Derivatives in global financial supply chains
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Numerous new financial products are created by bundling mortgages, credit card dues etc. They are tranched to create sub products with varying risks and rewards. The financial crisis of 2007-08 owes its origin to these products.
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Derivatives in global financial supply chains
- 1. Derivative Products in Global Financial Supply Chains Parasuram Balasubramanian, Founder & CEO, Theme Work Analytics, Bangalore balasubp@gmail.com A Research Initiative of Jan 2016
- 2. MBS, CMO.CDO,CDS,SIV etal Mortgages Synthetic CDO SIV CDO (Cash Flow based) MBO, MBS Complex financial products have been constructed out of simple mortgages and other financial assets such as Home Equity and Business Receivables MBO: Mortgage backed Obligation MBS : Mortgage backed Securities CMO : Collateralized Mortgage Obligation CDO : Collateralized Debt Obligation CDS : Credit Default Swaps SIV : Structured Investment Vehicle CDS CMO
- 3. Mortgage Year 0 1 2 5 10 15 20 25 30 Each mortgage generates mul> year payments to the bank from the borrower. Each payment has an Interest component. Each payment has a Principal component. Interest component is larger than the Principal component in earlier years and vice versa. MBS, CMO.CDO,CDS,SIV etal
- 4. Mortgage Year 0 1 2 5 10 15 20 25 30 Prepayment Risk Mortgage ge)ng closed earlier than the planned period either due to refinancing of the loan or its foreclosure. No loss in Principal. Each payment has an Interest component. Each payment has a Principal component. MBS, CMO.CDO,CDS,SIV etal Default Risk Inability to recover the dues pertaining to Interest or Principal or both.
- 5. Collection of mortgages 0-5 Years 5-10 Years 10-15 Years 15-25 Years 25-30 Years Interest Payments Interest PaymentsInterest Payments Interest Payments Interest Payments Principal Payments Principal Payments Principal Payments Principal Payments Principal Payments Group 1 Mortgages can be grouped by way of similar maturity period and interest rates etc MBS, CMO.CDO,CDS,SIV etal Group 3Group 2 Group 5Group 4
- 6. Collection of mortgages Group X Interest Payments Principal repayment Tranch 1 Year 1 MBS, CMO.CDO,CDS,SIV etal Tranch 2 Tranch 3 Equity Year 3Year 2 Year N Interest Payments Interest Payments Dividend Mortgage Receipts Principal repayment Principal repayment Capitall repayment Tranches can be constructed in many ways. The waterfall method stipulates a hierarchy of payments. Interest obligations of Tranch 2 are paid only after Tranch 1 is fully paid etc. Tranches need not be equal in size. They could also be constructed by segmenting the mortgages into prime and subprime further. Tranches carry different levels of risk and commensurate returns. Reserves
- 7. Collection of mortgages Group X Interest Payments Principal repayment Tranch 1 Year 1 MBS, CMO.CDO,CDS,SIV etal Tranch 2 Tranch 3 Equity Year 3Year 2 Year N Interest Payments Interest Payments Dividend Mortgage Receipts Principal repayment Principal repayment Capitall repayment Reserves Even subprime mortgages can be tranched. Some tranches will carry lower risk than the underlying assets while others will carry higher risk. Usually the highest risk tranches are retained as equity.
- 8. MBS :: A Bond created by securitizing a pool of mortgages CMO :: A tranched MBS CDO :: ( Cash Flow Based) :: A tranched Asset Backed Security where the asset can be a Home Equity Loan or Credit Card Dues etc. CDO :: ( Synthetic) :: No Asset backing exists but is based on a pool of Credit Default Swap (CDS) CDS :: Credit Default Swap :: Protection against a loss or default, like insurance MBS, CMO.CDO,CDS etal
- 9. CMO is tranched based on the returns ( interest and principal repayment) from underlying mortgage assets.CMO can be a protection against the Prepayment risk inherent in mortgages. (Superior tranches get this benefit at the cost of inferior tranches) CDO ( Cash flow based) is tranched on the pool of loans or other assets such as credit card receivables. Superior tranches offer protection against the credit risk while the inferior tranches exacerbate the risk. CDO (synthetic) is created from a pool of securities ( like Credit Default Swaps) that are contingent upon the occurrence of a default event. The are a form of protection against the default risk. MBS, CMO.CDO,CDS,SIV etal