CASE2SOL (1).pdf - CASE 2: The Week End That Changes Wall...

This preview shows page 1 - 3 out of 5 pages.

CASE 2: The Week End That Changes Wall StreetPART I:Testimony of Lehman Brothers CEO Richard (“Dick”) Fuld.PART II:Mortgage Back Security (MBS) MarketStep 1:Cash flows from individual mortgages are pooled into MBS;Step 2:Cash flows of the pool are tranched to produce Senior and Junior CollateralizedMortgage Obligations (CDOs). As there were some problems to find investors for theJunior tranches, these later were themselves pooled to produce new Senior and Juniortranches. These new Senior tranches were perceived very safe and received AAA ratings.Subprime mortgage market:One particular attractive market during the boom was themarket for subprime mortgages. These mortgages, targeting borrowers who weretraditionally poor credit risks, were extremely lucrative (in the shortrun) to thecompanies that issued and service these mortgage loans. Subprime mortgages chargedhigher interests on the loan, and generated larger fees than conventional mortgages.These made lenders highly motivated to originate such mortgages. In 2007, the subprimemortgage market in the US was valued at $1.2 trillion, a 600% increase from 2001, and82% of the debt was rated AAA.From 20022005, subprime mortgages had a low default rate as refinancing was easysince house prices were rising. From 20062007, no more easy financing was possible andbanks will not lend more than the market value of the house. The default rate forsubprime mortgage skyrocketed to 40%. This had two important consequences. First, theoriginal MBS appear to be riskier than expected. Securities protected against default ratein excess of 20% (seen extremely safe until 2005) began to experience losses. Second,things turned even worst for CDO securities created from Junior MBS. The safety of theSenior tranches of the CDOs relies on diversification and will be safe if no more than 20%of Junior MBS default. But almost all securities backing CDOs were running dry (low cashflows). Many of the once AAA rated securities saw their value decline to pennies on thedollar.
PART III: Case Study

Upload your study docs or become a

Course Hero member to access this document

Upload your study docs or become a

Course Hero member to access this document

End of preview. Want to read all 5 pages?

Upload your study docs or become a

Course Hero member to access this document

Term
Spring
Professor
N/A
Tags
Lehman Brothers

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture