Tutorium 2

Question 1

Define a credit crisis

Answer 1

Sharp reduction in lending, bc. financial institutions face difficulties

Question 2

Credit crisis —> Housing sector

Answer 2

Hh. can‘t get loans –> can‘t buy houses
–> housing demand down
–> house prices down

Crisis: some borrowers might not be able to repay loans
—> have to sell their houses —> housing supply up
—> house prices down

Question 3

credit crisis —> labor market

Answer 3

Firms can‘t get loans —> stop investing and hiring

—

Question 4

Credit crisis —> public finance

Answer 4

unemployment up —> state has to pay social benefits
—> economic activity down and tax revenues down
—> uncertainty: interest rates on state debts go up
—> costs for the gov‘t up

—> Bailout of large companies
—> gov‘t has to rescue companies & economy
—> fiscal stimulus (subsidies for a new car, etc.)

Question 5

Why: long-term unemployment worse than short-term ue.

Answer 5

Short-term:
• can be beneficial for the match between firms and employees

long-term
• long-term makes it harder to find a job (skills get lost)
• expected wages down

Question 6

Definition: Recession (from NBER)

Answer 6

NBER= National Bureau of Economic Research

recession= GDP declines for at least 2 consecutive quarters

Question 7

Definition: Asset price bubble

Answer 7

Prices of an asset (houses, stocks, gold) become over-inflated and are not supported by underlying demand

Question 8

interest rate —> fundamental value of an asset

Answer 8

Negative correlation.
Interest rates tells, how much future payments are discounted. The more you discount them, the lower the fundamental value.

Question 9

r(f) = 5%
house value = 100.000 $

What is the rental revenue?

Answer 9

5% * 100.000 = 5000/year

Question 10

Definition: Asset price bubble

Answer 10

Prices of an asset (houses, stocks, gold) become over-inflated and are not supported by underlying demand

Question 11

interest rate —> fundamental value of an asset

Answer 11

Negative correlation.
Interest rates tells, how much future payments are discounted. The more you discount them, the lower the fundamental value.

Question 12

r(f) = 5%
house value = 100.000 $

What is the rental revenue?

Answer 12

5% * 100.000 = 5000/year

Question 13

rents = 3.000 / year
r(f) = 0%
house value in t(1) = 100.000$

What is the NPV?

Answer 13

(3000/1,0^1) + (100.000/1,0^1) = 103.000

Question 14

rents = 3000/year
r(f) = 3%
house value in t(1) = 100.000

What is the NPV?

Answer 14

(3000/1,03^1) + (100.000/1,03^1) = 100.000

Question 15

Bond:
T = 1
C = 10$
V = 100$
r(f) = 10%
default rate = 1%

What is the NPV?

Answer 15

NPV = (10/1,1^1) + (100/1,1^1) - 100*0,01 = 99$

Question 16

Bond:
T = 1
C = 10$
V = 100$
r(f) = 10%
default rate = 1%

—> trades at present value 99$

What is its return?

Answer 16

0,99 * (110-99) + 0,01 * (0-99) = 9,9

in %: (9,9/99) = 10%

Question 17

Mortgage backed security:
T = 1
collateralized: only interest payments can be lost

based on 2 different mortgages:
T = 1
rent = 10.000
value = 90.000
default rate = 10%
r(f) = 5% 
—> risk uncorrelated

NPV of this MBS?

Answer 17

Case Probability

no default 0,9 * 0,9 = 0,81
one default 0,9 * 0,1 = 0,09
two defaults 0,1 * 0,1 = 0,01

expected payments:

0,81 * 2 * (90.000 + 10.000) —> no default
+ 2 * 0,09 * (90.000 + 90.000 + 10.000) —> one default + one d.
+ 0,01 * 2 * 90.000 —> two defaults

= 198.000

198.000 / 1,05^1 = 189.000

Question 18

Mortgage backed security:
T = 1
collateralized: only interest payments can be lost

based on 2 different mortgages:
T = 1
rent = 10.000
value = 90.000
default rate = 10%
r(f) = 5% 
—> always default together

NPV of this MBS?

Answer 18

expected payoff:
0,9 * 200.000 + 0,1 * 180.000

= 198.000

198.000 / 1,05^1 = 189.000

Question 19

Mortgage backed security:
T = 1
collateralized: only interest payments can be lost

based on 2 different mortgages:
T = 1
rent = 10.000
value = 90.000
default rate = 10%
r(f) = 5% 

What is the probability of ending up with less money than invested?
(correlated and independent risk)

Answer 19

independent risk:

one default: 90.000 + 90.000 + 10.000 = 190.000 > 189.000
two defaults: < 189.000

—> 1%

correlated risk:

—> 10%

Question 20

How can decrease in asset prices be amplified through borrower‘s balance sheet?

