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Sub Prime Mortgage Crisis

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Structured finance is a sector that transfers risk using complex legal entities like securitization and tranching. Securitization pools debt instruments and issues new securities backed by the pool, while tranching splits securities into different risk levels. Mortgage-backed securities represent claims on cash flows from mortgage loans. Collateralized mortgage obligations (CMOs) issue bonds backed by mortgages and use tranching to create bonds of varying risk levels, like sequential or parallel tranching. The subprime mortgage crisis originated in the late 1990s and became apparent in 2007, caused by risky lending practices and the shadow banking system's involvement in securitization.

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Review Structured Finance : A sector of finance that was created to help transfer risk using complex legal and corporate entities . Important Features – Securitization , Tranching. Securitization : A structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool. Tranching : Splitting the individual securities into different slices, with each tranche having a different level of risk exposure than another .
Mortgage Backed Security : An asset backed security or debt obligation that represents a claim on the cash flows from mortgage loans. Important Players : Home-owners , Originator , Issuer and Investors. Features : WAC , WAM and Pass-through Rate Types : a) Pass-though MBS b) Collateralized Mortgage Obligation(CMO) c) Stripped MBS Uses : a) Enhance Liquidity. b) Replenish the Originator’s Funds. c) Efficient source of Financing.
CMO CMO is a special purpose entity that is wholly separate from the institution(s) that create it. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and receive payments according to a defined set of rules. Mortgages called Collateral Bonds called Tranches Set of rules that dictates how money received from the collateral will be distributed - Structure
CMO The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply be to "split it". For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 , 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00% This format has various problems : a) Prepayment Risk b) Interest Rate Risk c) Credit Risk A CMO is essentially a way to create many different kinds of bonds from the same mortgage loan so as to please many different kinds of investors
TYPES OF TRANCHING : Credit Protection Credit Tranching Overcollateralization Excess Spread Prepayment Tranching Sequential Tranching (or by time ) Parallel Tranching Coupon Tranching IO/Discount fixed rate pair PO/Premium fixed rate pair IO/PO pair Floater/Inverse pair
Credit Tranching Credit losses will be absorbed by the most junior class of bondholders. Threshold is set related to quantities of delinquencies or defaults in the loans . Overcollateralization Principal value of the bond is less than the value of the underlying pool of mortgages. Excess Spread Bonds issued at a lower interest rate than the underlying mortgages.
Sequential Tranching All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. Parallel Tranching The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgage For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays LIBOR with a cap of 16%, the other being an inverse floater that pays a coupon of 16% minus LIBOR .
IO/Discount fixed rate pair A fixed rate CMO tranche can be further restructured in to an Interest Only (IO) tranche and a discount coupon fixed rate tranche For example a $100 million tranche off 6% collateral with a 6% coupon can be cut into a $100mm tranche with a 5% coupon, and a IO tranche with a notional principal of $16.666667 million and paying a 6% coupon. PO/Premium fixed rate pair Similarly from fixed rate CMO tranche principal can be removed to form a Principal Only (PO) class and a premium fixed rate tranche. Floater/Inverse pair CMO floaters have a coupon that moves in line with a given index (usually 1 month LIBOR) plus a spread In creating a CMO floater, a CMO Inverse is generated
The construction of a floater/inverse can be seen in two stages : The first stage is to synthetically raise the effective coupon to the target floater cap, in the same way as done for the PO/Premium fixed rate pair. As an example using $100 million 6% collateral, targeting an 8% cap, we generate $25m of PO and $75m of Premium Fixed Rate. The next stage is to cut up the premium coupon into a floater and inverse coupon, where the floater is a linear function of the index, with unit slope and a given offset or spread. In the example, the 8% coupon is cut into : Floater Rate : 1 * LIBOR + 0.40% Inverse Rate : 8% - (1 * LIBOR + 0.40%) = 7.60% - 1 * LIBOR
SUB-PRIME MORTGAGE CRISIS The subprime mortgage crisis is an ongoing real estate crisis and financial crisis in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 .
IMPORTANT CONCEPTS : Foreclosure Adjustable Rate Mortgage Shadow Banking System Credit Default Swap ( CDS)
Foreclosure Foreclosure is the legal and professional proceeding in which a mortgagee or a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption. The violation of the mortgage is a default in payment of a promissory note.
Adjustable Rate Mortgage It is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices Indices : 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR ). ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes
Shadow Banking System It consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate. Typically intermediaries between investors and borrowers. Do not accept deposits like a depository bank and therefore are not subject to the same regulations. E.g. Bear Stearns and Lehman Brothers
Credit Default Swap It is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default . The buyer of a CDS does not need to own the underlying security . The credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded .
Background and timeline of events
CAUSES Boom and bust in the housing market High-risk mortgage loans and lending/borrowing practices Securitization practices Inaccurate credit ratings Credit default swaps Boom and collapse of the shadow banking system
INTERESTING FACTS Between 1997 and 2006, the price of the typical American house increased by 124%. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion During 2008, the typical USA household owned 13 credit cards Mark Pittman, one of the great financial journalists(Bloomberg News) of our time predicted this crisis in his stories and also featured prominently in a documentary about subprime mortgages, “American Casino”.
REFERENCES : www.wikipedia.org www.newyorkfed.org www.garpdigitallibrary.org

