financial crisis Flashcards
issuers of structured finance instruments were eager to have their instruments rated on same scale
as regular bonds so investors subject to rating based constraints would be able to purchase securities
when examining single-name business, agencies did not have to account for
correlation as these securities were assessed independently
rating of securities is highly sensitive to estimates
of correlation coefficient
several issues with the ratings
- seems that rating agencies did not understand impact of errors in correlation assumptions on default probabilities
- many agencies assumed that housing prices would always appreciate
- there was a conflict of interest, where the issuer was party that paid for the credit rating so rating agencies had the incentive to give better ratings in order to get more business
- most investors did not independently assess level of risk, but rather relied exclusively on rating agencies
Default rates were also thought to be low because
it was assumed that housing prices would rise continuously (based on recent history).
As a result, borrowers would be able to either refinance or sell their homes for a higher price than the mortgage, reducing the risk of default
roughly % of global structured products were AAA rated
60%
compared to under 1% of corporate issues -> clear sign that the ratings may be overstated
Construction of securities from subprime mortgages
& how tranches should be prioritized
-can manufacture a range of securities with different cash flow risks, or tranches, against the portfolio of high risk subprime mortgages;
tranches should be prioritized in how they absorb losses and how they are paid from the high risk subprime mortgages
if no one defaults on the mortgages
all tranches will be paid
when monthly mortgage payments are not made
payments may not reach holders of lower rated tranches (junior tranches) since the higher rated tranches (senior tranches) are paid first
Junior tranches, being risky, will have low prices and high promised returns, while the senior tranches, being relatively safe, will have relatively higher prices and lower promised returns
Structured Finance Vehicles artificially created
a supply of credit at very low cost to the market
demand for these vehicles was very high due
to their perceived low risk (AAA rated) and attractive yields compared to similar rated investments
in order to increase the amount of credit available to homebuyers
government has created certain agencies to purchase mortgages from banks -> agencies then repackage these mortgages into mortgage backed securities
in order to be eligible to be purchased by agencies
-mortgages must meet certain size and quality requirements
role of federally sponsored agencies (Fannie/Freddie) in packaging CDOs for sale to the markets led to the assumption
of an implied federal backstop or air of legitimacy
mortgages that do not meet the requirements
are either held by issuers or directly sold in secondary markets
amount of non-conforming mortgages specifically subprime mortgages
have increased dramatically
-at same time, quality of subprime borrowers has deteriorated
reasons quality of subprime borrowers deteriorated
- ratio of mortgage values to home prices increased
- increased use of second lien loans
- increased issuance of mortgages with low/no documentation
CDOs allowed banks to be isolated from
credit risk
because they could simply transfer the credit risk of the mortgages they were writing to investors
Hence, they had incentives to reduce underwriting standards in order to generate more loans and satisfy the demand of the market
these subprime residential mortgage backed securities were often repackaged
into collateralized mortgage obligations which were essentially CDO^2
several properties of these CMOs were biased
against the investors
reasons CMOs were biased against investors
- higher probability of default due to lower credit quality of borrowers
- lower recovery values because when assets do need to be sold, they are often sold under financial pressure
- high level of default correlation due to pooling mortgages from similar geographic areas/vintages
- due to CDO^2 structure, impact of errors in estimates is magnified
when the housing bubble burst
home prices decreased and many owners defaulted
- when subprime mortgages began to default in large numbers, value of these securities plummeted
- junior and mezzanine tranches to default, but losses also made their way to senior tranches that were perceived to be risk free & high credit ratings
when housing bubble burst, tranches had their credit ratings
downgraded which led to mark to market losses. They were often used as collateral, so calls for more collateral were made to compensate for the decreased value.
-At this point, funding in the market was scarce as banks got caught warehousing subprime mortgages to be repackaged, but there was no longer a market for them. A liquidity crisis ensued. A fire sale of assets was necessary in order to meet collateral requirements
authors believe market for structured credit
will not return to its prior size
in future, investors
will be reluctant to invest in these complicated securities which they do not fully comprehend
- investors now know that structure of CMOs was biased against them
- investors lost a lot of money, and are now suspicious of structured finance products, and have less faith in the agency ratings
credit rating process should improve to better reflect
the parameter and model uncertainty -> portion of securities that are AAA rated will decrease dramatically
investors will need to be able to better distinguish difference in types of risk between single-name and structured securities
risk from structured securities is comprised of almost all systematic risk and therefore they should demand a premium
