Financial Markets Topic 8 - The Financial Crisis

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					Financial Markets

Laurent E. Calvet
John Lewis

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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                  Market makers

• 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 Swaps

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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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              Example of
          credit default swap
                    Payment if default
                    by reference entity

     Default                                   Default
protection buyer                           protection seller
                     90 basis points
                        per year

• 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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          Hedging strategy

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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              Financial crisis

• 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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            Payment Schedules
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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    Level-Payment Fixed-Rate
Each month, the borrower pays a fixed amount,
which includes both interest and principal payment.

The monthly payment MP can be derived from the
annuity formula:
               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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   Level-Payment Fixed-Rate
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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       Payment Schedule
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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             Default Risk

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
security (MBS)
Mortgages are collected in a pool whose shares or participation
certificates are sold to investors.

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       Securitized Mortgages
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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US Mortgage-Backed

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            Finance Instruments
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
  mortgage-backed securities.

• Collateralized Debt Obligations (CDOs) are based on a pool of
  fixed-income assets.
      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
  cash flow.

  Junior tranches are paid only after senior tranches are
  paid out.

  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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       “Waterfall” of
collaterized debt obligation

                                     Toxic waste

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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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            of Securitization
More distance between borrowers and lenders
• more difficult to evaluate the underlying credit risk;
• lower incentive to monitor the loans;
• lower credit standards.

Regulatory arbitrage
• 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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    Nonconforming products
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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