1. Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 October 27, 2015

2. 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

3. Yield curve Junk bonds TreasuriesCorp Bonds Rates Maturities

4. Yield curve Junk bonds TreasuriesCorp Bonds Rates Maturities

5. 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 30, 2014

6. 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

7. 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)?

8. 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 81/100 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 30, 2014

9. 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 30, 2014

10. 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 30, 2014

11. 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 30, 2014

12. 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 30, 2014

13. 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 30, 2014

14. History of US ABS Issuance October 30, 2014

15. ABS Issuance in Europe October 30, 2014

16. October 27, 2015