The document discusses credit default swaps (CDS) and their role in the 2007-2009 financial crisis. It begins by explaining what a CDS is and how the market for them grew enormously in the years leading up to the crisis. It then discusses three ways CDS affected the crisis: by creating uncertainty about who held credit risk; making major CDS dealers vulnerable to each other; and allowing sellers of insurance to take on large risks. The lack of transparency and interconnectedness in the over-the-counter CDS market contributed to systemic risk and the need for government intervention during the crisis.
Summerlin Asset Management, LLC (SAM), is a diversified real estate investment and management company. SAM's expertise is the purchase, service, and resale, of both performing and non-performing real estate notes secured by the Deed of Trust or Mortgage.
Summerlin Asset Management, LLC (SAM), is a diversified real estate investment and management company. SAM's expertise is the purchase, service, and resale, of both performing and non-performing real estate notes secured by the Deed of Trust or Mortgage.
A credit derivative is a financial contract in which the underlying is a credit asset (debt or fixed-income instrument). The purpose of a credit derivative is to transfer credit risk (and all or part of the income stream in relation to the borrower) without transferring the asset itself.
A credit derivative serves as a sort of insurance policy allowing an originator or buyer to transfer the risk on a credit asset (of which he may or may not be the owner) to the seller(s) of the protection or counterparties.
Active Capital Reinsurance Ltd commenced operations in 2007, mainly providing credit-related reinsurance solutions to financial institutions in Latin America, and it has a general insurance and reinsurance license issued in Barbados.
9 Mortgage MarketsCHAPTER OBJECTIVESThe specific objectives of.docxblondellchancy
9 Mortgage Markets
CHAPTER OBJECTIVES
The specific objectives of this chapter are to:
· ▪ provide a background on mortgages,
· ▪ describe the common types of residential mortgages,
· ▪ explain the valuation and risk of mortgages,
· ▪ explain mortgage-backend securities, and
· ▪ explain how mortgage problems led to the 2008- 2009 credit crisis.
9-1 BACKGROUND ON MORTGAGES
A mortgage is a form of debt created to finance investment in real estate. The debt is secured by the property, so if the property owner does not meet the payment obligations, the creditor can seize the property. Financial institutions such as savings institutions and mortgage companies serve as intermediaries by originating mortgages. They consider mortgage applications and assess the creditworthiness of the applicants.
The mortgage represents the difference between the down payment and the value to be paid for the property. The mortgage contract specifies the mortgage rate, the maturity, and the collateral that is backing the loan. The originator charges an origination fee when providing a mortgage. In addition, if it uses its own funds to finance the property, it will earn profit from the difference between the mortgage rate that it charges and the rate that it paid to obtain the funds. Most mortgages have a maturity of 30 years, but 15-year maturities are also available.
9-1a How Mortgage Markets Facilitate the Flow of Funds
WEB
www.mbaa.org
News regarding the mortgage markets.
The means by which mortgage markets facilitate the flow of funds are illustrated in Exhibit 9.1. Financial intermediaries originate mortgages and finance purchases of homes. The financial intermediaries that originate mortgages obtain their funding from household deposits. They also obtain funds by selling some of the mortgages that they originate directly to institutional investors in the secondary market. These funds are then used to finance more purchases of homes, condominiums, and commercial property. Overall, mortgage markets allow households and corporations to increase their purchases of homes, condominiums, and commercial property and thereby finance economic growth.
Institutional Use of Mortgage Markets Mortgage companies, savings institutions, and commercial banks originate mortgages. Mortgage companies tend to sell their mortgages in the secondary market, although they may continue to process payments for the mortgages that they originated. Thus their income is generated from origination and processing fees, and not from financing the mortgages over a long-term period. Savings institutions and commercial banks commonly originate residential mortgages. Commercial banks also originate mortgages for corporations that purchase commercial property. Savings institutions and commercial banks typically use funds received from household deposits to provide mortgage financing. However, they also sell some of their mortgages in the secondary market.
Exhibit 9.1 How Mortgage Markets Facilitate t ...
2.
Role in the Financial Crisis. CDS affected the financial crisis and the policy response
in three important ways:
1) by creating uncertainty about who ultimately bears credit risk;
2) by making the leading CDS sellers mutually vulnerable in a way that fostered
systemic risk (see the Chapter 5 module: Systemic Risk);
3) by making it easier for sellers of insurance to assume risk.
First, the ability to transfer credit risks through CDS makes it difficult to evaluate the
riskiness of specific intermediaries. The problem is that the amount of CDS a bank
buys and sells is not reported on their balance sheet. This lack of disclosure makes it
much more difficult for a bank’s counterparties (its depositors or the investors who
purchase the bank’s bonds or commercial paper) to tell how risky it is. Put another
way, CDS can make the true riskiness of a financial institution invisible.
This loss of transparency made the financial system as a whole more vulnerable to a
shock that threatens trust in counterparties. For example, when subprime mortgage
defaults soared in 2008, uncertainty about the soundness of many intermediaries
rose because no one knew who would face the losses. Was it the holders of the
(subprime) mortgage‐backed securities (MBS) or someone else who had written
CDS to insure the MBS? The result was a decline in counterparty trust that
contributed to the collapse in key markets (such as interbank lending).
Second, CDS dealers – the intermediaries that sold the insurance – became
collectively vulnerable to a failure by any one dealer, much like a convoy of train
cars that can be derailed by the weakest car. How did these institutions – a small
group of the world’s largest financial intermediaries – become sufficiently
interconnected to create such systemic risk?
The answer is that most CDS contracts were traded over the counter (OTC), rather
than on an exchange (see Chapter 3 and the Chapter 9 module: Centralized
Counterparties and Systemic Risk). In an OTC market, it is impossible for a dealer to
know what any customer is doing with others. The problem is like that of someone
wishing to avoid a contagious disease. The only way to know how safe it is to come
into contact with someone is to know about the health of all the people that that
person has previously contacted. In the context of CDS, knowing the riskiness of
dealing with any particular customer (a counterparty) requires knowing what
contracts they already have with others. When those other contracts are unseen,
intermediaries are unable to seek adequate compensation for risk, in contrast with
core principle 2.
The lack of transparency in the OTC market helped AIG take the risks that were
highlighted at the start of this module. The collateral that AIG’s counterparties
required was low in good times because of the firm’s high credit rating and because
no trading partner could see the risks that AIG had assumed in its trades with other
parties. When default risks rose during the crisis, AIG faced a vicious cycle of