Todays Our Team Agenda ..

y Securitization y CDS(Credit default Swaps) y CDO(Credit Debt Obligation)

yLIQUIDITY

NEED FOR SECURITIZATION

y 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 their

requirement as per their subjective risk preferences. y It also reduces the risk of the system .

Types of securitization
y Mortgage Backed Securities (MBS) y Asset backed securities (ABS)

y Mortgage Backed Securities (MBS)

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

collection of mortgages
These securities must also be grouped in one of the top

two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.

y Asset backed securities (ABS)

Asset-backed securities (ABS) are bonds backed by a pool of financial assets that cannot easily be traded in their existing form originator creates a pool of financial assets and then sells these assets to a specially created investment vehicle that issues bonds backed by those financial assets.

Why securitize assets ?

y Efficient funding y Lower Cost y Alternative investor base y Issuer s credit rating becomes irrelevant y Improving balance sheet structure y Improves capital utilization y Better risk management y Releases capital

Benefits to investors?
y Better security y Greater moral responsibility y Create instruments to match investment objectives y Better and more resilient credit ratings

Benefits to Investor

y Enjoys low cost operations and

servicing due to economies of scale of the originator y Credit risk is minimized y Exposure on rated, low-risk housing loans y Expertise of originators helps maintain quality of underlying assets y Credit enhancement possible

Benefits sheetOriginator to financing y Off balance

y Regulatory capital relief y Improvement of RoCE y Multiple alternative sources of funding y Conversion of illiquid assets into liquid

securities y Systemically solves ALM problems in the sector - mismatch due to difference in tenor and characteristics of assets (mostly fixed rate and up to 30 years) and liabilities

Features of securitization

Securitization is necessary to the economy similar to organized markets.

1. Creation of markets in financial claims:

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

2. Spread of holding of financial assets:

Intent of securitization is to spread financial assets amidst as many savers as possible. Recent securitization applications, viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to small investors.

3. Risk diversification :

Securitization spreads diversified risk to a wide base of investors, with the result that the risk inherent in financial transactions is diffused.

4. Promotion of savings:

Securitization makes it possible for the simple investors to invest in direct financial claims at attractive rates.

5. Focuses on use of resources, and not ownership:

their

The property is diffused over investors. In this sense, securitization process assumes the role of a trustee of resources and not the owner.

Insurance

Tojin Explain
(Investor)
Go to sham for insurance of Ferrari Pays premium Buys Ferrar i

Sam (Insurer)AI G

Tojin Explain
(Investor)
Period = 5 yrs jin go to sam for insurance of his bond risk Pay premium $100k annually

Sam (Insurer)AI G

jin buys bonds of GM Worth $5M

Collateral $500k

Collater al $500k

Collater al $500k

Collater al $500k

Collater al $500k

Collater al $500k

Collater al $500k

Collater al $500k

Collater al $500k

y Now GM starts looking

risky and it seems that it can go down.

Sam (Insurer)AI G
AAA

BBB

Sam your rating go down and my investment got risky so I don t trust you anymore and I want assurance so I want more collateral.

Collateral $500k

+
Collateral $1m

Sam (Insurer)AI G

Collateral $500k Collateral $500k

+
Collateral $1m
Collateral $500k

+
Collateral $1m

+ +
Collateral $500k

Collateral $1m

Sam (Insurer)AI G
BBB

BB

GM default

Now jin will go and sell of his bonds

Now jin sells the bond and get $2m Sam (Insurer)AI G
Now AIG will pay $3m

Jin buy bonds= $5m Jin sell bonds= $2m ________________________ Loss = $3m

Collateral Debt Obligation

What is a CDO?
CDO is a security backed by a diversified pool of one or more kinds of debt obligations. interest Party initiating a CDO is called a sponsor (e.g. financial institutions, banks). Proceeds Sponsor creates a Special Purpose Vehicle (SPV) to isolate CDO investors from the credit risk of the underlying assets. SPV transfers the credit risk by issuing debt obligations (tranches).

Management Fees

Tranche investors have the ultimate credit risk exposure to the underlying reference entities.
interest interest AAA Tranche

Proceeds

Proceeds

AA Tranche A Tranche

Residual Proceeds Management Fees

BBB - BB Tranche Equity Tranche

Types of CDO s

Cash CDO
y 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 of

seniority

Security 1

Senior Tranches

Security 2 Cash Security 3 Return SPE Return Cash Mezzanine Tranches

Security N

Junior Tranches

Synthetic CDO
y Do not own cash assets These CDOs gain exposure to the assets through CDS. Protection seller - CDO
Security 1 High Quality Assets Return Payment If Default SPE Swap Premium Return Investments Cash Mezzanine Tranches Senior Tranches

Security 2 Security 3

Security N

Junior Tranches

Hybrid CDO
Security 1 High Quality Assets Return Payment If Default SPE Swap Premium Premium Investments Interest Mezzanine Tranches Senior Tranches Security 2 Security 3

Security N

Cash Reserve

Junior Tranches

Arbitrage of a CDO
y Excess spread

key consideration in structuring of the CDO during underwriting process. Excess spread = yield - interest payable to each tranche management fees

skew

How Access Liquidity In Market.

y CDS y CDO y MBS y Secondary Mortgage markets

CDS

Secondary Mortgage markets y The secondary mortgage market allows banks to sell
mortgages, giving them new funds to offer more mortgages 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, and potential homebuyers would have a more difficult time to find mortgage lenders.

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

Possible inter linkage in the US subprime mortgage market

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

What s wrong?
y Too many people bought too many home that they couldn t afford. y Now those people are being foreclosed.
y y y y y y y y y y y y

That is causing housing prices to fall, which in turn in decreasing consumer confidence, which in turn in decreasing consumer spending, which in turn is causing a recession, which in turn is causing layoffs, which in turn is reducing consumer spending, which in turn is causing layoffs, which in turn is causing people to lose their homes to foreclosure, which in turn is causing housing prices to fall, which in turn is causing builders to stop building, which in turn is causing a downward spiral Go to the top of the list and repeat

y What is Subprime y Subprime is a financial term used to identify borrowers who don t qualify for a prime loan. y How do financial institutions distinguish between prime and

subprime?

y If you have a credit score below 620, you are a subprime borrower.

y So what s 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 to financial 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.

US ECONOMY?
y The "Subprime crises" deals mainly with the

problems of Mortgages in USA. Over the past few years,many reputed Banks,including CITIBANK freely lended cash for people in USA to buy houses,but the prices of the Homes crashed and those property got devalued causing enormous loss to the Banks. This situation became to be known as "Subprime Crises" where US Banks lost Billions of Dollars.

IN THE END

It s all

about money.