TheCredit Crisis of2007Chapter 6RiskManagementandFinanciallnstitutions3e,Chapter6,CopyrightJohnC.Hull2012
The Credit Crisis of 2007 Chapter 6 Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 1
U.S.Real Estate Prices, 1987 to 2011:S&P/Case-ShillerComposite-10Index250.00200.00150.00100.0050.000.00Jan99Jan02Jan05Jan 11Jan87Jan90Jan93Jan96Jan082RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull2012
U.S. Real Estate Prices, 1987 to 2011: S&P/Case-Shiller Composite-10 Index Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 2
What happened...Starting in 2000, mortgage originators in the US relaxedtheir lending standards and created large numbers ofsubprime first mortgages.This, combined with very low interest rates, increasedthe demand for real estate and prices rose.To continue to attract first time buyers and keep pricesincreasing they relaxed lending standards furtherFeatures of the market: 100% mortgages, ARMs, teaserrates, NINJAs, liar loans, non-recourse borrowing3RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull 2012
What happened. ⚫ Starting in 2000, mortgage originators in the US relaxed their lending standards and created large numbers of subprime first mortgages. ⚫ This, combined with very low interest rates, increased the demand for real estate and prices rose. ⚫ To continue to attract first time buyers and keep prices increasing they relaxed lending standards further ⚫ Features of the market: 100% mortgages, ARMs, teaser rates, NINJAs, liar loans, non-recourse borrowing Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 3
What happened..Mortgages were packaged in financial products and sold to investorsBanks found it profitable to invest in the AAA rated tranchesbecause the promised return was significantly higher than the cost offunds andcapital requirementswerelowIn2oo7thebubbleburst.Someborrowerscouldnotaffordtheirpayments when the teaser rates ended. Others had negative equityandrecognizedthatitwasoptimalforthemtoexercisetheirputoptions.U.S. real estate prices fell and products, created from the mortgages,that were previously thought to be safe began to be viewed as riskyThere was a “flight to quality" and credit spreads increased to veryhigh levelsRiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull 20124
What happened. ⚫ Mortgages were packaged in financial products and sold to investors ⚫ Banks found it profitable to invest in the AAA rated tranches because the promised return was significantly higher than the cost of funds and capital requirements were low ⚫ In 2007 the bubble burst. Some borrowers could not afford their payments when the teaser rates ended. Others had negative equity and recognized that it was optimal for them to exercise their put options. ⚫ U.S. real estate prices fell and products, created from the mortgages, that were previously thought to be safe began to be viewed as risky ⚫ There was a “flight to quality” and credit spreads increased to very high levels Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 4
Asset Backed Security (Simplified)ABSSenior TrancheAsset 1Principal: $75 millionAsset 2Return=6%Asset 3Mezzanine Tranche1SPVPrincipal:$20 millionReturn=10%Asset nA"waterfall"definesEquity TranchePrincipal:thepreciserulesforPrincipal: $5 millionallocatingcashflows$100 milliontotranchesReturn =30%5RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull2012
Asset Backed Security (Simplified) A “waterfall” defines the precise rules for allocating cash flows to tranches Asset 1 Asset 2 Asset 3 Asset n Principal: $100 million SPV Senior Tranche Principal: $75 million Return = 6% Mezzanine Tranche Principal:$20 million Return = 10% Equity Tranche Principal: $5 million Return =30% Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 5 ABS
The WaterfallAssetCashFlowsSeniorTrancheMezzanineTrancheEquityTrancheRiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull20126
The Waterfall Equity Tranche Senior Tranche Mezzanine Tranche Asset Cash Flows Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 6
ABS CDOs or Mezz CDOs (Simplified)ABSsSubprime MortgagesSenior Tranches (75%)ABSCDOAAASeniorTranche (75%)AAAMezzanineTranches(20%)BBBMezzanine Tranche(20%) BBBEquityTranches(5%)NotRatedEquityTranche(5%)Howmuchoftheoriginalportfolioofsubprimemortgages is AAA?RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull20127
ABS CDOs or Mezz CDOs (Simplified) Subprime Mortgages Senior Tranches (75%) AAA Mezzanine Tranches (20%) BBB Equity Tranches (5%) Not Rated Senior Tranche (75%) AAA Mezzanine Tranche (20%) BBB Equity Tranche (5%) How much of the original portfolio of subprime mortgages is AAA? Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 7 ABSs ABS CDO
Losses to AAA Tranche of ABS CDO(Table 6.1)Losses onLosses onLosses onLosses onLosses onSubprimeEquityMezzanineSeniorMezzanineportfoliosTrancheofTrancheofTrancheofTrancheofABSABS CDOABS CDOABS CDO10%25%0%100%100%15%50%100%100%33.3%20%75%100%100%66.7%25%100%100%100%100%RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull 20128
Losses to AAA Tranche of ABS CDO (Table 6.1) Losses on Subprime portfolios Losses on Mezzanine Tranche of ABS Losses on Equity Tranche of ABS CDO Losses on Mezzanine Tranche of ABS CDO Losses on Senior Tranche of ABS CDO 10% 25% 100% 100% 0% 15% 50% 100% 100% 33.3% 20% 75% 100% 100% 66.7% 25% 100% 100% 100% 100% Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 8
A MoreRealistic Structure(Figure 6.5)HighGradeABSCDOSenior88%AAAJunior AAA5%AA3%A2%BBB1%ABSNR1%AAA81%AA11%SubprimeA4%MezzABSCDOCDOofCDOMortgagesBBB3%SeniorAAASeniorAAA62%60%BB,NR1%Junior AAAJunior AAA14%27%AAAA8%4%yA6%3%BBBBBB6%3%NRNR4%2%9RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull2012
A More Realistic Structure (Figure 6.5) Subprime Mortgages AAA AA A BBB BB, NR Senior AAA Junior AAA AA A BBB NR Senior AAA Junior AAA AA A BBB NR Senior AAA Junior AAA AA A BBB NR 81% 11% 4% 3% 1% ABS High Grade ABS CDO Mezz ABS CDO CDO of CDO 62% 14% 8% 6% 6% 4% 88% 5% 3% 2% 1% 1% 60% 27% 4% 3% 3% 2% Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 9
BBBTranchesBBB tranches of ABSs were often quite thin (1%wide)This means that they have a quite different lossdistribution from BBB bonds and should not betreated as equivalent to BBB bondsThey tend to be either safe or completely wipedout (cliff risk)What does this mean for the tranches of theMezz ABS CDO?RiskManagementandFinancialInstitutions3e,Chapter6,CopyrightJohnC.Hull 201210
BBB Tranches ⚫ BBB tranches of ABSs were often quite thin (1% wide) ⚫ This means that they have a quite different loss distribution from BBB bonds and should not be treated as equivalent to BBB bonds ⚫ They tend to be either safe or completely wiped out (cliff risk) ⚫ What does this mean for the tranches of the Mezz ABS CDO? Risk Management and Financial Institutions 3e, Chapter 6, Copyright © John C. Hull 2012 10