Securitization CDO CDS Subprime Crises

8/3/2019 Securitization CDO CDS Subprime Crises

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Todays Our Team Agenda..ySecuritization

y

CDS(Credit default Swaps)yCDO(Credit Debt Obligation)

yLIQUIDITY


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NEED FOR SECURITIZATIONy Provides a potential platform for the small investor

y To raise funds when other sources of funds are unavailable

y It gives an opportunity of investors to go with theirrequirement as per their subjective risk preferences.

y It also reduces the risk of the system .


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Types of securitization

y Mortgage Backed Securities (MBS)

y Asset backed securities (ABS)


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yMortgage Backed Securities (MBS)

A type of asset-backed security that is secured by a mortgage orcollection of mortgages

These securities must also be grouped in one of the toptwo ratings as determined by a accredited credit rating agency,and usually pay periodic payments that are similar to couponpayments. Furthermore, the mortgage must have originatedfrom a regulated and authorized financial institution.


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yAsset backed securities (ABS)

Asset-backed securities (ABS) are bonds backed by a pool offinancial assets that cannot easily be traded in theirexisting form originator creates a pool of financial assets

and then sells these assets to a specially created investmentvehicle that issues bonds backed by those financial assets.


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Why securitize assets ?

y Efficient funding

y Lower Cost

y Alternative investor base

y Issuers credit rating becomes irrelevant

y Improving balance sheet structure

y

Improves capital utilization

y Better risk management

y Releases capital


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Benefits to investors?y Better security

y Greater moral responsibility

y Create instruments to match investment objectives

y Better and more resilient credit ratings


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Benefits to InvestoryEnjoys low cost operations and

servicing due to economies of scale ofthe originator

yCredit risk is minimized

yExposure on rated, low-risk housingloans

yExpertise of originators helpsmaintain quality of underlying assets

yCredit enhancement possible


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Benefits to Originatory Off balance sheet financing

y Regulatory capital relief

y Improvement of RoCE

y Multiple alternative sources of funding

y Conversion of illiquid assets into liquidsecurities

y Systemically solves ALM problems in thesector - mismatch due to difference in tenorand characteristics of assets (mostly fixed rateand up to 30 years) and liabilities


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Features of securitization

Securitization is necessary to

the economy similar to

organized markets.


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1. Creation of markets in financial claims:

Securitization makes financial markets more efficient,by reducing transaction costs.


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2. Spread ofholding of financial assets:

Intent of securitization is to spread financial assets amidstas many savers as possible.

Recent securitization applications, viz., mortgages,receivables, etc. are, therefore, yet to become acceptable

to small investors.


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3. Risk diversification :

Securitization spreads diversified risk to a wide base of

investors, with the result that the risk inherent infinancial transactions is diffused.


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4. Promotion of savings:

Securitization makes it possible for the simple investors

to invest in direct financial claims at attractive rates.


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.

Focuses on use of resources, and not their

ownership:

The property is diffused over investors. In this sense,securitization process assumes the role of a trustee of

resources and not the owner.


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Insurance


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To Explainjin(Investor)

Sam(Insurer)AIG

BuysFerrari

Go to sham forinsurance of Ferrari

Pays premium


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To Explainjin(Investor)

Sam(Insurer)AIG

jin buys bonds of GMWorth $5M

jin go to sam for insuranceof his bond risk

Pay premium $100k annually

Collateral$500k

Period = 5 yrs


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Collateral$500k

Collateral$500k

Collateral$500k

Collateral

$500k

Collateral

$500kCollateral$500k

Collateral$500k

Collateral$500k


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y Now GM starts looking

risky and it seems that itcan go down.


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AAA

BBB

Sam

(Insurer)AIG


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Sam your rating go down and my

investment got risky so I dont trustyou anymore and I want assurance

so I want more collateral.

Sam(Insurer)AIG

Collateral$500k

+Collateral$1m


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BBB

BB

Sam

(Insurer)AIG


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GM default


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Now jin will go and sell of his bonds

Now jin sells the bond and get $2m

Jin buy bonds= $5mJin sell bonds= $2m________________________Loss = $3m

Sam(Insurer)AIG

Now AIG will pay$3m


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Collateral Debt Obligation


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What is a CDO?

