Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 October 27-29, 2015

The Fed and “Raising Rates” “So Fed officials have devised new tools, including an overnight reverse-repo facility, under which the central bank temporarily takes in cash from a variety of lenders in exchange for government bonds offered by the Fed as collateral.” from Katy Burne’s article in Oct 27, 2015 Wall Street Journal Notice that Fed taking in cash is associated with “reverse-repo” October 27-29, 2015

Present Value is the most Crucial Concept in Finance Value of future stream of payments As valued today Emphasis on “discounting” future revenue streams Common practice to use higher rates to reflect higher uncertainty of receipt of future payments

Yield curve Junk bonds TreasuriesCorp Bonds Rates Maturities

ABS (Asset-Backed Securities) Includes a wide variety of securities: CLOs, CDOs, CMBS, and on and on (in 2007, amounted to 20 % 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 October 27-29, 2015

A Simple One Period ABS (Asset Backed Security) with default risk Bond A Pays $ 100,000 at end of period with 90 % probability Bond B Pays $ 100,000at end of period with 90 % probabiilty The Pool: 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)?

If bonds A and B are “independent” 1/10 times 1/10 = 1/100, meaning that the probability that both default is 1/100 or a one percent chance of simultaneous default – Not very likely – Get a AA rating for the first tranche (Security 1) That neither one will default: 90/100 times 90/100 or 81 percent of the time. – Pretty often (slightly more than 1/5 of the time) – Get a C rating for the second tranche (Security 2) October 27-29, 2015

But, what if the bonds are not “independent” What if their correlation is one? (Which means that either both pay off or both default, not one or the other) Then each of Security 1 and Security 2 have a 90 percent chance of paying off Both get a B- rating Compared to independence pricing – “Independence” assumption overprice Security One – “Independence” assumption underprice Security Two October 27-29, 2015

What is a CDO? Collateralized Debt Obligation Could be a pool of any group of fixed income securities or bank loans CLO is a special case of CDO: CLO is Collateralized Loan Obligation (bank loans normally, but could be car loans, etc.) October 27-29, 2015

CMBS Collateralized Mortgage-Backed Securites Commercial real estate (mostly office buildings are financed by CMBS) Typical office mortgage financing is 5 – 7 year maturites (unlike residential mortgages) October 27-29, 2015

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 October 27-29, 2015

What Else “Credit Enhancements” – Main enhancement is a CDS (credit default swap) – CDS is basically an insurance contract Normally on a debt instrument (note or bond) An act of default (not paying interest or principal) triggers the payment of CDS, insurer takes the defaulted note or bond and gives the insured the cash value as if no default) October 27-29, 2015

History of US ABS Issuance October 27-29, 2015

ABS Issuance in Europe October 27-29, 2015