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

2. 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 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On November 12, 1999, President Bill Clinton signed into law the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act of 1933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

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

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

5. 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

6. 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

7. 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

8. 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

9. Collateralized Debt Obligations (CDO)
CDO Example
NationsBank 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

10. 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

11. 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

12. 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

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

14. Subprime Mortgage Crisis: Winners and Losers
Winners? (are you kidding me? Yes there are winners such as the first batch investors.)
Big losers:
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

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

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