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Sub Prime Mortgage Crisis

  • 2. Review Structured Finance : A sector of finance that was created to help transfer risk using complex legal and corporate entities . Important Features – Securitization , Tranching. Securitization : A structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool. Tranching : Splitting the individual securities into different slices, with each tranche having a different level of risk exposure than another .
  • 3.
  • 4. Mortgage Backed Security : An asset backed security or debt obligation that represents a claim on the cash flows from mortgage loans. Important Players : Home-owners , Originator , Issuer and Investors. Features : WAC , WAM and Pass-through Rate Types : a) Pass-though MBS b) Collateralized Mortgage Obligation(CMO) c) Stripped MBS Uses : a) Enhance Liquidity. b) Replenish the Originator’s Funds. c) Efficient source of Financing.
  • 5. CMO CMO is a special purpose entity that is wholly separate from the institution(s) that create it. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and receive payments according to a defined set of rules. Mortgages called Collateral Bonds called Tranches Set of rules that dictates how money received from the collateral will be distributed - Structure
  • 6. CMO The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply be to "split it". For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 , 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00% This format has various problems : a) Prepayment Risk b) Interest Rate Risk c) Credit Risk A CMO is essentially a way to create many different kinds of bonds from the same mortgage loan so as to please many different kinds of investors
  • 7. TYPES OF TRANCHING : Credit Protection Credit Tranching Overcollateralization Excess Spread Prepayment Tranching Sequential Tranching (or by time ) Parallel Tranching Coupon Tranching IO/Discount fixed rate pair PO/Premium fixed rate pair IO/PO pair Floater/Inverse pair
  • 8. Credit Tranching Credit losses will be absorbed by the most junior class of bondholders. Threshold is set related to quantities of delinquencies or defaults in the loans . Overcollateralization Principal value of the bond is less than the value of the underlying pool of mortgages. Excess Spread Bonds issued at a lower interest rate than the underlying mortgages.
  • 9. Sequential Tranching All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. Parallel Tranching The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgage For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays LIBOR with a cap of 16%, the other being an inverse floater that pays a coupon of 16% minus LIBOR .
  • 10. IO/Discount fixed rate pair A fixed rate CMO tranche can be further restructured in to an Interest Only (IO) tranche and a discount coupon fixed rate tranche For example a $100 million tranche off 6% collateral with a 6% coupon can be cut into a $100mm tranche with a 5% coupon, and a IO tranche with a notional principal of $16.666667 million and paying a 6% coupon. PO/Premium fixed rate pair Similarly from fixed rate CMO tranche principal can be removed to form a Principal Only (PO) class and a premium fixed rate tranche. Floater/Inverse pair CMO floaters have a coupon that moves in line with a given index (usually 1 month LIBOR) plus a spread In creating a CMO floater, a CMO Inverse is generated
  • 11. The construction of a floater/inverse can be seen in two stages : The first stage is to synthetically raise the effective coupon to the target floater cap, in the same way as done for the PO/Premium fixed rate pair. As an example using $100 million 6% collateral, targeting an 8% cap, we generate $25m of PO and $75m of Premium Fixed Rate. The next stage is to cut up the premium coupon into a floater and inverse coupon, where the floater is a linear function of the index, with unit slope and a given offset or spread. In the example, the 8% coupon is cut into : Floater Rate : 1 * LIBOR + 0.40% Inverse Rate : 8% - (1 * LIBOR + 0.40%) = 7.60% - 1 * LIBOR
  • 12. SUB-PRIME MORTGAGE CRISIS The subprime mortgage crisis is an ongoing real estate crisis and financial crisis in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 .
  • 13.
  • 14. IMPORTANT CONCEPTS : Foreclosure Adjustable Rate Mortgage Shadow Banking System Credit Default Swap ( CDS)
  • 15. Foreclosure Foreclosure is the legal and professional proceeding in which a mortgagee or a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption. The violation of the mortgage is a default in payment of a promissory note.
  • 16. Adjustable Rate Mortgage It is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices Indices : 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR ). ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes
  • 17. Shadow Banking System It consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate. Typically intermediaries between investors and borrowers. Do not accept deposits like a depository bank and therefore are not subject to the same regulations. E.g. Bear Stearns and Lehman Brothers
  • 18. Credit Default Swap It is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default . The buyer of a CDS does not need to own the underlying security . The credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded .
  • 20.
  • 21.
  • 22. CAUSES Boom and bust in the housing market High-risk mortgage loans and lending/borrowing practices Securitization practices Inaccurate credit ratings Credit default swaps Boom and collapse of the shadow banking system
  • 23.
  • 24.
  • 25. INTERESTING FACTS Between 1997 and 2006, the price of the typical American house increased by 124%. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion During 2008, the typical USA household owned 13 credit cards Mark Pittman, one of the great financial journalists(Bloomberg News) of our time predicted this crisis in his stories and also featured prominently in a documentary about subprime mortgages, “American Casino”.
  • 26. REFERENCES : www.wikipedia.org www.newyorkfed.org www.garpdigitallibrary.org
  • 27.