1. ABSs, CDOs, and the Credit Crunch of 2007
Chapter 16
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

2. U.S. Real Estate Prices, 1987 to 2008: S&P/Case-Shiller Composite-10 Index
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

3. 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 2e, Chapter 16, Copyright © John C. Hull 2009

4. 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 2e, Chapter 16, Copyright © John C. Hull 2009

5. Asset Backed Security (Simplified)
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%
A “waterfall” defines the precise rules for allocating cash flows to tranches
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

6. The Waterfall Asset Cash Flows Senior Tranche Mezzanine Tranche
Equity Tranche
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

7. ABS CDOs or Mezz CDOs (Simplified)
Subprime Mortgages
Senior Tranche (75%)
AAA
Mezzanine Tranche (20%)
BBB
Equity Tranche (5%)
Not Rated
Mezzanine Tranche (20%) BBB
How much of the original portfolio of subprime mortgages is AAA?
The mezzanine tranche is repackaged with other mezzanine tranches
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

8. Losses to AAA Tranche of ABS CDO
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% 0%
15%
50%
33.3%
20%
75%
66.7%
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

9. A More Realistic Structure
Subprime Mortgages
AAA AA A
BBB
BB, NR
Senior AAA
Junior AAA NR
81%
11% 4% 3% 1%
ABS
High Grade ABS CDO
Mezz ABS CDO
CDO of CDO
62%
14% 8% 6%
88% 5% 2%
60%
27%
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

10. Key Mistakes Made By the Market
Assumption that factors are normally distributed. (This is equivalent to assuming that the probability distribution of the default rate has thin tails)
Assumption that a BBB tranche is like a BBB bond
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

11. Need to Align Interests of Originators and Investors
There is evidence that mortgage originators used lax lending standards because they knew loans would be securitized
For a rebirth of securitization it is necessary to align the interests of originators and investors
My suggestion: when credit risk is being transferred originators should be required keep some percentage (say 20%) of each instrument created
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

12. Role of Compensation Plans
Short term compensation (the end-of-year bonus) is the most important part of the compensation for many employees of financial institutions
This creates short term horizons for decision making
Bonuses should be based on performance over a longer period than one year (e.g., 5 years)
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

13. Transparency ABSs and ABS CDOs were complex inter-related products
Once the AAA rated tranches were perceived as risky they became very difficult to trade because investors realized they did not understand the risks
Arguably the onus should be on the creators of the products to provide a way for potential purchasers to assess the risks (e.g., by providing software)
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

14. Need for Models
Most financial institutions did not have models to value the tranches they traded (It appears that they did not follow their own procedures on this)
ABS CDOs have the same structure as CDO squareds which synthetic CDO traders find difficult to value
Without a valuation model risk management is virtually impossible
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

15. More Emphasis on Stress Testing
We need more emphasis on stress testing and managerial judgement; less on the mechanistic application of VaR models (particularly when times are good)
Senior management must be involved in the development of stress test scenarios
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

16. Synthetic CDOs
Instead of creating an ABS from corporate bonds it can be created from CDSs
This is referred to as a synthetic CDO
Tranche 1 might be responsible for the first $5 million of losses
Tranche 2 might be responsible for the next $20 million of losses
And so on
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

17. Standard Tranches of Standard Portfolios
The 125 company iTraxx portfolio
Tranches are responsible for losses in the range 0 to 3%, 3% to 6%, 6% to 9%, 9% to 12%, 12% to 22%, and 22% to 100%
The 125 company CDX IG portfolio
Tranches are responsible for losses in the range 0 to 3%, 3% to 7%, 7% to 10%, 10% to 15%, 15% to 30%, and 30% to 100%
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

18. Mid-Market Quotes for iTraxx
Tranche
0-3%
3-6%
6-9%
9-12%
12-22%
Index
Jan 31, 2007
10.34%
41.59
11.95
5.60
2.00 23
Jan 31, 2008
30.98%
316.90
212.40
140.00
73.60 77
Jan 31, 2009
64.28%
606.69
315.63
97.13
165
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009

19. Default Correlation
The Gaussian copula model is the standard model for valuing synthetic CDOs
The role of correlation is crucial
Low correlations lead to the equity tranche being risky and senior tranches being safe
High correlations lead to the equity tranche being less risky and the senior tranches being more risky
To understand this consider what happens when the correlation approaches one
Risk Management and Financial Institutions 2e, Chapter 16, Copyright © John C. Hull 2009