Subprime Mortgage Crisis will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis: The Roadmap Prime Rate: the interest rate commercial banks charge their most creditworthy customers. Subprime loans are characterized by low ‘introductory’ interest rates, usually for the first two or three years. These rates frequently rise rapidly in subsequent years Regulation change: prior to 1992, only commercial banks offered almost exclusively fixed-rate, prime-market mortgages The subprime mortgage market has expanded dramatically in the US, growing at an annual rate of 25 per cent between 1994 and 2005, a tenfold increase in a decade. Homeownership increased 1.94% per year during Clinton administration, reached 67.7% in 2000. In 1994, fewer than five percent of mortgages in the US were subprime, but by 2005 nearly 20 percent of new mortgage loans were subprime In the United States today, there is approximately $10 trillion in outstanding mortgages, and of these, about one-quarter are subprime and Alt-A loans (1980s S&L crisis cost, by comparison, about $240 billion in today's dollars, blamed for the 90-91 recession) Interest rate rose since 2004H2, housing price dropped and mortgage payments increased  default rate rose! will not calculate until another chapter. On November 12, 1999, President Bill Clinton signed into law the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act of 1933 Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Collateralized Debt Obligation (CDO) A CDO is an asset backed security (ABS) whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loans.CDO can be classified according to debt type: Collateralized loan obligation (CLO); Collateralized bond obligations (CBO); Collateralized mortgage obligations (CMO) The first CDO was created in 1987 by the famous Drexel Burnham Lambert, for a $100 million loan. Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Collateralized Debt Obligation (CDO) A CDO cashflow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection (tranches) of CDO securities. First tranche covers x% of notional and absorbs first x% of default losses Second tranche covers y% of notional and absorbs next y% of default losses Etc. A tranche earns a promised yield on remaining principal in the tranche Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Cash CDO Structure Illustration Tranche 1 1st 5% of loss Yield = 35% Bond 1 Bond 2 Bond 3  Bond n Average Yield 8.5% Tranche 2 2nd 10% of loss Yield = 15% Trust Tranche 3 3rd 10% of loss Yield = 7.5% Tranche 4 Residual loss Yield = 6% Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Typical CDO Contractual Relationships Ongoing Communication Collateral Manager Trustee will not calculate until another chapter. Underlying Securities (Collateral) CDO Special Purpose Vehicle (SPV) Hedge Provider (If Needed) Senior Fixed/ Floating Rate Notes Mezzanine Fixed/Floating Rate Notes Subordinated Notes/Equity Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Collateralized Debt Obligations (CDO) CDO Example NationsBank 1997-1 CLO tranches Obligors $2.164 billion will not calculate until another chapter. Issuer Interest Rate Swaps $2 billion (AAA) B. $43 million (A) C. $54 million (BBB) D. $64 million (NR) Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Collateralized Debt Obligations (CDO) Single-Tranche CDO Senior Tranche Bond 1 Bond 2 Bond 3  Bond n Selected Tranche Trust investors Equity Tranche Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Collateralized Debt Obligations (CDO) CDO Squared Senior Tranche SelectedTranche Equity Tranche Senior Tranche Senior Tranche SelectedTranche MezzanineTranche Equity Tranche Equity Tranche Senior Tranche SelectedTranche Equity Tranche Collateralized Debt Obligations (CDO) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis and CDO CDOs are the power packs of the late housing boom Hedge funds invest in CDO tranches backed by residential mortgages backed securities (RMBS) with large portion in subprime CDOs have become an important part of the mortgage market because they buy the riskier parts of MBS that others don't want. The higher-rated portions, or tranches, of MBS are sold to pension funds and insurers. But if the riskier tranches aren't sold too, the whole deal is off Causes? Reckless lenders; Greedy investors/borrowers Rating agencies are criticized. Most CDOs had A rating Effect on baby boomers' retirement will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis: Direct Causes Demyanyk and Van Hemert (2007) Higher loan-to-value mortgages from riskier borrowers Less housing price appreciation in 2006-2007 Causes of housing bubble? (media & politics) will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis: Winners and Losers Winners? (are you kidding me? Yes there are winners such as the first batch investors.) Big losers: http://ml-implode.com/ Bear Stearns: two hedge funds (>$1 billion) Australia: Basis Capital ($1 billion?); Absolute Capital ($200 million?); IKB Deutsche Industriebank … May take two more years to completely resolve! Big losers: Citigroup ($18B+) Merrill Lynch ($11.5B+) UBS ($17.8B+) Morgan Stanley ($9.4B+) … Bank of China (initial estimate $223 million, now could be $4-5B) Effect on baby boomers' retirement will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis: Consequence will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang

Subprime Mortgage Crisis: Delinquencies will not calculate until another chapter. Mortgage Backed Securities (MBS) Summer 07, MFIN7011, Tang