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How Resilient are MBS to CDO Market Disruptions
 

How Resilient are MBS to CDO Market Disruptions

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    How Resilient are MBS to CDO Market Disruptions How Resilient are MBS to CDO Market Disruptions Presentation Transcript

    • How Resilient Are MBS to CDO Market Disruptions? By Joseph Mason Joshua Rosner Discussion by Tyler Yang, IFE Group February 15, 2007
    • The Paper
      • Reviews recent changes in primary mortgage market operations => entering into riskier products
      • Introduces various MBS and CDO structures => complex securities
      • Establishes link among CDO and MBS and mortgage lending => leverage effect
      • Recommends tighter regulation and more extensive disclosure
    • Comments
      • Impact of CDO on home mortgage lending
      • Policy and regulation implications
      • Recent issues of primary mortgage markets
      • Possible next steps
    • Typical Private MBS (REMIC) Structure Tranche A1 Tranche A2 Tranche BBB Tranche Residual Prepaid Principal Default Loss First Loss Default Loss Mezzanine Loss AA Support Level Mortgage Pool CDO Buys
      • REMIC needs to have junior tranche to support senior tranches
      • CDO is a main buyer of REMIC junior tranches
      • Therefore, if CDO pulls out
      • there could be a shortage
      • of funds to home mortgage
      • market
      From Home Mortgage to CDO Borrower Lender/ Issuer REMIC Tranches CDO Junior tranches Mortgage pool Mortgage loan $ $ $
    • Magnitude of Impact
      • CDO purchased $140B of MBS junior tranches in 2005
      • The subordination level for AA rated tranche is about 10%
      • Therefore, CDO supported about $1,400B private label MBSs issuance (> $1,326B actual issuance)
      • If CDO pulls out, there will be no private label MBS issuances
    • CDO Investors Borrower Lender/ Issuer REMIC Tranches CDO Junior tranches Mortgage pool Mortgage loan $ $ $ Foreign Investors Mutual Fund Hedge Fund
    • What Happens if CDO Disappear?
      • Prior to CDO, there are other buyers of the junior tranches, down to non-rated tranche
      Borrower Lender/ Issuer REMIC Tranches CDO Junior tranches Mortgage pool Mortgage loan $ $ $ Foreign Investors Mortgage REIT Mutual Fund Hedge Fund
    • Alternative Outlays of Private Mortgages
      • Alternative funding or credit risk management tools for jumbo/subprime loans
      Borrower Lender/ Issuer REMIC Tranches CDO Junior tranches Mortgage pool Mortgage loan $ $ $ Fund by Capital Purchase PMI Sell as MBB/PT Cross hedge Other credit enhancements
    • Other Credit Enhancement Methods
      • Credit derivatives helps lenders proactively manage portfolio credit risk
        • lower funding cost and mortgage rates
      • Senior-Sub is only one of many credit enhancement methods to achieve AA+ rating
        • Bond insurer
        • Over-collateralization
        • Wrap around
        • Pool insurance
        • Synthetic swap
        • Credit lined note (e.g. MODERNs)
    • MORDERNs
      • 1998 Freddie Mac, US$20B US RMs, use mortgage default recourse notes to insure first loss and mezzanine credit risk
      US$20B US seasoned RM G-3 SPV Insurance Premium Default Claims Collateral ($520M) Issue Proceeds P&LIBOR rate Freddie Mac A, 60M, BBB, 1% B, 30M BBB-, 1.3% C, 50M, BB, 2.85% D, 46M, B, 6.5% E, 64M, NR, 20% * P&LIBOR+Spread Issue Proceeds * Only $57.3M of class E was actually issued.
    • Why CDOs?
      • CDO offers the cheapest capital to fund MBSs
      • The question should therefore be:
      • If CDO pulls out, how much additional cost (rate) will borrowers need to pay?
        • Higher spread required by alternative investors
        • Higher PMI insurance premium
        • Less favorable selling prices of MBB/PT
        • Higher funding cost by bank debt and capital
        • Less efficient hedge of credit risk via conforming loan CD swaps
      • The authors could try to quantify the impact by analyzing the execution cost of these alternatives
    • BBB Trache Is Riskier than BBB Bond Tranche A1 Tranche A2 Tranche BBB Tranche Residual Prepaid Principal Default Loss First Loss Default Loss Mezzanine Loss AAA Support Level Mortgage Pool Pass Through BBB Over Collateral Principal & Interest Default Loss First Loss
    • Tranche BBB And PT Gets Same Rating Tranche A1 Tranche A2 Tranche BBB Tranche Residual Mortgage Pool Pass Through BBB Over Collateral Loss
