Improved 1 32 figure 11 asset backed securities

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Unformatted text preview: articularly lower capital requirements on securitized loans, requirements • Improvement in information capabilities, • Credit enhancement provided by pool issuers has Credit improved marketability. improved 1-32 Figure 1.1 Asset-backed Securities Outstanding 1-33 Key Trends Financial Engineering Repackaging cash flows of a security to enhance Repackaging marketability (carried out by Financial Intermediaries) Financial Bundling and unbundling of cash flows o Bundling: Bundling: Combining more than one asset into a composite security, for example securities sold backed by a pool of mortgages. of o Unbundling Selling separate claims to the cash flows of one Selling security, for example a CMO security, 1-34 Computer Networks Online low cost trading Information made cheaply and widely Information available available Direct trading among investors via Direct electronic communication networks electronic 1-35 The Future Globalization will continue and investors will Globalization have far more investment opportunities than in the past in Securitization will continue to grow after the Securitization crisis crisis Continued development of derivatives and Continued exotics, more regulation for “over the counter” derivatives counter” Strong fundamental foundation of Strong understanding is critical understanding Understanding corporate finance requires Understanding understanding investments understanding 1-36 1.7 The Financial Crisis of 2008 • Changes in Housing Finance • Low interest rates and a stable economy created housing market boom, driving investors to find higher-yield investments • 1970s: Fannie Mae and Freddie Mac bundle mortgage loans into tradable pools (securitization) • Subprime loans: Loans above 80% of home value, no underwriting criteria, higher default risk 1-37 1.7 The Financial Crisis of 2008 • Mortgage Derivatives • CDOs: Consolidated default risk of loans onto one class of investor, divided payment into tranches • Ratings agencies paid by issuers; pressured to give high ratings 1-38 1.7 The Financial Crisis of 2008 • Credit Default Swaps • Insurance contract against the default of borrowers • Issuers ramped up risk to unsupportable levels • AIG sold $400 billion in CDS contracts 1-39 1.7 The Financial Crisis of 2008 • Systemic Risk • Risk of brea...
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