Fixed Income Market (3)

1
Fixed Income Market (3)

• Week 15 November 30, 2005

2
Consumer Debt

• Major household asset is housing, major
  liabilities are home mortgages
• Second most important assets are consumer durable
  goods, mainly automobiles
• Households borrow in the form of secured lending
  (e.g. installment loans for autos) and
  non-secured loans (e.g. revolving or credit-card
  loans)

3
Consumer Credit Regulation

• Truth in Lending regulated by Federal Reserve in
  Regulation Z
• Annual percentage rate (APR) includes all fees
  and points
• Usury laws have existed in the past, usually
  imposed by the states
• Community Investment Act (CRA) regulations
  require reinvestment of local funds

4
Home Financing

• Long-term government involvement, including
  establishment of federally chartered home lenders
  in the Home Owners Loan Act (1935), namely
  savings and loans
• Home have an important tax preference in tax
  deductibility of home mortgage interest
• Until 1986, all consumer credit interest was
  deductible, mortgage deduction survived

5
Additional Home Loan Subsidies

• Government guarantees like FHA-VA or GNMA
  guarantees
• Tax breaks to qualifying residential lenders
  (e.g. savings and loans)
• Sponsorship of agencies (FNMA, FHLMC, FHLB)
  reducing their cost of borrowing
• Authorization of agencies to develop active
  secondary markets in mortgages and sponsorship of
  mortgage pools

6
Housing Policy

• Commitment to home ownership
• Reduce cost of home ownership
• Subsidies
• Tax breaks
• Standardize contract designs (30-year fixed,
  variable rates, etc.) to facilitate transfers
• Connect the institutional investor market (the
  bond market) to the home mortgage market to
  increase liquidity and reduce the cost of funds

7
Mortgage Market 1970 to 2002
Source Flow of Funds
8
Pools Asset-Backed Securities

• Many small loans pooled together can be sold to
  institutional investors (mutual funds, pension
  funds)
• Each loan may prepay or default providing risks
  to investors
• Default produces losses
• Prepayments occur when rates go down
• Each event can be viewed as an option held by
  borrower (prepay is a call, default a put)

9
Pass-Through MBS Cash Flows
Mortgage Pool No Pre-Payments/No Defaults
Principal
Cash Flows
Interest
Time
Mortgage Pool Pre-Payments/No Defaults
Principal
Cash Flows
Interest
Time
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Options in Mortgages
Default option as put
Prepay option as call
Option value
Option value
Loan Balance
Home Value
Loan Balance
Mortgage Value
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Mortgage Valuation

• Mortgage is present value of mortgage payments
• Minus value of default put
• Minus value of prepay call
• Can be modelled as a two-state option (states are
  home values and interest rates) as opposed to
  stock-option single-state option (value of stock)

12
Risk and Pools and Asset-Backed

• Pooling allows diversification of default risks
• Government can eliminate default and late-payment
  risks through guarantees (e.g. GNMA
  pass-throughs)
• Private mortgage insurance (PMI) can mitigate
  default risk
• Cash flows can either be passthroughs of interest
  and principal or divided into tranches of
  interest and principal in collateralized mortgage
  obligations (CMOs)

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Payments to a CMO
PaymentIP
Principal
Interest
PaymentIP
0
30
Principal
Interest
0
30
Interest rates fall
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Cash Flows to CMO Tranches

• Example cash flows divided into three tranches
  tranche A gets all principal payments until 1/3
  of principal is paid off, C gets interest only
  until A and B principal is paid off, and B gets
  principal payments until 2/3 principal A paid
  off, C gets all cash flows after A and B paid off
• A has short-duration, C a long duration

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CMOs Cash Flows to Tranches
PaymentIP
Principal
Interest
0
PaymentIP
30
Interest rates fall
A
C
0
30
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PACs
PAC Planned Amortization Class Source FNMA
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PAC Bands (75-150)
PAC Planned Amortization Class Source FNMA
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PAC Payments

• Payments of principal paid to PAC classes as
  defined by PAC bands
• Other classes absorb differences between actual
  and payments defined by bands

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Mortgage Servicing

• Individual mortgages must be processed
• Payments credited and cleared
• Reports (e.g. monthly billings year-end tax
  statements)
• Late payments and delinquencies processed
• Defaults litigated and managed
• Master-servicers
• Payments to investors in pools with different
  tranches and risks

