1. Lecture 24 Loan Securitization – Market Risk Chap 26, Chap 17 -19, Chap 10 1

2. You are responsible for all the material presented in class and in the book since the previous exam. This is a review of some elements of that information. It is not a comprehensive review of all the information you will be responsible for on the Exam! 2

3.  Loan Securitization  Liquidity Risk  Liability and Liquidity Management  Depository Insurance  Market Risk 3

4. Loan Securitization 4

5.  Securitization Process ◦ Vehicles: SPV, SIV, similarities/differences, Procedure Advantages & Disadvantages  Pass-Through Securities ◦ What are they, how are they created, payments, ownership  Agencies ◦ GNMA, FNMA, FHLMC – what do they do, how are they similar/different  Costs and benefits of securitization  Cash flows ◦ Payments, value, pre-payment risk  Other Securitizations ◦ CMOs, CDOs, RMBS 5

6. Bank of America purchased 6000 mortgages with an average principal of $143,000 each. BoA intends to finance the purchase by raising deposits and want to maintain its current risk profile. Currently BoA has a Tier I risk-based capital ratio of 5.8%, The Federal Reserve requires 10% of deposits to be held in reserve, and the FDIC charges 27 bps annual premium to insure deposits. Find the total regulatory tax BoA is exposed to from these mortgages. If the risk weight on residential mortgages is 50%, they currently have a 20% default rate and pay an aggregate coupon of 4.3%. 6 $119,950,020.67

7. Deutsche Bank purchases a pool of 1000 mortgages with an average principal value of $323,500 each. The mortgage pool has an aggregate mortgage coupon rate of 4.3% and the average time to maturity is 30 years. Deutsche Bank sells the pool to an SPV who collects a 38bp annual servicing fee. GNMA Charges an 18bp annual fee to insure the pass-through security payments. a) Find the aggregate monthly payment to GNMA bondholders assuming no pre-payment risk. b) Find the value of the issue after 12 years have past if a similar pool of mortgages yields a 2.3% mortgage coupon 7 $1,496,343.87

8. How much should Carlyle Capital expect to get for the sale of a newly originated GNMA securitization with $703M of residential mortgage principal. The pool of mortgages has 30 years left to maturity. Currently, a 30-year Treasury note with face value of $1,000 sells for $98.23. A 30-year BBB rated corporate bond with $1,000 sells for $56.23 and the OAS for a 30-year GNMA pass-through bond is $0.002 per dollar of face value. 8 $67,649,690.00

9. UBS originates a CMO backed by interest only GNMA bonds with $20M of Class A principal, $150M of Class B principal and $200M of Class C principal. The Class A, Class B and Class C bonds pay an annual coupon of 12%, 5% and 3% respectively. Find the payments to the Class A, B and C bond holders at the end of month 3 if: (assume all payments are made in arrears) a) $5M of principal is pre-paid each month b) $5M of residential mortgage principal defaults each month c) $5M is prepaid each month but $500,000 of the interest payment is delinquent in month 3 9 A)Class A = 5,100,000 Class B = 625,000 Class C = 500,000 B.No Change C.No Change

10. 1. Regulatory tax – cost of holding mortgages on balance sheet 2. Pass Though bond payments – No prepayment risk a) No Fees b) With GNMA & Servicing Fees 3. Pass Through bond value – No prepayment risk 4. Pass through bond payments – with prepayment risk (interest only) 5. Option Adjusted Spread (OAS) 6. CMO Payments – interest only loan pool 10

11. Liquidity Risk 11

12.  Types of liquidity ◦ Asset-side Liquidity ◦ Liability-side Liquidity  Managing Liquidity ◦ Stored Liquidity – sell assets ◦ Purchased Liquidity – borrow funds  Measuring Liquidity 12

13. Suppose a customer of a bank takes down $100 million of a loan commitment. How would the banks balance sheet, shown below, change if the DI: (i) Uses stored liquidity to meet its commitment (ii) Uses purchased liquidity to meet its commitment Assets Liabilities and Equity Cash$50Deposits$168 Loans50Borrowed Funds125 Marketable Securities200 Equity7 Total assets$300Total liabilities and equity$300 13 (i)Cash = 0, Loans = 150, MS = 150 (ii)Loans = 150, Borrowed = 225

14. Suppose a bank with the following balance sheet experiences a $100 million net deposit drain, how would the balance sheet change if the DI: (i) Uses stored liquidity to meet its commitment (ii) Uses purchased liquidity to meet its commitment Assets Liabilities and Equity Cash$50Deposits$168 Loans50Borrowed Funds125 Securities200 Equity7 Total assets$300Total liabilities and equity$300 14 (i)Cash = 0, MS = 150, Deposits = 68 (ii)Deposits = 68 Borrowed = 225

15. 1. Sources and uses of liquidity 2. Peer Group Comparison 3. Liquidity Index 15

