Lecture 3 + 4 Flashcards
Describe the old way (before crisis) of financing houses
Local thrift institutions made mortgage loans to homeowners. Thrift’s major asset was a portfolio of long-term mortgage loans and his main liability was deposits. ‘Originate to hold’
Describe the new way of financing houses just before the crisis.
Securitization. Fannie Mae and Freddie Mac (Investment banks) bought mortgage loans and bundled them into large pools, thereby reducing the risk due to diversification but it gave a steady stream of payment (principal and interest). Mortgage-backed securities are tradable claims against the underlying mortgage pool. ‘Originate to distribute’
Describe how a Real estate Mortgage Backed Security was built.
Large amounts of mortgage loans were bundled into one pool of mortgage loans. Every mortgage in this pool got a rating (AAA, AA, A, BBB, BB, B, Unrated). The pool of mortgages existed of different tranches (Super senior tranche, mezzanine tranche 3, mezzanine tranche 2, mezzanine tranche 1 and the equity tranche). Investors could choose in which tranche they wanted to invest in and the lower the tranche, the higher the risk but also the higher the interest.
Why increased the number of (bad) mortgages because of the RMBS?
All banks wanted to create more RMBSs because they made so much money on them. However, at a certain point the number of new, reliable mortgages stops. Therefore, banks decided to give people who actually couldn’t afford it, also mortgages with an adjustable rate. This meant that the first couple years, the interest would be very low but the last couple years very high. However, when the higher interest was about to kick in, the people just refinanced those loans with new loans. This went on and on. People who couldn’t afford mortgages suddenly had two or three or more. Check NINJA or NINA mortgages.
What is a NINJA and NINA mortgage?
‘No-Income-No-Job-or-Assets’ loan
‘No-Income-No-Assets’ loan
What did the banks do with the equity tranches that didn’t sell good?
Because the equity tranches were the most risky part of the RMBS, they didn’t sell well. Therefore, the banks created another financial product. They bundled all equity tranches in a new product, called a Collateralized Debt Obligation (CDO)
What is a CDO?
Collateralized Debt Obligation. A new financial product which is a bundle of equity tranches from RMBS. Therefore highly risky. However, these CDOs also were divided into the same tranches as a RMBS and therefore, people didn’t realize that CDOs were way riskier.
What is a CDO squared?
The equity tranches of the CDOs also didn’t sell well so were also bundled in a new product, called the CDO squared.
Why was credit risk underestimated at the time of the crisis?
No one expected the entire housing market to collapse all at once.
Geographic diversification did not reduce the risk as anticipated.
Agency problems with the rating agencies (the had no choice but to oblige the big banks)
Credit Default Swaps did not reduce risk as anticipated.
What is a CDS?
A Credit Default Swap is an insurance contract against the default of the borrower. Investors bought sub-prime loans through CDOs and used CDSs to insure their safety. A way to short the housing market. You pay premium to the insurance party as long as there is no event.
What is a synthetic CDO?
A CDO like scheme but built out of other securities such as a pool of CDSs or student loans or car loans.
Why did CDS not work as expected?
Some big swap issuers didn’t have the capital to actually back up their CDS contracts so when the market collapsed, they couldn’t meet their obligations.
What is systemic risk?
A potential breakdown of the financial system in which problems in one market spill over and disrupt others. One default may set off a chain of further defaults. Waves of selling may occur in a downward spiral as asset prices drop. Potential contagion from institution to institution and from market to market.
What is a risk in capital structure when there is a rise in systemic risk?
To be highly levered. Also, a mismatch between the maturity and liquidity of assets and liabilities can be fatal. The liabilities of banks where short and liquid while the assets were long and illiquid and therefore, there was a constant need to refinance the asset portfolio.
Describe the downfall of the economy in 2008.
From 2000 to 2006, there was a sharp increase in housing prices and that caused investors to believe that continually rising home prices would bail out poorly performing loans.
In 2004, the interest rates began rising and in 2006, the home prices peaked. In 2007, housing defaults and losses on mortgage-backed securities surged. Also, Bear Stearns announces trouble at its subprime mortgage-related hedge funds. In 2008, money market breaks down, credit market freeze up and there is federal bailout to stabilize the financial system. Troubled companies were Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, AIG
