Pick up their bill three factors convinced buyers of

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pick up their bill Three factors convinced buyers of senior MBS they were safe (1) the junior-senior structure (2) credit-default swaps (3) the ratings agencies gave these securities very high credit ratings
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7 Ashcraft and Schuermann (2007): Studied 4000 mortgages originated in 2006 by New Century Financial (now bankrupt) All subprime (poor income, credit rating, and/or collateral) Almost all called for borrower to increase monthly payments by 25% to 45% within 2-1/2 years 79% rated AAA 94% rated at least A $ Originator Arranger $ AAA AA or A Trust Manager Investors $ $ % % % % $ sell loan sell loan Flow chart for how mortgage securitization worked Who was willing to buy the junior tranches (“toxic waste”)? 4 Answer: Collect toxic waste in CDOs (Collateralized Debt Obligations) for retranching 1% 3% 4% 11% 81% 4% 6% 8% 14% 62% 6% MEZZANINE Other CDOs Then collect toxic tranches from CDOs in “CDOs squared” Why did the ratings agencies say these were so safe? key parameters for evaluating senior tranches are (a) default probabilities and (b) correlations lend 100 0.8 0.2 150 0 lend 100 0.8 0.2 150 0 lend 200 0.64 0.04 300 0 150 If loans are independent, probability both default is (0.2)(0.2) = 0.04 0.32 Probabilities if loans are independent
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8 lend 100 0.8 0.2 150 0 lend 100 0.8 0.2 150 0 lend 200 0.8 0.2 300 0 150 If loans are perfectly correlated, probability both default is 0.2 0.0 Probabilities if loans are perfectly correlated Ratings agencies assumed default rates and correlations would remain at their old historical levels But the magnitude of the securitization and new loans extended vastly changed the default rates and correlations When house prices were rising, default rates and correlations were low
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  • Spring '08
  • Kim
  • Economics, insurance company, risky drivers, pooling risky loans

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