS = US$ 11 Billones

US$ 1.7 Billones Bernanke (July 19, 2007) talking about

subprime losses to Congress: “… some
(subprime) estimates are on the order of between $50
billion to $ 100 billion, this is not a big number
in a $ 13-trillion economy, especially since the
losses will be spread out over several years.”
((( OUCH!!! )))
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Subprime Market…

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