Summer 07, MFIN7011, Tang

1
Subprime Mortgage Crisis
2
Subprime Mortgage Crisis The Roadmap

• Prime Rate the interest rate commercial banks
  charge their most creditworthy customers.
• Subprime loans are characterized by low
  introductory interest rates, usually for the
  first two or three years. These rates frequently
  rise rapidly in subsequent years
• Regulation change prior to 1992, only commercial
  banks offered almost exclusively fixed-rate,
  prime-market mortgages
• The subprime mortgage market has expanded
  dramatically in the US, growing at an annual rate
  of 25 per cent between 1994 and 2005, a tenfold
  increase in a decade.
• Homeownership increased 1.94 per year during
  Clinton administration, reached 67.7 in 2000.
• In 1994, fewer than five percent of mortgages in
  the US were subprime, but by 2005 nearly 20
  percent of new mortgage loans were subprime
• In the United States today, there is
  approximately 10 trillion in outstanding
  mortgages, and of these, about one-quarter are
  subprime and Alt-A loans (1980s SL crisis cost,
  by comparison, about 240 billion in today's
  dollars, blamed for the 90-91 recession)
• Interest rate rose since 2004H2, housing price
  dropped and mortgage payments increased ? default
  rate rose!

3
Subprime Mortgage Crisis
4
Subprime Mortgage Crisis
5
Collateralized Debt Obligation (CDO)

• A CDO is an asset backed security (ABS) whose
  underlying collateral is typically a portfolio of
  bonds (corporate or sovereign) or bank loans.CDO
  can be classified according to debt type
• Collateralized loan obligation (CLO)
• Collateralized bond obligations (CBO)
• Collateralized mortgage obligations (CMO)
• The first CDO was created in 1987 by the famous
  Drexel Burnham Lambert, for a 100 million loan.

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Collateralized Debt Obligation (CDO)

• A CDO cashflow structure allocates interest
  income and principal repayments from a collateral
  pool of different debt instruments to a
  prioritized collection (tranches) of CDO
  securities.
• First tranche covers x of notional and absorbs
  first x of default losses
• Second tranche covers y of notional and absorbs
  next y of default losses
• Etc.
• A tranche earns a promised yield on remaining
  principal in the tranche

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Cash CDO Structure Illustration
Tranche 1 1st 5 of loss Yield 35
Bond 1 Bond 2 Bond 3 ? Bond n Average
Yield 8.5
Tranche 2 2nd 10 of loss Yield 15
Trust
Tranche 3 3rd 10 of loss Yield 7.5
Tranche 4 Residual loss Yield 6
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Typical CDO Contractual Relationships
Ongoing Communication
Collateral Manager
Trustee
CDO Special Purpose Vehicle (SPV)
Underlying Securities (Collateral)
Hedge Provider (If Needed)
Senior Fixed/ Floating Rate Notes
Mezzanine Fixed/Floating Rate Notes
Subordinated Notes/Equity
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CDO Example
NationsBank 1997-1 CLO tranches
Obligors 2.164 billion
Interest Rate Swaps
Issuer

• 2 billion
• (AAA)

B. 43 million (A)
C. 54 million (BBB)
D. 64 million (NR)
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Single-Tranche CDO
Senior Tranche
Bond 1 Bond 2 Bond 3 ? Bond n
Selected Tranche
Trust
investors
Equity Tranche
11
CDO Squared
Senior Tranche
SelectedTranche
Equity Tranche
Senior Tranche
Senior Tranche
SelectedTranche
MezzanineTranche
Equity Tranche
Equity Tranche
Senior Tranche
SelectedTranche
Equity Tranche
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Subprime Mortgage Crisis and CDO

• CDOs are the power packs of the late housing boom
  
• Hedge funds invest in CDO tranches backed by
  residential mortgages backed securities (RMBS)
  with large portion in subprime
• CDOs have become an important part of the
  mortgage market because they buy the riskier
  parts of MBS that others don't want. The
  higher-rated portions, or tranches, of MBS are
  sold to pension funds and insurers. But if the
  riskier tranches aren't sold too, the whole deal
  is off
• Causes? Reckless lenders Greedy
  investors/borrowers
• Rating agencies are criticized. Most CDOs had A
  rating
• Effect on baby boomers' retirement

13
Subprime Mortgage Crisis Direct Causes

• Demyanyk and Van Hemert (2007)
• Higher loan-to-value mortgages from riskier
  borrowers
• Less housing price appreciation in 2006-2007
• Causes of housing bubble? (media politics)

14
Subprime Mortgage Crisis Winners and Losers

• Winners? (are you kidding me? Yes there are
  winners such as the first batch investors.)
• Big losers http//ml-implode.com/
• Bear Stearns two hedge funds (1 billion)
• Australia Basis Capital (1 billion?) Absolute
  Capital (200 million?) IKB Deutsche
  Industriebank
• May take two more years to completely resolve!
• Big losers
• Citigroup (18B)
• Merrill Lynch (11.5B)
• UBS (17.8B)
• Morgan Stanley (9.4B)
• Bank of China (initial estimate 223 million, now
  could be 4-5B)
• Effect on baby boomers' retirement

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Subprime Mortgage Crisis Consequence
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Subprime Mortgage Crisis Delinquencies