CDO is a security backed by adiversified pool of one or morekinds of debt obligations.

Party initiating a CDO is called asponsor (e.g. financial institutions,banks).

Sponsor creates a Special PurposeVehicle (SPV) to isolate CDOinvestors from the credit risk of theunderlying assets.

SPV transfers the credit risk byissuing debt obligations (tranches).

interest

Proceeds

ManagementFees


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Tranche investors have the ultimate credit risk

exposure to the underlying reference entities.

interest

Proceeds

ManagementFees

interest

Proceeds

AAA Tranche

AA Tranche

A Tranche

BBB - BBTranche

Equity Tranche

Proceeds

Residual


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Types of CDOs


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Cash CDOCash CDOy Involve a portfolio of cash assets (corporate bonds)y Ownership of assets is transferred to SPV, issuing the tranches

y Risk of loss of assets is divided among tranches in reverse order ofseniority

Security 1

Security 2

Security 3

SecurityN

SPE

Senior Tranches

MezzanineTranches

JuniorTranches

Cash

Return

Cash

Return


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Synthetic CDOSynthetic CDOy Do not own cash assets

These CDOs gain exposure to the assets through CDS.Protection seller - CDO

Security 1

Security 2

Security 3

SecurityN

SPE

Senior Tranches

Mezzanine

Tranches

Junior

Tranches

PaymentIf Default

Return

Cash

Return

High QualityAssets

Investments

SwapPremium


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Hybrid CDOSecurity 1

Security 2

Security 3

SecurityN

SPE

Senior Tranches

MezzanineTranches

JuniorTranches

PaymentIf Default

Return

Interest

Premium

High QualityAssets

Investments

Swap

Premium

Cash Reserve


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Arbitrage of a CDOy Excess spread key consideration in structuring of the

CDO during underwriting process.

Excess spread = yield - interest payable to eachtranche management fees


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skew


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How Access Liquidity In Market.y CDS

y CDO

y

MBSy Secondary Mortgage markets


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CDS


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Secondary Mortgage marketsy The secondary mortgage market allows banks to sellmortgages, giving them new funds to offer moremortgages to new borrowers.

y If banks had to keep these mortgages the full 15 or 30

years, they would soon use up all their funds, andpotential homebuyers would have a more difficult timeto find mortgage lenders.

Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html


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Possible inter linkage in the US subprime mortgage market

Source: http://www.norges-bank.no/templates/article____66901.aspx


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Whats wrong?y Too many people bought too many home that they couldnt afford.

y Now those people are being foreclosed.y That is causing housing prices to fall,y which in turn in decreasing consumer confidence,y which in turn in decreasing consumer spending,y which in turn is causing a recession,y which in turn is causing layoffs,y which in turn is reducing consumer spending,y

which in turn is causing layoffs,y which in turn is causing people to lose their homes to foreclosure,y which in turn is causing housing prices to fall,y which in turn is causing builders to stop building,y which in turn is causing a downward spiraly Go to the top of the list and repeat


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y What is Subprimey Subprime is a financial term used to identify borrowers who dont qualify

for a prime loan.

y How do financial institutions distinguish between prime andsubprime?y If you have a credit score below 620, you are a subprime borrower.

y

So whats a prime loan?y A prime loan is a loan that charges the prime interest rate, also known as

the prime rate. Typically the prime rate is the interest rate charged tofinancial institutions best, most credit-worthy customers..

y So what can you expect if you are a subprime borrower?y You can expect to pay a higher interest rate and higher fees for a loan.


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US ECONOMY?

y The "Subprime crises" deals mainly with theproblems of Mortgages in USA. Over the past fewyears,many reputed Banks,including CITIBANK

freely lended cash for people in USA to buyhouses,but the prices of the Homes crashed andthose property got devalued causing enormousloss to the Banks. This situation became to beknown as "Subprime Crises" where US Banks lost

Billions of Dollars.


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IN THE END

$Its all

about money.

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Securitization CDO CDS Subprime Crises

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