Subprime Mess and Securitization

8/13/2019 Subprime Mess and Securitization

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Of the Subprime Mess and

Securitization10 th September 2007


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Agenda

What is Securitization ? The US Mortgage Process

The Sub-prime Story Where do credit derivatives fit in ? How bad is the problem ?


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Securitization defined

Securitisation is effectively a process throughwhich loans, receivables,and other assets arepooled. The related cash flows and economicvalues are employed to support payments onrelated securities. - Frank Fabozzi


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The US Mortgage Market- Process

The underwriter then sells securities to a variety of investors with different portfolio needs

Seller typically works closely with a credit rating

agency that will rate the credit risk of each tranche.

The rating agency will typically require some form of

credit enhancement

Originator quickly transfers the loan to a subsidiary of an investment banking firm

This securitization sponsor, then transfers the loanand hundreds of others like it into a pool of loans.

This pool of loans becomes its own business entity,called SPV.

A mortgage broker identifies a potential borrower

Use FICO Score to determine interest rate and other pricing variables


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The US Mortgage Market Process (contd)

Securitization of subprime mortgage loans has proven extremely adept at generating high

volume.

Even lenders with modest capital can quickly assign their loans into a securitization conduit,and use the proceeds of the sale to make a new round of loans

Pooling mortgages together and relying on a rating agency to assess the securities funded bythe pool,- reliable prediction of expected returns without investigating each individual loan

The seller arranges for a servicer which corresponds with consumers, receives monthlypayments, monitors collateral, and foreclosure


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Sub-prime Money Trail

Securitization


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Credit scores ranges from 300 850

Prime: >720 Alt-A: 620-720 Sub-Prime:


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So then The Obvious

Subprime lending is a rapidly growing segmentof the mortgage market that expands the pool ofcredit to borrowers who, for a variety of reasons,

would otherwise be denied credit Poor credit history is associated with substantially

more delinquent payments and defaulted loans,the interest rates for subprime loans are

substantially higher than those for prime loans PD is atleast 6 times higher for subprime than

prime


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Interest Rate & FICO Scores


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ErrWhats the problem again ?

The rate of serious delinquencies corresponding to mortgages in foreclosure orwith payments ninety days or more overdue

rose sharply during 2006 and recently stood atabout 11 percent, about double the recent lowseen in mid- 2005.

-Ben Bernanke Subprime mortgages have been roughly

accounting for more than half of the foreclosures.


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ButWhy have the deliquenciesrisen ?

House prices have decelerated.Interest rates on both fixed- and adjustable-ratemortgage loans moved upwardSome subprime borrowers with ARMs, whocounted on refinancing before their paymentsrose, didnt have enough home equity to qualifyfor a new loanRegional economic problems

Some of the states with the highest delinquency andforeclosure rates are those most hard-hit by job cuts inthe auto industry.

Loosened underwriting standards.


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Lets take a pause The story so far The lenders, dont have to worry very much about the risk of default, because they

rolled these mortgages into bonds called Mortgage-Backed Securities, which theythen sold. They got to be off-risk within a few weeks, because by then these re-packaged mortgages belonged to other financial organizations.

But credit-ratings agency will only give the subprime MBS a low credit score, which

means it is not considered investment grade. Investment bankers slice the MBS into several tranches. These are known as

Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones by slicing

up the MBS into what are called equity (high risk), mezzanine (middle risk) and themuch sought-after investment grade bonds (low risk).

Higher risk equals higher returns, of course, so the equity tranche of the MBS will earnthe highest profits if things go well. But if things start to go wrong, the equity is lost first,and then the mezzanine. Even then, the investment-grade bonds could still get fully paidout.


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Do you know what justhappened ?

The ability to borrow more prompted banks andother large investors to create collateralized debtobligations (CDO), which essentially scooped up

equity and "mezzanine" (medium-to-low rated)tranches from MBSs and repackaged them yetagain, this time into mezzanine CDOs.

Importantly, even the investment grade AAA

tranche may consist of sub prime loans becausethese tranches were promised the first dollarsthat came into the security


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Mezzanine and Equity Duh !Who wants it anyway ?

The investment bankmight choose to set upa hedge fund The hedgefunds objective is totrade in the high-riskequity and mezzanineCDO instruments.

The hedge fund thenbuys the equity trancheof the CDO from theinvestment bank. Ineffect, buying fromitself.

Housing market goes up

It gets marked up invalue. Further OutsideInvestment comes in

The hedge fund goesout to an unrelatedlending bank, holdingits high-performing butilliquid toxic waste in itshand, and it asks toborrow money using

the waste as collateral.The lending bank hasaccess to cheap money,and so it has theprospect of lending forspectacular profits.

So the money lent by the bank against the CDO equity goes back to the hedge fund, which buysmore CDOs from the investment bank, which buys more MBS from the mortgage lender, which

provides more money to subprime borrowers, who then buy more houses, pushing real-estate prices higher again.

Something like this is what happened to Bear Stearns hedge funds. Its two funds wereleveraged 5 times and 15 times respectively.


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Impact of the meltdown on theMarkets

On July 19, 2007, the DJIA hit a record high,closing above 14,000 for the first time.

By August 15, the Dow had dropped below13,000

Similar drops occurred in virtually every market inthe world, with Brazil and Korea being hard-hit.

Large daily drops became common, with, forexample, the KOSPI dropping about 7% in one day.


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How bad is the problem ?

In his recent testimony to Congress, Bernankeestimated potential losses on sub-prime mortgages tobe in the range of $50-100 billion, or less than 1% of GDP.

Viewed from this perspective, the potential losses on sub-prime mortgages appear to be very manageableDespite this favorable backdrop, a further deteriorationin financial market conditions cannot be overruled

the problems in residential housing are unlikely to beresolved anytime soon, and delinquency rates are likelyheaded higher.lack of transparency about the exposure of hedge fundsand financial institutions to complex instruments such asCDOs and CLOs and asset-backed commercial paper will

keep investors on edge.when markets are over-extended and correct the rarel


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The Indian side of the story

India receives sizeable FII inflows; within FIIs, we alsoget money from hedge funds.While it has always been difficult to quantify how muchinfluence hedge funds have on stock markets, the fact

remains that hedge funds owing to their overleveraged positions have lead to liquidity issues.The trouble starts when largesized funds (withexposure to highly leveraged sub prime markets)start liquidating their holdings in emerging markets tomake good their losses in a sinking sub prime market.Whenever hedge funds start making losses, theytemporarily exit from profitmaking destinations. Thistime round, it was more of an uninformed fear led sell

off from foreign institutions.


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Theres more to this game Synthetic CDOs

In some CDOs the underlying portfolio iscomposed of credit default swaps (CDS)rather than bonds or loans


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CDS - Wazzthat ?

A CDS is a contract between two parties in which onebuys credit protection from the other. In some respects,a CDS is similar to an insurance policy that covers creditrisk.

For example, party X might purchase protection fromparty Y covering the credit risk of ABC Corporation.

X is the protection buyer Y is the protection seller. X agrees to pay Y a periodic fee during the term of thecontract unless and until a credit event occurs. A credit event could be ABCs bankruptcy or a default on itsfinancial obligations.. If a credit event occurs, Y has to pay Xthe amount specified in the contract.

Subprime Mess and Securitization

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