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Servicing Income
Servicing Fee Balance
Fees, Costs
Servicing Costs
Time
Value of mortgage servicing portfolio depends on
prepayments and defaults
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Consumer Credit

• Small transactions, heterogeneous borrowers, high
  default risk and problems with delinquency and
  monitoring
• Development of credit scoring with huge consumer
  credit data bases
• Credit bureaus and department stores
• Growth of TRW, Transunion, Equifax
• Fair-Isaac analysis (FICO)

22
Recent Developments

• Advances in computer analysis and customer
  communication
• Data warehousing and data mining
• Call service centers and other channels
• Risk-based pricing
• Credit scoring
• Regulatory encouragement/approval
• Dynamic underwriting
• Performance based fees and charges
• Feedback from the market

23
Mortgage Market Led the Way

• Selling claims on pools of consumer loans was
  fostered by government agencies in the 1970s
  creating active secondary markets
• CMOs were developed by investment banking
  industry together with government-sponsored
  agencies
• Bank of America first securitized auto loans
• Recent years have seen a major growth in
  asset-backed securities based on unsecured
  consumer credit (credit-card receivables)

24
Consumer Credit
Source Flow of Funds
25
Unsecured ABS Issuances

• To be made attractive to investors, must have
  investment-grade or higher ratings (e.g. AAA)
• Must resolve problems of lenders selling lowest
  quality credits
• Vehicle is master trust with lender keeping
  equity portion and investors lending amounts that
  are over-collateralized

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ABS Structure

• Individual loans placed in a trust
• Notes or other claims are debt obligations of the
  trust
• High-rated notes represent senior claims on cash
  flows from principal and interest into the trust
• Reserve accounts and subordination of claims of
  senior notes to residual (equity-like)
  participations retained by seller means
  effectively over-collateralized

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Asset-Backed Securities
High Risk Cash Flows (Residual)
Borrower
Loans (held in trust) (Over-Collateralized)
N/R
Borrower
Borrower
Principal Payments
Higher Risk Cash Flows From Principal
Borrower
BAA
Borrower
Interest Payments
Borrower
Low Risk Cash Flows From Interest
Borrower
AAA
Borrower
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Growth in Consumer Credit
Source Federal Reserve
29
Growth in ABS Issuances
Source Federal Reserve
30
Consumer Loan Credit Risk
Source Federal Reserve
31
Providian and Bank Risk

• Providian Financial was a 18-20 billion bank
• Very rapid growth (earnings in 2000 up 44)
• Growth came from innovation
• Specialized in unsecured lending (credit cards)
• Financed growth with securitization of
  credit-card receivables (2000 27 billion
  managed, 13 billion on balance sheet)
• Used extensive market-risk hedging
• Providian same size as SeoulBank (Korea),
  Bumiputra-Commerce (Indonesia), Dao-Heng Bank
  (Hong Kong)

32
Risk Characteristics

• Innovative lending products to untested market
  sub-prime lending
• Sophisticated approach to market
• Risk-based pricing
• Dynamic underwriting
• Extensive data analysis and control
• State-of-the-art customer management systems,
  call centers, marketing

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U.S. 2001III

• U.S experiences a slow-down or a recession
  (debate continues)
• Unemployment rates increase slightly
• Sub-prime delinquency and default increased
  sharply
• Providian experienced unexpectedly large loan
  losses and down-grades in securitized loans

34
Providian Losses

• 2001IV loss of 481 million, about 25 equity
• Stock price from 59 to 2

35
Important Implications

• Providian did not hedge credit risk as consumer
  credit-risk market not as developed as commercial
  credit risk market
• Providians risk exaggerated because of
  securitization where it retained higher risk
  tranches of cash flows and downgrades forced
  early amortization of loans
• No historical precedent

36
Trends in Credit-Risk

• Cannot rely on historical estimates of
  variability and covariability in markets
  characterized by innovation or recent emergence
• Stress tests capture the problems but management
  must imagine the unexperienced problems

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Final Exam December 7, 2005

• Examination is comprehensive with 1/3 on material
  covered before the midterm, 2/3 on material
  covered since the midterm
• Five long answer questions or problems with equal
  weight
• Questions based on weekly objectives, important
  vocabulary, in-class problems
• Suggestion Review Wall Street Journal article
  listing to identify key issues this semester