- NIKHIL PUNDE

ReviewStructured Finance : A sector of finance that was created

to help transfer risk using complex legal and corporate entities .

Important Features – Securitization , Tranching.

Securitization : A structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool.

Tranching : Splitting the individual securities into different slices, with each tranche having a different level of risk exposure than another .

Mortgage Backed Security : An asset backed security

or debt obligation that represents a claim on the cash flows from mortgage loans.

Important Players : Home-owners , Originator , Issuer and Investors.

Features : WAC , WAM and Pass-through Rate

Types : a) Pass-though MBS b) Collateralized Mortgage Obligation(CMO) c) Stripped MBS

• Uses : a) Enhance Liquidity. b) Replenish the Originator’s Funds. c) Efficient source of Financing.

CMOCMO is a special purpose entity that is wholly

separate from the institution(s) that create it.The entity is the legal owner of a set of

mortgages, called a pool.Investors in a CMO buy bonds issued by the

entity, and receive payments according to a defined set of rules.

Mortgages called CollateralBonds called TranchesSet of rules that dictates how money received

from the collateral will be distributed - Structure

CMOThe most basic way a mortgage loan can be transformed into

a bond suitable for purchase by an investor would simply be to "split it". For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 , 1000 dollar bonds. These bonds would have a 30 year amortization, and an interest rate of 6.00%

This format has various problems : a) Prepayment Risk b) Interest Rate Risk c) Credit Risk

• A CMO is essentially a way to create many different kinds of bonds from the same mortgage loan so as to please many different kinds of investors

TYPES OF TRANCHING :

Credit Protectiona) Credit Tranchingb)Overcollateralizationc) Excess Spread

• Prepayment Tranchinga) Sequential Tranching (or by time)b)Parallel Tranching

• Coupon Tranchinga) IO/Discount fixed rate pairb)PO/Premium fixed rate pairc) IO/PO pair

d)Floater/Inverse pair

Credit TranchingCredit losses will be absorbed by the most junior class of

bondholders.Threshold is set related to quantities of delinquencies or

defaults in the loans .

OvercollateralizationPrincipal value of the bond is less than the value of the

underlying pool of mortgages.

Excess SpreadBonds issued at a lower interest rate than the underlying

mortgages.

Sequential Tranching

All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on.

Parallel Tranching

The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgage

For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays LIBOR with a cap of 16%, the other being an inverse floater that pays a coupon of 16% minus LIBOR.

IO/Discount fixed rate pairA fixed rate CMO tranche can be further restructured in to an

Interest Only (IO) tranche and a discount coupon fixed rate tranche

For example a $100 million tranche off 6% collateral with a 6% coupon can be cut into a $100mm tranche with a 5% coupon, and a IO tranche with a notional principal of $16.666667 million and paying a 6% coupon.

PO/Premium fixed rate pairSimilarly from fixed rate CMO tranche principal can be

removed to form a Principal Only (PO) class and a premium fixed rate tranche.

Floater/Inverse pairCMO floaters have a coupon that moves in line with a given

index (usually 1 month LIBOR) plus a spread In creating a CMO floater, a CMO Inverse is generated

The construction of a floater/inverse can be seen in two

stages :

The first stage is to synthetically raise the effective coupon to the target floater cap, in the same way as done for the PO/Premium fixed rate pair. As an example using $100 million 6% collateral, targeting an 8% cap, we generate $25m of PO and $75m of Premium Fixed Rate.

The next stage is to cut up the premium coupon into a floater and inverse coupon, where the floater is a linear function of the index, with unit slope and a given offset or spread. In the example, the 8% coupon is cut into :

Floater Rate : 1 * LIBOR + 0.40% Inverse Rate : 8% - (1 * LIBOR + 0.40%) = 7.60% - 1 *

LIBOR

SUB-PRIME MORTGAGE CRISIS

The subprime mortgage crisis is an ongoing real estate crisis and financial crisis in the United States, with major adverse consequences for banks and financial markets around the globe.

The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 .

IMPORTANT CONCEPTS :

Foreclosure

Adjustable Rate Mortgage

Shadow Banking System

Credit Default Swap ( CDS)

Foreclosure

Foreclosure is the legal and professional proceeding in which a mortgagee or a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption.

The violation of the mortgage is a default in payment of a promissory note.

Adjustable Rate Mortgage

It is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices

Indices : 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London

Interbank Offered Rate (LIBOR).

ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes

Shadow Banking System

It consists of non-bank financial institutions that play an increasingly critical role in lending businesses the money necessary to operate.

Typically intermediaries between investors and borrowers.

Do not accept deposits like a depository bank and therefore are not subject to the same regulations.

E.g. Bear Stearns and Lehman Brothers

Credit Default Swap It is a swap contract in which the buyer of the CDS makes a

series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default .

The buyer of a CDS does not need to own the underlying security .

The credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded .

Background and timeline of events

CAUSESBoom and bust in the housing market

High-risk mortgage loans and lending/borrowing practices

Securitization practices

Inaccurate credit ratings

Credit default swaps

Boom and collapse of the shadow banking system

INTERESTING FACTS Between 1997 and 2006, the price of the typical American

house increased by 124%.

USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.

The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion

During 2008, the typical USA household owned 13 credit cards

Mark Pittman, one of the great financial journalists(Bloomberg News) of our time predicted this crisis in his stories and also featured prominently in a documentary about subprime mortgages, “American Casino”.

REFERENCES :

www.wikipedia.org

www.newyorkfed.org

www.garpdigitallibrary.org