Of the Subprime Mess and Securitization

10th September 2007

Agenda
What is Securitization ? The US Mortgage Process The Sub-prime Story Where do credit derivatives fit in ? How bad is the problem ?

Securitization defined
Securitisation is effectively a process through which loans, receivables,and other assets are pooled. The related cash flows and economic values are employed to support payments on related securities. - Frank Fabozzi

The US Mortgage Market- Process

A mortgage broker identifies a potential borrower
Use FICO Score to determine interest rate and other pricing variables

Originator quickly transfers the loan to a subsidiary of an investment banking firm

This securitization sponsor, then transfers the loan and hundreds of others like it into a pool of loans. This pool of loans becomes its own business entity, called SPV.

The underwriter then sells securities to a variety of investors with different portfolio needs
Seller typically works closely with a credit rating agency that will rate the credit risk of each tranche. The rating agency will typically require some form of credit enhancement

The US Mortgage Market Process (contd)

The seller arranges for a servicer which corresponds with consumers, receives monthly payments, monitors collateral, and foreclosure

Pooling mortgages together and relying on a rating agency to assess the securities funded by the pool,- reliable prediction of expected returns without investigating each individual loan

Even lenders with modest capital can quickly assign their loans into a securitization conduit, and use the proceeds of the sale to make a new round of loans

Securitization of subprime mortgage loans has proven extremely adept at generating high volume.

Sub-prime Money Trail

Securitization

Players ??
The Mortgage Originator
Consist of banks, mortgage bankers and mortgage brokers. Make money through the fees that are charged to originate a mortgage and the difference between the interest rate given to a borrower and the premium a secondary market will pay for that interest rate. The Aggregator Large mortgage originators with ties to WS firms and government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac. Purchase newly originated mortgages and along with their own originations, form pools of mortgages that they either securitize into private label mortgage-backed securities

Mortgage Market

Securities Dealers
After an MBS has been formed (and sometimes before it is formed, depending upon the type of the MBS), it is sold to a securities dealer. The end goal is to sell securities to investors

Investors
Foreign governments, pension funds, insurance companies, banks, GSEs and hedge funds are all big investors in mortgages

Et tu Sub Prime ?
Credit scores ranges from 300 850 Prime: >720 Alt-A: 620-720 Sub-Prime: <620
Percenti le 2nd % of people 2 SCORE 300-499 Delinquency Rate % 87

7th
15th 27th

5
8 12 15 18 27 13

500-549
550-599 600-649 650-699 700-749 750-799 800-850

71
51 31 15 5 2 1

U.S FICO Score Distribution

100 80 60 40 20 0 30 25 20 15 10 5 0

42nd 60th 87th 100th

300-499 500-549 550-599 600-649 650-699 700-749 750-799 800-850

Delinquency Rate % % of people

So then The Obvious

Subprime lending is a rapidly growing segment of the mortgage market that expands the pool of credit to borrowers who, for a variety of reasons, would otherwise be denied credit Poor credit history is associated with substantially more delinquent payments and defaulted loans, the interest rates for subprime loans are substantially higher than those for prime loans PD is atleast 6 times higher for subprime than prime

Interest Rate & FICO Scores

ErrWhats the problem again ?

The rate of serious delinquencies corresponding to mortgages in foreclosure or with payments ninety days or more overdue rose sharply during 2006 and recently stood at about 11 percent, about double the recent low seen in mid-2005. -Ben Bernanke Subprime mortgages have been roughly accounting for more than half of the foreclosures.

ButWhy have the deliquencies risen ?

House prices have decelerated. Interest rates on both fixed- and adjustable-rate mortgage loans moved upward Some subprime borrowers with ARMs, who counted on refinancing before their payments rose, didnt have enough home equity to qualify for a new loan Regional economic problems
Some of the states with the highest delinquency and foreclosure rates are those most hard-hit by job cuts in the auto industry.

Loosened underwriting standards.

ButWhere does a CDO come in ?

