125.

811 Advanced Risk Analytics

Week 2: Learnings from the Financial Disasters

 The Credit Crisis of 2007-2008

Chapter 6

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 U.S. Real Estate Prices, 1987 to 2017: S&P/Case-
Shiller Composite-10 Index
250.00

200.00

150.00

100.00

50.00

0.00

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 What happened…
• Starting in 2000, mortgage originators in the US relaxed
their lending standards and created large numbers of
subprime first mortgages.
• This, combined with very low interest rates, increased the
demand for real estate and prices rose.
• To continue to attract first time buyers and keep prices
increasing they relaxed lending standards further
• Features of the market: 100% mortgages, ARMs, teaser
rates, NINJAs, liar loans, non-recourse borrowing

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 What happened...
• Mortgages were packaged in financial products and sold to investors
• Banks found it profitable to invest in the AAA rated tranches because
the promised return was significantly higher than the cost of funds
and capital requirements were low
• In 2007 the bubble burst. Some borrowers could not afford their
payments when the teaser rates ended. Others had negative equity
and recognized that it was optimal for them to exercise their put
options.
• U.S. real estate prices fell and products, created from the mortgages,
that were previously thought to be safe began to be viewed as risky
• There was a “flight to quality” and credit spreads increased to very
high levels

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 Securitization
• The originators of mortgages sold portfolios of mortgages to
companies (Special Purpose Vehicle – SPV) that created
products for investors from them
• This process called securitization
• A tool for transferring risk but played a part in the creation of
the housing bubble
• The most important thing for the lender: whether the mortgage
could be sold to others
• Information received by the buyers of products (backed by
mortgages): Loan-to-value (LTV) ratio and the FICO (credit) score
• Both LTV and FICO can be made nicer purposely

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 Securitization
• Research by Keys et al. (2010) “Did securitization lead to lax
screening? Evidence from subprime loans” Quarterly Journal of
Economics 125, 307-362:
• Based on data on securitized subprime mortgage loan
contracts in the US
• Findings suggest an adverse effect of securitization practice
on screening incentive of subprime mortgage originators

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 Asset Backed Securities
• Securities created from a portfolio of loans, bonds, credit card
receivables, mortgages, auto loans, aircraft leases, music
royalties, etc
• Usually the income from the assets is tranched
• A “waterfall” defines how income is first used to pay the
promised return to the senior tranche, then to the next most
senior tranche, and so on.

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 Asset Backed Security (Simplified)
ABS

Senior Tranche
Asset 1 Principal: $75 million
Asset 2 Return = 6%
Asset 3

Mezzanine Tranche
 SPV Principal:$20 million
Return = 10%
Asset n
A “waterfall” defines
Principal: Equity Tranche the precise rules for
$100 million Principal: $5 million allocating cash flows
Return =30% to tranches

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 The Waterfall

Asset
Cash
Flows

Senior
Tranche

Mezzanine Tranche

Equity Tranche

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 Collateralized Debt Obligations (CDO)
• A particular type of ABS is a collateralized debt obligations (CDO)
• A cash CDO is an ABS where the underlying assets are debt
obligations
• Back to an ABS created from subprime mortgages:
• Selling senior tranche of ABS is not difficult
• Equity tranche is normally retained by the mortgage originator or sold
a to hedge fund.
• Mezzanine trance is more difficult to sell → solution: create an ABS
from the mezzanine tranche of ABS created from subprime mortgages,
called an ABS CDO or Mezz ABS CDO
• The senior tranche of the ABS CDO is rated AAA!

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 ABS CDOs or Mezz CDOs (Simplified)
ABSs
Subprime Mortgages Senior Tranches (75%)
AAA
ABS CDO
Senior Tranche (75%)
Mezzanine Tranches (20%) AAA
BBB
Mezzanine Tranche
(20%) BBB
Equity Tranches (5%)
Not Rated
Equity Tranche (5%)

• How much of the original portfolio of subprime mortgages is rated as

AAA?
• Imagine if an ABS is created from a mezzanine tranche of the ABS
CDO? (this did happen in practice)

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 Losses to AAA Tranche of ABS CDO

Losses on Losses on Losses on Losses on Losses on

Subprime Mezzanine Equity Tranche Mezzanine Senior
portfolios Tranche of of ABS CDO Tranche of Tranche of
ABS ABS CDO ABS CDO
10% 25% 100% 100% 0%
15% 50% 100% 100% 33.3%
20% 75% 100% 100% 66.7%
25% 100% 100% 100% 100%

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 CDOs and ABS CDOs in Practice
High Grade ABS
CDO
Senior AAA 88%
Junior AAA 5%
AA 3%
A 2%
BBB 1%
ABS
AAA NR 1%
81%
AA 11%
Subprime
A 4% Mezz ABS CDO CDO of CDO
Mortgages
BBB 3% Senior AAA Senior AAA
62% 60%
BB, NR 1% Junior AAA Junior AAA
14% 27%
AA 8% AA 4%
A 6% A 3%
BBB 6% BBB 3%
NR 4% NR 2%

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 BBB Tranches
• BBB tranches of ABSs were often quite thin (1% wide)
• This means that they have a quite different loss
distribution from BBB bonds and should not be
treated as equivalent to BBB bonds
• They tend to be either safe or completely wiped out
(cliff risk)
• What does this mean for the tranches of the Mezz
ABS CDO?