Answer 20

Decline in asset prices
—> worse balance sheet
—> no chance to buy more assets
—> demand for assets down
—> asset prices decrease further

Question 21

small shock to the balance sheet of the bank —> bankrupt

Answer 21

Creditors believe, that other creditors will be worried
—> stop funding this bank
—> bankruptcy

Question 22

Definition:

The originate and distribute bank model

Answer 22

• banks do not keep the loans in their own balance sheet
—> sell them to e.g. funds
—> receive new money for new loans —> don‘t have to use own capital

• the funds package multiple loans to a portfolio, distributed by risk

Question 23

How does the originate and distribute model affect the incentive of a bank, to monitor its borrowers?

Answer 23

They have less incentives to monitor,

bc. they won‘t be affected by failures of loans they originated

Question 24

Advantages of repackaging loans into new securities

Answer 24

• enables banks to increase the diversification of portfolios
• increases capital ratio if the securities receive a good rating
• selling the securities makes new money, that can be used for safer projects —> diversification
• fit the products better to risk preferences of different investors

Question 25

2 mortgages:
each pays 100 every period
default rate = 10% 
—> new security:
junior tranche + senior tranche:
each pays 100
defaults independent

What does a risk neutral investor pay?

Answer 25

junior tranche only pays out, when no mortgages default
—> probability 90% * 90% = 81%
expected payoff: 81% * 100 = 81

Question 26

2 mortgages:
each pays 100 every period
default rate = 10% 
—> new security:
junior tranche + senior tranche:
each pays 100
—> default together

What does a risk neutral investor pay?

Answer 26

junior tranche pays out, when no mortgages default:
—> probability 90% (default together)
—> willingness to pay 90

senior tranche pays out, when no one defaults (bc. if both default, it does not pay out and they default together)
—> 90% —> willingness to pay 90

If investors think, risk is uncorrelated but they are correlated, they overpay for senior tranches and underpay for junior tranches

Question 27

2 tranches, risk is correlated.
BUT: investors think, it is uncorrelated.

Who wins, who loses?

Answer 27

investor in the junior tranche wins. his asset is less risky than he initially thought. The investor in the senior tranche loses, the security is riskier than he thought.

Question 28

How can securitization increase the leverage of a bank?

Answer 28

Securitization creates safer securities (e.g. AAA rated)
—> they have lower capital requirements
—> bank can increase its debt and thus its leverage

Question 29

Definition: overnight repo

Answer 29

Security with one-day maturity. Owner of an asset sells his asset and promises to buy it back the next day at higher price

—> equivalent to short-term securitization loans

Question 30

Pro‘s and con‘s of short-maturity financing

Answer 30

pro:
•cheaper

con:
•need to finance more often
—> higher risk that you will not be able to refinance and thus be short of funds (maybe in a crisis)

Question 31

Why did rating agencies rate structured mortgages too optimistically?

Answer 31

• get higher fees for these products and so may give better ratings to ensure, they don‘t lose the business
• mortgages defaults were historically low (bc. the lending standards were better)
• they offered consulting services together with the ratings
  —> incentives to give the grade they promised
  -they believed that mortgage defaults were independent from each other
  -high competition among rating companies —> rating shopping

Question 32

housing boom –> erosion of lending standards

Why is this not sustainable?

Answer 32

banks believe that house prices are going to keep increasing —> can recover the amount lent by selling the built house later in case of loan default

sustainablity:

mortgages with teaser rates (subprime credits with high rates): borrowers will have to pay a higher interest rate & erosion of lending standards
—> likely to default —> more houses will be foreclosed (Zwangsvollstreckung) —> housing supply increases —> prices drop

—> the housing boom is creating a behavior among bankers, that can‘t sustain the housing boom

Question 33

Bank buys:
100 assets with 80 debt and 20 equity.
Asset value drops to 90.

Banks want to keep leverage —> sell assets

Answer 33

Assets 100
Liabilities 80
Equity 20

—> Asset value decreases:
Assets 90
Liablilities 80
Equity 10

—> preserve capital ratio of 20%
sell 40 assets

Assets 50
Liablities 40
Equity 10

—> capital ratio: 10/50 = 20%

Question 34

Bank buys:
100 assets with 80 debt and 20 equity.
Asset value drops to 90.

Banks want to keep leverage —> raise equity

Answer 34

preserve capital ratio of 20% —> raise 10 equity

Assets 90+10
Liabilities 80
Equity 20

Question 35

Why do margins go up when asset prices drop?

Answer 35

asset prices drop –> higher volatility
—> investors are uncertain about the future value of the collateral (Gesamtheit)
—> lenders expect prices to further drop
—> higher margins (even though the low price could be seen as a buying opportunity)

Question 36

small shock to asset prices —> gets bigger by increasing the incentives of bankers to hoard (anhäufen) liquidity

Answer 36

bankers anticipate future difficulties to obtain funds —> hoard liquidity
—> can‘t finance other profitable projects (bc. money is saved)
—> lower demand for assets —> prices decrease