W7: the credit crisis

• mortgage-backed securities (MBS) were created due to fund the increased demand for residential mortgages
• mortgage-backed securities market - portfolio of mortgages were created and the cash flows generated by the portfolios were packages as securities and sold to investors
• mortgage-backed securities transfer the default risk from the bank to the investors
• tranches of asset-backed securities:

  • senior tranche
  • mezzanine tranche
  • equity tranche
• asset-backed security - portfolio of income-producing assets are sold by the originating bank to a special purpose vehicle (SPV) and the cash flows are allocated to tranches
• the senior tranche has the lowest return, while the equity tranche has the highest return
• equity tranche:

  • more likely to lose part of its principal
  • less likely to receive promised interest payments
• the waterfall:

  • principal repayments are allocated to senior tranche until its principal has been fully repaid
  • the equity tranche is first to suffer losses of principal
• ratings for tranches:

  • senior = AAA
  • mezzanine = BBB
  • equity = unrated
• CDOs - collateralised debt obligation
• as they are difficult to sell, mezzanine tranches are put into a portfolio to create the ABS CDO
• asset-backed security CDOs are more risky than asset-backed securities
• US real estate prices:

  • low interest rates contributed to increased demand for mortgages and increased house prices
  • the demand encouraged subprime mortgage lending
• subprime mortgages are mortgages considered more risky than average mortgages because the homeowner is more likely to default
• relaxation of lending standards and the growth of subprime mortgages made house purchase possible for those previously considered not creditworthy for mortgage qualification
• higher house prices meant that lending was covered by the underlying collateral → unlikely that the borrower defaulting would lead to a loss
• rising house prices made it more difficult for first-time buyers to afford a house → more relaxed lending standards
• why was the government not regulating lenders' behaviour?

  • US government were aiming to expand home ownership and wanted lenders to increase loans to low- and moderate-income people
  • applicants lied on their mortgage applications → if borrower has negative equity, optimal decision was to exchange house for outstanding mortgage principal
• many US states have non-recourse mortgages,

  • when there is default, the lender possess the house but the borrower's other assets are protected
  • borrower has free American-style put option
• losses of the credit crisis:

  • financial institutes with big positions in some tranches incurred significant losses
  • houses in foreclosure were often in poor condition and sold for a small fraction of their previous value - tranche investors incurred big losses
  • lack of lending due to mistrust from the crises
• credit crisis highlights agency costs:

  • mortgage originators aim was to originate mortgages that could be securitised
  • valuers were under pressure to provide high valuations so loan-to-value ratios looked good
  • creators of tranches found ways to achieve AAA-rated tranches using rating agency criteria
  • traders focused on the short-term bonus and not long-term problems
• aftermath of credit crisis:

  • more regulation - central clearing parties for OTC derivatives
  • bonuses are more scrutinised
  • limits to proprietary trading
  • banks are required to hold more capital and satisfy liquidity ratios