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 Mortgage backed securities  Off balance sheet securitization  Equivalent to double securitization 
 Mortgage backed securities
 Off balance sheet securitization
 Equivalent to double securitization
 Created through (a) mortgage packaging and (b) pass
throughs
through (a) mortgage packaging and (b) pass throughs • Principal Payments: – The $1.5m cash flows

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.

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

it each class does not have the same structure of payments.  Bonds collateralized by a

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.

with MBBs the relationship is one of collateralization. How it attracts different classes of investors? 

How it attracts different classes of investors?

Suppose 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

50m  Class C: Annual fixed coupon 9%, class size $50m  CMO classes  Class

CMO classes

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

retired plus any reinvestment income earned by the trust  Normally remain on the balance sheet

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

Assets

Liabilities

Collateral

$12

MBB

$10

Other Mortgages

$

8

Insured Deposits

$10

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 Disadvantage:  MBBs are tied up in the balance sheet for a long time

Disadvantage:

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

such as capital adequacy and reserve requirement  Principal Only (PO) strip: The mortgage principal

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

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 Costs 1 New funding source 1. Cost of public/private credit risk insurance and guarantees
Benefits
Costs
1 New funding source
1. Cost of public/private credit risk
insurance and guarantees
2. Increased liquidity of bank loans
2. Cost of overcollateralization
3. Enhanced ability to manage the
3. Valuation and packaging costs

duration gap (the cost of asset heterogeneity)

4. If off=balance-sheet, the issuer

on reserve requirements, deposit insurance premiums, and capital

adequacy requirements

insurance premiums, and capital adequacy requirements • Pass-through strips – Interest Only (IO) strips:

Pass-through strips

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.

is likely to shrink, which reduces the value of IO bonds.  Securitization of other assets

Securitization of other assets

CARDs (Certificates of Amortized Revolving Debts)

Various receivables, loans, junk bonds, ARMs.

Debts)  Various receivables, loans, junk bonds, ARMs. Culprit  Greedy mortgage industry  Failure by

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 CDO’s

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.

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Effects:  Contributed to the world food price crisis and increase in oil price 

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”

and put it into commodities as “stores of value” Should financial engineering take the blame? (NO.)

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.

could have prevented the subprime crisis from happening. Effect (cont.)  U.S Stock Index S&P 500

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

 Third world economies did not suffer that much  http://www.engineering.cornell.edu/news/engineeri

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/

_o

/Advantages_and_Disadvantages

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. Martin’s Press

Topper, J. (2005). Financial Engineering with Finite Elements. England: John Wiley & Sons Ltd.

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