Laurent E. Calvet firstname.lastname@example.org
John Lewis email@example.com
Topic 8 - The Financial Crisis
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A swap is an agreement to exchange cash flows at
specified future times according to a prearranged
Usually, the cash flows involve the future value of
an interest rate, an exchange rate, a commodity price
or other market variable.
A forward contract can be viewed as a simple
example of a swap.
Forward: exchange of cash flows on a future date.
Swap: typically involves cash flows on several future dates.
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• In practice, it is unlikely that two companies will
contact a financial institution at the same time
to take opposite positions in exactly the same swap.
• For this reason, many large financial institutions act as
market makers for swaps
They are prepared to enter into a swap without having
an offsetting swap with another counterparty.
• Market makers must carefully quantify and hedge the risks
they are taking.
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Credit default swap
Provides insurance against the risk of default by a particular
The company is known as the reference entity, and
a default as a credit event.
The buyer has the right to sell bonds issued by the company
for their face value when a credit event occurs. The total face
value of the bonds that can be sold is known as the credit
default swap’s notional principal.
The buyer of the CDS makes periodic payments to the seller
until the end of the life of the CDS or a credit event occurs.
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credit default swap
Payment if default
by reference entity
protection buyer protection seller
90 basis points
• Example: Notional principal is $100 million.
The protection buyer pays $900,000 per year.
• CDS spread = total amount paid per year,
as a fraction of the notional principal.
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in case of default
• If the contract specifies physical settlement,
the protection buyer has the right to sell bonds
issued by the reference entity at their face value.
• If the contract requires cash settlement,
the protection buyer will receive the difference
between the face value and the market price
of the bonds.
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A CDS can be used to hedge the default risk of
a corporate bond.
Consider the following position:
• Long 1 corporate bond
• Long 1 CDS
The position is (approximately) equivalent to
holding a risk-free bond.
Hence the CDS spread is approximately:
(yield on an n-year corporate bond)
- (yield of an n-year risk-free bond).
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Reallocation of risk
Traditionally banks have been in the business of
making loans and then bearing the credit risk that
the borrower will default.
Since the mid-1990’s, banks have shifted
the credit risk in their loans to other institutions.
Banks have been net buyers of credit protection,
while insurance companies have been net sellers.
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• In September 2008, AIG was on the verge of
bankruptcy due to large CDS losses.
• AIG was taken over by the U.S. government and
received an $85 billion loan from the Fed.
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2 - Mortgages
A mortgage is a loan secured by the collateral of a
real estate property, which obliges the borrower to
make a predetermined series of payments.
The mortgage gives the lender the right to foreclose
on the property if the borrower defaults.
We can distinguish between residential (houses,
condominiums …) and non-residential (commercial,
farm properties …) mortgages
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Mortgages also differ in terms of payment schedule.
• Level-payment fixed-rate: the same amount is paid
each month with interest calculated through a fixed
• Adjustable-rate mortgage (ARM): the contract rate
is adjusted periodically in accordance with some
chosen reference rate (inflation, prime rate …).
• Hybrids: initially fixed rate and then adjustable.
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Each month, the borrower pays a fixed amount,
which includes both interest and principal payment.
The monthly payment MP can be derived from the
MP = −T
1 − (1 + i )
where FV0 is the initial balance (amount borrowed),
i is the mortgage rate divided by 12,
T is the number of months to maturity.
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Interest payment = monthly mortgage rate i times
the outstanding mortgage balance.
Principal payment is the residual of the monthly
payment minus the interest payment. It is subtracted
from the initial mortgage balance to obtain the next
month mortgage balance.
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Consider a 20-year, level-payment $200,000 mortgage.
Fixed annual rate of 5%
The monthly payment is $1,319.91.
Month MB MP Interest Principal
1 200,000 1,319.91 833.33 486.58
2 199,513 1,319.91 831.31 488.61
3 199,025 1,319.91 829.27 490.64
4 198,534 1,319.91 827.23 492.69
5 198,041 1,319.91 825.17 494.74
6 197,547 1,319.91 823.11 496.80
235 7,805 1,319.91 32.52 1,287.39
236 6,518 1,319.91 27.16 1,292.75
237 5,225 1,319.91 21.77 1,298.14
238 3,927 1,319.91 16.36 1,303.55
239 2,623 1,319.91 10.93 1,308.98
240 1,314 1,319.91 5.48 1,314.43
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The main risk taken by lending institutions is
When default occurs the lender can liquidate
the collateral (house, land …) in order to
enforce the contract.
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Traditional banking model
Loans are kept on bank balance sheets
New banking model
Loans are pooled in portfolios and transferred legally to special
purpose vehicles (SPV) which collect principal and interest
payments and pass them through to investors.
Mortgage pass-through or mortgage-backed
Mortgages are collected in a pool whose shares or participation
certificates are sold to investors.
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Type of securitized mortgages
• Prime mortgages: conforming, non-conforming (jumbo)
• Subprime mortgages (lower credit worthiness)
• Alternative-A mortgages with credit worthiness in between
Prime and Subprime
• Second Liens: second mortgage on the same property
Conforming mortgages are guaranteed and serviced
by government sponsored agencies such as Freddie
Mac and Fannie Mae.
Other mortgages are passed through by SPV that
are not sponsored or guaranteed by the government.
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Claims to specific cash flows from large pools of underlying
assets. The cash flow payments are distributed to the
different tranches according to a complicated deal structure.
• Collateralized Mortgage Obligations (CMOs): based on a pool of
• Collateralized Debt Obligations (CDOs) are based on a pool of
Collateralized Loan Obligations (CLOs) when loans
Collateralized Bond Obligations (CBOs) when corporate bonds.
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The tranches are designed to offer various degrees of
protection against default and prepayment risk.
Senior tranches are the first to be paid out of the pool
Junior tranches are paid only after senior tranches are
Toxic waste : lowest protection tranche usually held at
the issuing bank.
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Tranches are rated by one or several rating agencies.
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collaterized debt obligation
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Benefits of Securitization
Tranches cater to the specific needs of different investor
Risk can be spread among many market participants.
Lending institution are able to unload default risk and
therefore offer more credit, thereby inducing lower rates.
Institutional investors can access new security classes
through AAA rated tranches allowing better portfolio
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More distance between borrowers and lenders
• more difficult to evaluate the underlying credit risk;
• lower incentive to monitor the loans;
• lower credit standards.
• reduces the stability of the financial system.
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The Crisis of 2007-8
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First half of the decade
Massive origination of mortgages, CMOs, and
other structured finance products.
Riskier mortgages grew significantly, reaching
50% of total mortgage origination in 2006.
Property prices increased rapidly.
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as % of total mortgage origination
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US Real Estate Prices
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Summer 2007: Banks realize that they are exposed
to massive losses on their subprime loans and
CMO investments. Sharp increase in foreclosures.
Negative impact on balance sheets of banks.
Banks no longer trust each other. Liquidity crisis.
Central banks and governments need step in
to contain the panic.
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Global CDO issuance
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