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Chapter 6 SECURITIZATION, SHADOW-BANKING AND THE VALUE OF FINANCIAL INNOVATION.

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Presentation on theme: "Chapter 6 SECURITIZATION, SHADOW-BANKING AND THE VALUE OF FINANCIAL INNOVATION."— Presentation transcript:

1 Chapter 6 SECURITIZATION, SHADOW-BANKING AND THE VALUE OF FINANCIAL INNOVATION

2 Factors that contributed to the financial crisis Growth in foreign capitalSurplus balance of payment and increase in savings 1 Low interest ratesLow long term interest rates to stimulate investment 2 Promotion of homeownership by the federal government Homeownership - investment, source of property tax and stability 3 Deregulatory measures taken by Congress and SEC Placed some derivatives and firms beyond effective regulation 4 Growth of securitzation and subprime mortgages Securitization provided capital for on lending and “reduced risks” 5

3 Overview of the crisis Low interest rates as a result of the Federal Reserve Board efforts to keep interest rates low to stimulate investment MBS a solution for investors looking for higher interest rates and banks to release funds for on lending Sub prime loans developed without a proper regulatory environment Housing bubble burst made it difficult for borrowers to repay loans Low interest rates Demand for higher rates Financial innovations Sub prime loans Housing bubble burst

4 Securitization Securitization: the process of creating securities backed by pools of loans with similar characteristics Mortgage-backed securities (MBS) –the most prevalent type of securitized asset –more liquid than the underlying loans –MBS backed by subprime mortgages played important role in the recent economic crisis

5 The securitization process Borrowers take out loans from commercial banks or finance companies. The lenders sell their loans to the securitizer, a large financial institution. The securitizer gathers a large pool of similar loans, e.g. $100 million of subprime mortgages. The securitizer issues new securities that entitle their owners to a share of the payments the original borrowers make on the underlying loans. The securities are bought by financial institutions and traded in secondary markets.

6 Fannie and Freddie Federal National Mortgage Association (FNMA, or Fannie Mae), created in 1938 Federal Home Loan Corporation (Freddie Mac), created in 1970 both created to increase supply of mortgage loans, help more people achieve “the American dream” Fannie and Freddie are the largest securitizers of mortgages

7 Fannie and Freddie Fannie and Freddie are government sponsored enterprises (GSEs), private corporations linked to the government. –Perceived to have implicit govt backing, therefore can borrow funds at lower cost than other financial institutions can. Suffered huge losses on subprime mortgages in To prevent bankruptcy, federal government put Fannie and Freddie under conservatorship.

8 Benefits of securitization Homebuyers/borrowers –Easier to get loans, lower interest rates because securitization increases the pool of funds available for making home loans Banks –profit from selling loans for more than they lent, can use proceeds to make more loans –achieve geographic diversification: sell loans made in their community, buy MBS backed by loans throughout the country, thus protected from local shocks

9 Benefits of securitization Securitizers –Earn income from securitizing mortgages and selling MBS Buyers of MBS –get assets that are (usually) safe and very liquid

10 The subprime mortgage fiasco The housing bubble. House prices… –rose 71% during –fell 33% during Risky lending –Subprime lenders lowered standards regarding borrowers income, credit –Zero down payment loans, adjustable rate mortgages with low initial “teaser rates” –Lenders resold loans, so less concerned with default risk

11 The subprime mortgage fiasco The crash –Falling house prices put many homeowners “underwater” – market value of house less than amount owed on mortgage –Homeowners couldn’t afford payments, couldn’t borrow more –Rising delinquencies and foreclosures

12 12 CHAPTER 18 Banking

13 The subprime mortgage fiasco Consequences: huge losses for –Subprime lenders –investment banks and other institutions holding MBS Contributed to the worst recession in decades

14 The financial innovation led to the formation of non regulated intermediaries acting as banks Why it is important to define functions, instead of relying on legal/formal definitions Tucker’s definition of shadow banking system: instruments, structures, firms or markets which, alone or in combination, and to a greater or lesser extent, replicate the core features of commercial banks: liquidity services, maturity mismatch and leverage

15 Definition of Financial innovation ”Financial innovation is the act of creating and then popularizing new financial instruments, as well as new financial technologies, institutions and markets. The innovations are sometimes divided into product or process variants, with product innovations exemplified by new derivative contracts, new corporate securities or new forms of pooled investment products, and process improvements typified byn ew means of distributing securities, processing transactions or pricing transactions. In practice, even this innocuous differentiation is not clear, as process and product innovations are often linked. Innovation includes the acts of invention and diffusion, although in point of fact these two are related as most financial innovations are evolutionary adaptations of prior products.” By Source: Lerner, J. & Tufano, P. (2011) The Consequences of Financial Innovation: A Counterfactual Research Agenda. Annual Review of Financial Economics, 3, pp. 6

16 Shadow Banking system definition Buiter definition (2008) : “The shadow banking sector consists of the many highly leveraged non-deposit-taking institutions that lend long and illiquid and borrow short in markets that are liquid during normal or orderly times but can become very illiquid when markets become disorderly. They are functionally very similar to banks but : -are barely supervised or regulated. -hold very little capital, -are not subject to any meaningful prudential requirements as regards liquidity, leverage or any other feature of their assets and liabilities.”

