Economics 434: The Theory of Financial Markets Professor Burton Fall 2016 November 22, 2016

November 22, 2016

November 22, 2016

ABS (Asset-Backed Securities) Includes a wide variety of securities: CLOs, CDOs, CMBS, and on and on (in 2007, amounted to 40 % of all non-government lending in the United States…now much less) Simple Principle Create a “pool” of cash flows Then create new securities that assigned some part of the pool’s cash flows Why? To credit different “credit” and “duration” securities November 22, 2016

A Simple One Period ABS (Asset Backed Security) with default risk The Pool: Bond A Pays $ 100,000 at end of period with 90 % probability Bond B Pays $ 100,000 at end of period with 90 % probabiilty The New Securities to Be Created From The Pool: Security 1 Pays $ 100,000 if either bond fails to default Security 2 Pays $ 100,000 if both bonds fail to default Securities 1 and 2 are examples of ABS

The riskiness of the newly created securites: 1, 2 Imagine that each bond, A and B, separately have a 10 percent chance of default. What is the probability that Security 1 defaults (that both A and B will default)? What is the probability that Security 2 defaults (that either A or B will default or both)?

What is financed by CMBS? Residential mortgages Commercial mortgages Car loans Credit card receivables Home equity loans Student loans Defaulted loans (auto, credit card, etc.) Almost anything November 22, 2016

November 22, 2016