8/7/2010

Mortgage backed securities Off balance sheet securitization Equivalent to double securitization

How it attracts different classes of investors?

Suppose

Created through (a) mortgage packaging and (b) pass throughs

an investment bank buys a $150m issue of GNMAs and places them in trust as collateral. It then issues a CMO with:
Class A: Annual fixed coupon 7%, class size $50m Class B: Annual fixed coupon 8%, class size 50m Class C: Annual fixed coupon 9%, class size $50m

Principal Payments:
The $1.5m cash flows remaining will be paid to Class A holders to reduce its principal outstanding to $50m-$1.5m=$48.5m. Between 1.5 to 3 years after issue, Class A will be fully retired. The trust will continue to pay Class B and C holders the promised coupon payments of $333,333 and $375,000 monthly. Any cash flows over the promised coupons will be paid to retire Class B CMOs.

CMO

classes

Therefore, it attracts different classes of investors since it each class does not have the same structure of payments.

Class A shortest average life, min prepayment protection Class B have average prepayment protection Class C long expected duration Class Z last regular class that makes a payment to bondholders only when preceding classes have been retires Class R residual class or garbage class which gives the owner the right to any remaining collateral in the trust after all classes have been retired plus any reinvestment income earned by the trust

Bonds

collateralized by a pool of assets Differs from pass-throughs and CMOs in two key dimensions:
1. While pass-throughs and CMOs remove mortgages from balance sheets, MBBs normally remain on the balance sheet. 2. Pass-throughs and CMOs have a direct link between the cash flow on the underlying mortgages, with MBBs the relationship is one of collateralization.

Normally

remain on the balance sheet and over-collaterized to reduce funding costs.

Liabilities $12 $ 8 MBB Insured Deposits $10 $10

__________________________________________________________________ Assets Collateral Other Mortgages __________________________________________________________________

__________________________________________________________________

8/7/2010

Disadvantage:

Pass-through strips

MBBs are tied up in the balance sheet for a long time which increases illiquidity Ensure high-quality credit risk rating Regulatory requirements such as capital adequacy and reserve requirement

Interest Only (IO) strips: Whose cash flows reflect monthly interest payments received. When interest rates change, they affect the cash flows received on mortgages:

Discount Effect: As interest rates fall, the present value of any cash flows received on the strip rises, increasing the value of the IO strips. Prepayment Effect: As interest rates fall, mortgagees prepay their mortgages. The number of IO payments the investor receives is likely to shrink, which reduces the value of IO bonds.

Principal Only (PO) strip: The mortgage principal components of each monthly payment, which include the monthly amortized payment and any early prepayments.

Securitization

of other assets

CARDs (Certificates of Amortized Revolving Debts) Various receivables, loans, junk bonds, ARMs.

Discount Effect: As yields fall, the present value of any principal payments must increase and the value of the PO strip rises. Prepayment Effect: As yields fall, the mortgage holders pay off principal early. The PO bond holders received the fixed principal balance outstanding earlier than stated. This works to increase the value of the PO strip.

Benefits 1 New funding source 2. Increased liquidity of bank loans 3. Enhanced ability to manage the duration gap 4. If off=balance-sheet, the issuer on reserve requirements, deposit insurance premiums, and capital adequacy requirements

Costs 1. Cost of public/private credit risk insurance and guarantees 2. Cost of overcollateralization 3. Valuation and packaging costs (the cost of asset heterogeneity)

___________________________________________________________

Culprit Greedy mortgage industry Failure by individuals and companies to properly analyze the risks in complex credit related products such as the collateralized debt obligations or CDOs
CDO

___________________________________________________________

pool of securities often backed by mortgages, including more risky subprime loans, which are sliced into products based on their riskiness and sold to investors.

8/7/2010

Effects: Contributed to the world food price crisis and increase in oil price Financial firms around the world have written down their holdings of subprime related securities Caused panic in financial markets Encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as stores of value

Effect (cont.) U.S Stock Index S&P 500 was down 45% Housing prices had dropped The International Monetary Fund estimated that large U.S and European Banks lost more than $1 trillion from bad loans and toxic assets Toxic Assets- financial assets whose value has fallen significantly Third world economies did not suffer that much

Should financial engineering take the blame? (NO.)

A

better knowledge about the pricing of securities and risks could have prevented the subprime crisis from happening.

http://www.engineering.cornell.edu/news/engineeri ng-magazine/archives/cem-spring-2008/financial engineering.cfm http://www.wisegeek.com/what-is-financial engineering.htm http://web.mit.edu/15.407/file/Ch01.pdf cba.uah.edu/.../Advantages_and_Disadvantages_o f_Various_Hedges.doc Bansal, V., & Marshall, J. (1992). Financial Engineering: A Complete Guide to Financial Innovation. New York: New York Institute of Finance Eales, B. (2000). Financial Egineering. New York: St. Martins Press Topper, J. (2005). Financial Engineering with Finite Elements. England: John Wiley & Sons Ltd.