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18 Financial Innovation Traditional “Old-School” Make & Hold Business Model: BorrowersSavers Commercial Banks Cash MortgagesBank Deposits B or ro w er s SaversSavers Investment Banks Cash Fixed Income Funds (NAV) Cash Mort- gages CB’s Money Manag- ers Cash Pools of Mortgages SIVs & CDOs “Elongated” or “New-School” Originate & Distribute Model:

19 A Basic Balance Sheet with Leverage Leverage Factor = Assets / Equity 19 Assets Debt Equity Profit / Loss on Asset Priority of Re-Payment

20 Mortgage Gives Homeowners 5x’s Leveraged Returns Return on Equity = 25% [(Return on Assets - Interest Expense) / Equity] = 25% [($ $4.00) / $20] = 25% 20 House $100 Gain on House = 9% Mortgage Debt $80 Interest Rate = 5% Equity $20

21 Mortgage Securitization Creates “MBS” and Leverage 21 Pool of Mortgage Debts Equity D D D D D D D D D D D Super Senior AAA MBS BB MBS B MBS BBB MBS AA MBS A MBS Loss Position Credit Risk Yield First Loss High Risk High Yield Last Loss Low Risk Low Yield HOME OWNERSHOME OWNERS AAA MBS

22 Collateralized Debt Obligation (“CDO”)– More Leverage 22 Pool of AA, A, BBB MBS Equity MBS Super-Senior AAA CDO B CDO Loss Position Credit Risk Yield First Loss High Risk High Yield Last Loss Low Risk Low Yield WALL ST BANKSWALL ST BANKS MBS

23 Credit Default Swaps – Infinite Leverage Like an insurance contract that pays in the event of default. FASB requires mark-to-market valuation. Collateral Call - Protection Buyers can call for partial payment if default event is likely. Determined by mark-to-market value. 23  Does not usually own reference asset  Going “long”  Benefits when reference asset price INCREASES, max at Par  Tends to own reference asset  Hedging or going “short”  Benefits when reference asset price DECREASES Protection SellerProtection Buyer Payment upon Default of Reference Asset Premium Payments Reference Asset can be a MBS, CDO, Bond, or Loan

24 Sub-prime Mortgage 20X’s Leverage 24 House $100 Mortgage Debt $95 Equity $5 Homeowner 20X’s Increasing Leverage

25 Pooled into MBS – 30X’s Leverage 25 House $100 Mortgage Debt $95 Equity $5 Mortgage Debt $95 MBS $91.8 Equity $3.2 Homeowner 20X’s Increasing Leverage Mort. Securitiz 30X’s

26 Pooled into CDO – 50X’s Leverage 26 House $100 Mortgage Debt $95 Equity $5 MBS $91.8 CDO $90.0 Equity $1.8 Mortgage Debt $95 MBS $91.8 Equity $3.2 Homeowner 20X’s Increasing Leverage Mort. Securitiz 30X’s CDO Structure 50X’s

27 CDS on CDO – Infinite Leverage 27 House $100 Mortgage Debt $95 Equity $5 MBS $91.8 CDO $90.0 Equity $1.8 CDO $90.0 CDS on CDO $90.0 Equity $0 Mortgage Debt $95 MBS $91.8 Equity $3.2 Homeowner 20X’s Increasing Leverage Mort. Securitiz 30X’s CDO Structure 50X’s Credit Default Swap ∞

28 In-Class Exercise: Compare and Contrast the Make & Hold and Originate & Distribute Models You can consider the two types of FI models and their impact on the: Speed / velocity of lending Availability of credit in the economy Bank’s credit culture Executive compensation Role of regulators Profitability, Riskiness, & Growth of FIs Future of commercial banking Discuss these issues in small groups and report back to the class. 28

29 Financial Innovation forms of financial innovation which are of concern to the prudential regulator are those which have a potential to generate large negative externalities, producing not merely redistribution of an unchanged economic cake but harmful instability in overall patterns of economic growth.

30 Essential Readings 1.SECURITISATION, SHADOW BANKING AND THE VALUE OF FINA NCIAL INNOVATION by adair turner,19TH APRIL Economics of Money,Banking and Financial Markets, 9 th Edn, Chapter 9 by Frederic.S.Mishkin 3. Financial Innovation and the Global Crisis from International Journal of Business and Management by Manuel Sánchez, 11,November 2010.


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