financial crisis

Question 1

issuers of structured finance instruments were eager to have their instruments rated on same scale

Answer 1

as regular bonds so investors subject to rating based constraints would be able to purchase securities

Question 2

when examining single-name business, agencies did not have to account for

Answer 2

correlation as these securities were assessed independently

Question 3

rating of securities is highly sensitive to estimates

Answer 3

of correlation coefficient

Question 4

several issues with the ratings

Answer 4

1. seems that rating agencies did not understand impact of errors in correlation assumptions on default probabilities
2. many agencies assumed that housing prices would always appreciate
3. 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
4. most investors did not independently assess level of risk, but rather relied exclusively on rating agencies

Question 5

Default rates were also thought to be low because

Answer 5

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

Question 6

roughly % of global structured products were AAA rated

Answer 6

60%

compared to under 1% of corporate issues -> clear sign that the ratings may be overstated

Question 7

Construction of securities from subprime mortgages

& how tranches should be prioritized

Answer 7

-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

Question 8

if no one defaults on the mortgages

Answer 8

all tranches will be paid

Question 9

when monthly mortgage payments are not made

Answer 9

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

Question 10

Structured Finance Vehicles artificially created

Answer 10

a supply of credit at very low cost to the market

Question 11

demand for these vehicles was very high due

Answer 11

to their perceived low risk (AAA rated) and attractive yields compared to similar rated investments

Question 12

in order to increase the amount of credit available to homebuyers

Answer 12

government has created certain agencies to purchase mortgages from banks -> agencies then repackage these mortgages into mortgage backed securities

Question 13

in order to be eligible to be purchased by agencies

Answer 13

-mortgages must meet certain size and quality requirements

Question 14

role of federally sponsored agencies (Fannie/Freddie) in packaging CDOs for sale to the markets led to the assumption

Answer 14

of an implied federal backstop or air of legitimacy

Question 15

mortgages that do not meet the requirements

Answer 15

are either held by issuers or directly sold in secondary markets

Question 16

amount of non-conforming mortgages specifically subprime mortgages

Answer 16

have increased dramatically

-at same time, quality of subprime borrowers has deteriorated

Question 17

reasons quality of subprime borrowers deteriorated

Answer 17

1. ratio of mortgage values to home prices increased
2. increased use of second lien loans
3. increased issuance of mortgages with low/no documentation

Question 18

CDOs allowed banks to be isolated from

Answer 18

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

Question 19

these subprime residential mortgage backed securities were often repackaged

Answer 19

into collateralized mortgage obligations which were essentially CDO^2

Question 20

several properties of these CMOs were biased

Answer 20

against the investors

Question 21

reasons CMOs were biased against investors

Answer 21

1. higher probability of default due to lower credit quality of borrowers
2. lower recovery values because when assets do need to be sold, they are often sold under financial pressure
3. high level of default correlation due to pooling mortgages from similar geographic areas/vintages
4. due to CDO^2 structure, impact of errors in estimates is magnified

Question 22

when the housing bubble burst

Answer 22

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

Question 23

when housing bubble burst, tranches had their credit ratings

Answer 23

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

Question 24

authors believe market for structured credit

Answer 24

will not return to its prior size

Question 25

in future, investors

Answer 25

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

Question 26

credit rating process should improve to better reflect

Answer 26

the parameter and model uncertainty -> portion of securities that are AAA rated will decrease dramatically

Question 27

investors will need to be able to better distinguish difference in types of risk between single-name and structured securities

Answer 27

risk from structured securities is comprised of almost all systematic risk and therefore they should demand a premium