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19_subprime+criis+for+class+november+2008

19_subprime+criis+for+class+november+2008 - The Subprime...

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1 The Subprime Mortgage Crisis
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2 Main Ideas 1. Securitization a great idea 2. How the prime mortgage market works 3. How the subprime mortgage market works 3a. Pools and ratings 3b. CDS 3c. CDO 4. What a hedge fund does. 5. What went wrong 5a.Bond prices crashed, banks lost. 5b.Homeowner behavior changed. People out on streets. 5c. Homeowner behavior changed unpredictably and hedge funds lost. 6. How to save the homeowner 7. Why are things so bad for the economy? 8. The leverage cycle.
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3 1. Traditional Credit Careful screening Frequent monitoring Loan from Bank, of funds deposited Backed by Equity capital so depositors not at risk Equity capital = 5% -10%, say 7% What if required return on equity capital is 25%? Traditional loans are expensive.
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4 Equity Capital for Traditional Loans Expensive Equity investor does not know what loan will be made when he puts up the money. Loan money tied up Loans not diversified Loans bear interest rate risk and credit risk
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5 Corporate Debt Risky, if firm goes bankrupt bondholders are junior to secured lenders Takes a long time to get money after bankruptcy, even if secured.
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6 Traditional Loans still key to business ventures But replaced by securitization in mortgage markets
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7 2. History of Prime Securitizations 1970s Agencies Fannie Mae and Freddie Mac unleashed to create pools. 1980s CMOs created at First Boston and Salomon 1990s Hedge Funds
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8 Securitized Mortgages Agency $4 trillion Jumbo Prime $.8 trillion Alt-A (Near Prime) $.8 trillion Subprime $1 trillion Unsecuritized $4 trillion
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9 Prime MBS Hierarchy MORTGAGE MARKET Pass-Through Pools CMO  Collateral CMO CMO Derivative Contingent Promises Contingent Promises Investors Sells   Promise s Mortgages Sells   Promise s Mortgages CMO CMO
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10 Advantages of Securitized Loans Turned into bonds, so can be sold off at any time. Money not tied up. Diversified. Investor knows what he is getting. Adverse selection reduced. With CMOs payoffs tailored to investor needs.
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11 CMOs Divide Pools Derivative absorbs default risk and prepayment risk Floater Inverse Floater Residual + +
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12 CMO Welfare Benefits Insurance companies lose when interest rates go down – they buy inverse floaters Thrifts lose when interest rates go up – they buy floaters Neither has to worry so much about default and prepayments Mortgage rates go down again
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13 Kidder Peabody Dominated CMO market 1990-1995 Over 20% of all issuance Strategy was to line up buyer for derivative piece (or hold the piece itself), then go ahead and buy pool, before waiting to get all other pieces sold off. Kidder Peabody went out of business in 1995. From then on the critical role played by hedge fund holding riskiest piece.
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