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 Regulatory Arbitrage
• Capital required for securities created from a
portfolio of mortgages was considerably less than
capital that would be required if mortgages had been
kept on the balance sheet

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 Role of Incentives
• Arguably the incentives of valuers, the creators of
ABSs and ABS CDOs, and rating agencies helped to
create the crisis
• Compensation plans of traders created short-term
horizons for decision making

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 Importance of Transparency

• ABSs and ABS CDOs were complex inter-related

products
• Once the AAA rated tranches were perceived as
risky they became very difficult to trade because
investors realized they did not understand the
risks
• Other credit related products with simpler
structures (eg, credit default swaps) continued to
trade during the crisis.
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 Lessons from the Crisis
• Beware irrational exuberance
• Do not underestimate default correlations in stressed markets
• Recovery rate depends on default rate
• Compensation structures did not create the right incentives
• If a deal seems too good to be true (e.g., a AAA earning LIBOR
plus 100 bp) it probably is
• Do not rely on ratings
• Transparency is important in financial markets
• Resecuritization was a badly flawed idea

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 Practice Questions
6.1. Why did mortgage lenders frequently not check on
information in the mortgage application during the 2000 and
2007 period?

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 Practice Questions
6.1. Why did mortgage lenders frequently not check on
information in the mortgage application during the 2000 and
2007 period?

• Mortgages were frequently securitized

• The only information retained during the securitization
process was the borrower’s FICO score and LTV of the
mortgage
• The originators knew it and this is the only information they
cared about.
• Other reasons: relaxing bank lending standards.

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 Practice Questions
6.4. In what ways are the risks in the tranche of an ABS different
from the risks in a similarly rated bond?

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 Practice Questions
6.4. In what ways are the risks in the tranche of an ABS different
from the risks in a similarly rated bond?

• The probability distribution of the tranche of an ABS is very

different with that of a similarly rated bond.
• If loss occurs, there is high chance that the tranche would
experience a loss of 100%.
• This is much less likely for a similarly rated bond.

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 Practice Questions
6.5. Explain the difference between an ABS and an ABS CDO?

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 Practice Questions
6.5. Explain the difference between an ABS and an ABS CDO?

• An ABS is financial product structured as a set of tranches

created from a portfolio of loans, bonds, and so on.
• An ABS CDO is also structured as a set of tranches but it is
created from particular tranches (e.g., the BBB-rated tranches)
of a number of different ABSs.

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 Practice Questions
6.6. How were the risks in ABS CDOs misjudged by the market?

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 Practice Questions
6.6. How were the risks in ABS CDOs misjudged by the market?

• Underestimate the default correlations between mortgages in

a stressed market condition.
• Ignore the difference in probability distribution of losses
between a tranches and a similarly rated bond. The investors
inferred that the same ratings of the two is equivalent with the
same risk characteristics.
• An Irrational Exuberance behaviour that the house prices in
the U.S would not decrease.

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 Practice Questions
6.9. How is an ABS CDO created? What was the motivation to
create ABS CDOs?

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 Practice Questions
6.9. How is an ABS CDO created? What was the motivation to
create ABS CDOs?

• An ABS CDO is created from tranches of ABSs (e.g., BBB

tranches)
• Motivation: it is difficult for the mortgage originator to find
investors for the Mezzanine tranches

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 Practice Questions
6.10. How did Mian and Sufi show that mortgage lenders relaxed
their lending criteria during the 2000 to 2006 period?

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 Practice Questions
6.10. How did Mian and Sufi show that mortgage lenders relaxed
their lending criteria during the 2000 to 2006 period?

• Mian and Sufi showed that regions where mortgage

application denials were the highest in the U.S. in 1996 were
also the regions where mortgage origination grew particularly
fast during the 2000 to 2006 period.
• This research is based on the microeconomic data.

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 Practice Questions
6.12. Explain the influence of an increase in default correlation
on (a) the risks in the equity tranche of an ABS and (b) the risks in
the senior tranches of an ABS

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 Practice Questions
6.12. Explain the influence of an increase in default correlation
on (a) the risks in the equity tranche of an ABS and (b) the risks in
the senior tranches of an ABS

• As default correlation increases, the senior tranches of an ABS

becomes more risky because it is more likely to suffer losses
• The equity tranches become less risky as the default
correlation increases
• Consider if there is perfect default correlation and assuming no
recoveries: Rho =1 → all tranches have the same loss experience.
• As we move toward the perfect correlation, the tranches become
more and more similar so that the senior tranche is more risky and
the equity tranche is less risky
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