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Sub Prime Mortgage Crisis

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Sub Prime Mortgage Crisis

  1. 1. - NIKHIL PUNDE
  2. 2. Review <ul><li>Structured Finance : A sector of finance that was created to help transfer risk using complex legal and corporate entities . </li></ul><ul><li>Important Features – Securitization , Tranching. </li></ul><ul><li>Securitization : A structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool. </li></ul><ul><li>Tranching : Splitting the individual securities into different slices, with each tranche having a different level of risk exposure than another . </li></ul>
  3. 4. <ul><li>Mortgage Backed Security : An asset backed security or debt obligation that represents a claim on the cash flows from mortgage loans. </li></ul><ul><li>Important Players : Home-owners , Originator , Issuer and Investors. </li></ul><ul><li>Features : WAC , WAM and Pass-through Rate </li></ul><ul><li>Types : a) Pass-though MBS </li></ul><ul><li>b) Collateralized Mortgage Obligation(CMO) </li></ul><ul><li>c) Stripped MBS </li></ul><ul><li>Uses : a) Enhance Liquidity. </li></ul><ul><li>b) Replenish the Originator’s Funds. </li></ul><ul><li>c) Efficient source of Financing. </li></ul>
  4. 5. CMO <ul><li>CMO is a special purpose entity that is wholly separate from the institution(s) that create it. </li></ul><ul><li>The entity is the legal owner of a set of mortgages, called a pool. </li></ul><ul><li>Investors in a CMO buy bonds issued by the entity, and receive payments according to a defined set of rules. </li></ul><ul><li>Mortgages called Collateral </li></ul><ul><li>Bonds called Tranches </li></ul><ul><li>Set of rules that dictates how money received from the collateral will be distributed - Structure </li></ul>
  5. 6. CMO <ul><li>The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply be to &quot;split it&quot;. 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% </li></ul><ul><li>This format has various problems : </li></ul><ul><li>a) Prepayment Risk </li></ul><ul><li>b) Interest Rate Risk </li></ul><ul><li>c) Credit Risk </li></ul><ul><li>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 </li></ul>
  6. 7. <ul><li>TYPES OF TRANCHING : </li></ul><ul><li>Credit Protection </li></ul><ul><li>Credit Tranching </li></ul><ul><li>Overcollateralization </li></ul><ul><li>Excess Spread </li></ul><ul><li>Prepayment Tranching </li></ul><ul><li>Sequential Tranching (or by time ) </li></ul><ul><li>Parallel Tranching </li></ul><ul><li>Coupon Tranching </li></ul><ul><li>IO/Discount fixed rate pair </li></ul><ul><li>PO/Premium fixed rate pair </li></ul><ul><li>IO/PO pair </li></ul><ul><li>Floater/Inverse pair </li></ul>
  7. 8. <ul><li>Credit Tranching </li></ul><ul><li>Credit losses will be absorbed by the most junior class of bondholders. </li></ul><ul><li>Threshold is set related to quantities of delinquencies or defaults in the loans . </li></ul><ul><li>Overcollateralization </li></ul><ul><li>Principal value of the bond is less than the value of the underlying pool of mortgages. </li></ul><ul><li>Excess Spread </li></ul><ul><li>Bonds issued at a lower interest rate than the underlying mortgages. </li></ul>
  8. 9. <ul><li>Sequential Tranching </li></ul><ul><li>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. </li></ul><ul><li>Parallel Tranching </li></ul><ul><li>The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgage </li></ul><ul><li>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 . </li></ul>
  9. 10. <ul><li>IO/Discount fixed rate pair </li></ul><ul><li>A fixed rate CMO tranche can be further restructured in to an Interest Only (IO) tranche and a discount coupon fixed rate tranche </li></ul><ul><li>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. </li></ul><ul><li>PO/Premium fixed rate pair </li></ul><ul><li>Similarly from fixed rate CMO tranche principal can be removed to form a Principal Only (PO) class and a premium fixed rate tranche. </li></ul><ul><li>Floater/Inverse pair </li></ul><ul><li>CMO floaters have a coupon that moves in line with a given index (usually 1 month LIBOR) plus a spread </li></ul><ul><li>In creating a CMO floater, a CMO Inverse is generated </li></ul>
  10. 11. <ul><li>The construction of a floater/inverse can be seen in two stages : </li></ul><ul><li>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. </li></ul><ul><li>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 : </li></ul><ul><li>Floater Rate : 1 * LIBOR + 0.40% </li></ul><ul><li>Inverse Rate : 8% - (1 * LIBOR + 0.40%) = 7.60% - 1 * LIBOR </li></ul>
  11. 12. SUB-PRIME MORTGAGE CRISIS <ul><li>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. </li></ul><ul><li>The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 . </li></ul>
  12. 14. <ul><li>IMPORTANT CONCEPTS : </li></ul><ul><li>Foreclosure </li></ul><ul><li>Adjustable Rate Mortgage </li></ul><ul><li>Shadow Banking System </li></ul><ul><li>Credit Default Swap ( CDS) </li></ul>
  13. 15. Foreclosure <ul><li>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. </li></ul><ul><li>The violation of the mortgage is a default in payment of a promissory note. </li></ul>
  14. 16. Adjustable Rate Mortgage <ul><li>It is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices </li></ul><ul><li>Indices : 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR ). </li></ul><ul><li>ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes </li></ul>
  15. 17. Shadow Banking System <ul><li>It consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate. </li></ul><ul><li>Typically intermediaries between investors and borrowers. </li></ul><ul><li>Do not accept deposits like a depository bank and therefore are not subject to the same regulations. </li></ul><ul><li>E.g. Bear Stearns and Lehman Brothers </li></ul>
  16. 18. Credit Default Swap <ul><li>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 . </li></ul><ul><li>The buyer of a CDS does not need to own the underlying security . </li></ul><ul><li>The credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded . </li></ul>
  17. 19. Background and timeline of events
  18. 22. CAUSES <ul><li>Boom and bust in the housing market </li></ul><ul><li>High-risk mortgage loans and lending/borrowing practices </li></ul><ul><li>Securitization practices </li></ul><ul><li>Inaccurate credit ratings </li></ul><ul><li>Credit default swaps </li></ul><ul><li>Boom and collapse of the shadow banking system </li></ul>
  19. 25. INTERESTING FACTS <ul><li>Between 1997 and 2006, the price of the typical American house increased by 124%. </li></ul><ul><li>USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. </li></ul><ul><li>The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion </li></ul><ul><li>During 2008, the typical USA household owned 13 credit cards </li></ul><ul><li>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”. </li></ul>
  20. 26. REFERENCES : <ul><li>www.wikipedia.org </li></ul><ul><li>www.newyorkfed.org </li></ul><ul><li>www.garpdigitallibrary.org </li></ul>

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