    • Cliff! Tranche A1 Tranche A2 Tranche BBB Tranche Residual Mortgage Pool Pass Through BBB Over Collateral Loss Return = -100% Return = -20%
    • Understand CDO
      • CDO builds double Cliff! Even more concentrated default risk
        • What’s the impact?
      • Need to understand BBB tranche CDO is much riskier than BBB pass through (corporate bond)
        • Rating agency only measures the probability of not recoverprincipal
        • No LGD indicator, no interest income risk indication
        • Backward looking (rating change only after credit event)
        • Investors clearly understand it by the much higher spread they require for tranche
      • Need a forward looking credit score (similar to KMV or CreditMatrics)?
    • How Much to Disclose?
      • REMICs currently disclose
        • Pool level distribution of LTV, FICO, location, loan size, contract rate, and sometimes cross tabulation among variables
        • Some subprime REMICs even provide loan level disclose
        • Structure and payment sequences
        • Numerical examples of payment to individual sequences
        • Monthly prepayment, default, or even delinquency experience via Intex
      • Due diligence by major auditors
      • Need more financial disclosure? What specific information?
    • Who Should Government Protection?
      • The authors should clearly analyze who in the process should be protected by the government.
      • Typically only institutional investors purchases junior tranche CDOs
        • Pursue higher return by knowingly invest in high credit risk securities
        • Financial loss does not affect national economy or individual savers or households
      • Need to prevent pension funds, life insurance companies, and small individual investors from heavily invest in these high credit risk securities
        • Avoid hurting insurees, retirees, average savers
    • Risk Based Capital Regulation
      • Basel II
        • IRB approach will accurately reflect the higher default risk into higher capital requirement
        • Standardized approach specifies different capital requirement for different structured tranches (B or NR tranche required 1250% risk weight, BB tranche requires 200% risk weight)
        • Pillar II government supervision allow closer scrutiny
        • Pillar III market discipline
      • What additional regulations are needed? On which party? By which agency? Why?
    • Mortgage Lending: Higher Risk Products
      • Extremely high total LTV
      • Historically low interest rate environment
      • IO or option ARM with teaser (income constraint)
        • Introduced payment shocks much higher than income growth
        • Borrower could roll over using teaser (if rate remains low and house price does not fall)
        • But prepayment penalty made roll over impossible
      • Lead to high default rates
      • Is a problem, with or without CDO
      • This issue is less relevant to government and conforming loans
        • High default rate is particular sever in private markets
        • Government needs to educate home buyers about the risk entering into these loans
    • Probability of Income Shortage Yang, Ling, and Cho, 2006, “Balancing Credit and Interest Rate Risks: Choice between Fixed- and Adjustable- Rate Mortgages”, presented at 2006 International AREUEA coference
    • Relative Default Risks
    • Encourage Home Ownership High Income Household Poor Household Homeless current renters young professionals moderate-income households seniors person with disabilities No Yes No Yes Wealth Constrained? Income Constrained?
    • Conclusions
      • Made good inventory check and established basic link of CDO and primary mortgage market
      • Possible contributions to make
        • More clearly describe the linkage between CDO and mortgage borrowers
        • Focus on the marginal impact of CDO on the MBS market
        • Be more specific about what the government has done; what additional regulations are needed from which agency; and on which group
        • The high default rate is caused by the aggressive underwriting and product design, with or without CDO
        • Any implication of the balance between affordable housing objective and financial stability
    • Housing Market Forecast Follain and Follain, “Searching for Clues About the Future of House Prices”, 2007 Cyberhomes.com