An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. -Investopedia

Lets take a pause The story so far

The lenders, dont have to worry very much about the risk of default, because they rolled these mortgages into bonds called Mortgage-Backed Securities, which they then sold. They got to be off-risk within a few weeks, because by then these repackaged mortgages belonged to other financial organizations. But credit-ratings agency will only give the subprime MBS a low credit score, which means it is not considered investment grade. Investment bankers slice the MBS into several tranches. These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones by slicing up the MBS into what are called equity (high risk), mezzanine (middle risk) and the much sought-after investment grade bonds (low risk).
Higher risk equals higher returns, of course, so the equity tranche of the MBS will earn the highest profits if things go well. But if things start to go wrong, the equity is lost first, and then the mezzanine. Even then, the investment-grade bonds could still get fully paid out.

Do you know what just happened ?

The ability to borrow more prompted banks and other large investors to create collateralized debt obligations (CDO), which essentially scooped up equity and "mezzanine" (medium-to-low rated) tranches from MBSs and repackaged them yet again, this time into mezzanine CDOs. Importantly, even the investment grade AAA tranche may consist of sub prime loans because these tranches were promised the first dollars that came into the security

Mezzanine and Equity Duh ! Who wants it anyway ?

The investment bank might choose to set up a hedge fund The hedge funds objective is to trade in the high-risk equity and mezzanine CDO instruments. The hedge fund then buys the equity tranche of the CDO from the investment bank. In effect, buying from itself. Housing market goes up It gets marked up in value. Further Outside Investment comes in The hedge fund goes out to an unrelated lending bank, holding its high-performing but illiquid toxic waste in its hand, and it asks to borrow money using the waste as collateral. The lending bank has access to cheap money, and so it has the prospect of lending for spectacular profits.

So the money lent by the bank against the CDO equity goes back to the hedge fund, which buys more CDOs from the investment bank, which buys more MBS from the mortgage lender, which provides more money to subprime borrowers, who then buy more houses, pushing real-estate prices higher again. Something like this is what happened to Bear Stearns hedge funds. Its two funds were leveraged 5 times and 15 times respectively.

Impact of the meltdown on the Markets

On July 19, 2007, the DJIA hit a record high, closing above 14,000 for the first time.
By August 15, the Dow had dropped below 13,000 Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Large daily drops became common, with, for example, the KOSPI dropping about 7% in one day.

How bad is the problem ?

In his recent testimony to Congress, Bernanke estimated potential losses on sub-prime mortgages to be in the range of $50-100 billion, or less than 1% of GDP.
Viewed from this perspective, the potential losses on subprime mortgages appear to be very manageable

Despite this favorable backdrop, a further deterioration in financial market conditions cannot be overruled
the problems in residential housing are unlikely to be resolved anytime soon, and delinquency rates are likely headed higher. lack of transparency about the exposure of hedge funds and financial institutions to complex instruments such as CDOs and CLOs and asset-backed commercial paper will keep investors on edge. when markets are over-extended and correct, they rarely

The Indian side of the story

India receives sizeable FII inflows; within FIIs, we also get money from hedge funds. While it has always been difficult to quantify how much influence hedge funds have on stock markets, the fact remains that hedge funds owing to their over leveraged positions have lead to liquidity issues. The trouble starts when largesized funds (with exposure to highly leveraged sub prime markets) start liquidating their holdings in emerging markets to make good their losses in a sinking sub prime market. Whenever hedge funds start making losses, they temporarily exit from profitmaking destinations. This time round, it was more of an uninformed fear led sell off from foreign institutions.

Questions

Theres more to this game Synthetic CDOs

In some CDOs the underlying portfolio is composed of credit default swaps (CDS) rather than bonds or loans

CDS - Wazzthat ?
A CDS is a contract between two parties in which one buys credit protection from the other. In some respects, a CDS is similar to an insurance policy that covers credit risk. For example, party X might purchase protection from party Y covering the credit risk of ABC Corporation.
X is the protection buyer Y is the protection seller. X agrees to pay Y a periodic fee during the term of the contract unless and until a credit event occurs. A credit event could be ABCs bankruptcy or a default on its financial obligations.. If a credit event occurs, Y has to pay X the amount specified in the contract.