1. Economics 434: The Theory of Financial Markets
Professor Burton
Fall 2016
November 22, 2016

2. November 22, 2016

3. November 22, 2016

4. ABS (Asset-Backed Securities)
Includes a wide variety of securities: CLOs, CDOs, CMBS, and on and on (in 2007, amounted to 40 % of all non-government lending in the United States…now much less)
Simple Principle
Create a “pool” of cash flows
Then create new securities that assigned some part of the pool’s cash flows
Why? To credit different “credit” and “duration” securities
November 22, 2016

5. A Simple One Period ABS (Asset Backed Security) with default risk
The Pool:
Bond A Pays $ 100,000 at end of period
with 90 % probability
Bond B Pays $ 100,000 at end of period
with 90 % probabiilty
The New Securities to Be Created From The Pool:
Security 1 Pays $ 100,000 if either bond fails to default
Security 2 Pays $ 100,000 if both bonds fail to default
Securities 1 and 2 are examples of ABS

6. The riskiness of the newly created securites: 1, 2
Imagine that each bond, A and B, separately have a 10 percent chance
of default.
What is the probability that Security 1 defaults (that both A and B will default)?
What is the probability that Security 2 defaults (that either A or B will default
or both)?

7. What is financed by CMBS?
Residential mortgages
Commercial mortgages
Car loans
Credit card receivables
Home equity loans
Student loans
Defaulted loans (auto, credit card, etc.)
Almost anything
November 22, 2016

8. November 22, 2016