16. Example: use the following ratios to determine which bank is more exposed to liquidity risk (from external markets) Bank ABank B Borrowed funds to Total assets31.22%21.43% Core deposits to total assets26.28%45.82% Loans to deposits22.63%15.23% Loan Commitments to total assets19.87%17.52% 16

17. The table shows estimates of fundamental asset value and the value that could be recovered for immediate sale. Use this information to calculate the liquidity index of the bank. AssetFace ValueTrue ValueMarket collapse T-Bill10M$9 C&I144M$8.5$3.5 Real Estate360M$58$10 17 L=25.6%

18. 1. Asset/Liability side liquidity risk management 2. Peer Group Comparison 3. Liquidity Index 18

19. Liquidity & Liability Management 19

20.  Costs and benefits of regulating reserve requirements  Monetary policy and RR  Costs and benefits of holding liquid vs illiquid assets  Calculating reserve requirements  Managing & manipulating reserve requirements 20

21. Example: Over the period from February 14-27 a bank has:  Cumulative transaction account balance of $12,430M  They are owed 800M from other US DIs (cumulative)  They have $500M of cash in the process of being delivered (cumulative)  Cumulative vault cash of $200M. (i) Calculate the reserve requirement to be maintained at the fed 21 Total = 76.083M At the Fed = 61.793M

22. 1. Find computation & maintenance period 2. Calculate Reserve Requirements ◦ Total ◦ At the Fed ◦ In the vault 3. Over/under shoot reserve requirements & carry forwards 22

23. Deposit Insurance 23

24.  Depository Insurance history and structure ◦ Agencies, Limits, Structure  Purpose of depository insurance  Costs and benefits of depository insurance  Problems and proposed solutions with depository insurance 24

25. 25 By how much will the premium for depository insurance change if the bank is forced to write down a loss of $15M on its mortgage portfolio. The Bank is classified as supervisory concerned Assets Liabilities & Equity Cash37Deposits458 Mortgages245Short-term borrowing135 Consumer loans145Perpetual preferred stock (Qualified)3 C&I Loans164Common stock15 Securities40 Retained earnings20 631 Change = 1,099,200-137,400=961,800

26. 26 Total risk based capital ratio ≥ 10% and Tier I risk-based capital ratio ≥ 6% and Tier I Leverage ratio ≥ 5% Total risk-based capital ratio ≥ 8% and Tier I risk-based capital ratio ≥ 4% and Tier I Leverage ratio ≥ 4%

27. First Boston Bank has total assets of $398M total deposits of $345M all of which are insured. They have estimated the volatility of returns on assets to be 0.12 pa. Suppose the one-year risk free rate is 1.6%. Find the depository insurance premium that First Boston should be charged. 27 P(t) = 1,890,183.46

28. Find Φ(X 1 ) = -1.38 on the table: 1.0000 - 0.9162 0.0838

29. Find Φ(X 2 ) = -1.26 on the table: 1.0000 - 0.8962 0.1038

30. 1. Find the deposit insurance premium using the table 2. Find the deposit insurance premium using options pricing 30

31. Market Risk 31

32.  RiskMetrics – Variance Covariance  Estimates the risk of individual trading books using VaR  Combines the risk of all trading books accounting for diversification  Produces a daily earnings at risk (DEAR) that estimates the potential loss from the full trading book that occurs with a certain probability (1%, 5%...) 32

33. Example: Calculate the 99% DEAR for a bank with: (i) a $5M equity portfolio with beta equal to.8 (ii) a BBB portfolio of zero coupon bonds with maturity of 12.5 years, total face value of $20M and average YTM of 10.2%. Assume that the daily expected return and volatility of the market are 0.00012 and 0.0005 respectively. The risk free rate is 0.00001 per day. The mean and standard deviation of the daily changes in the yield on BBB bonds is 0.00 and 0.00082 respectively. Assume that the correlation between YTM changes and market returns is.23 33 128,253.05

34. 1. Calculate DEAR 34

35. More Examples 35

36. Securitization 36

37. Allied Bank originates a GNMA securitization backed by $12M in residential mortgage principal. The pool of mortgages generates a 4.1% aggregate mortgage coupon pa. Find the interest payment to GNMA bond holders, the SPV and GNMA after the 4 th month. The servicing fee is 28bp pa. and GNMA insurance costs 14bp pa. Assume 325% PSA. 37 Service fee = 2,692.10 GNMA insurance = 1,346.05 Bond Holders = 35,381.84

38. IDBI Money Market Mutual fund purchased a newly originated GNMA pass-through bond 7 years ago. The bond pays $1.2M per month. There is a 45bp annual servicing fee on the pool and GNMA insurance costs 12bps pa. The current mortgage rate is 3.9%. Find the current value of the GNMA bond if there is 23 years left to maturity. Assume no prepayment risk. 38 $231,174,604.3310