1、Chapter 8Securitization and the Credit Crisis of 2007Options, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20141SecuritizationTraditionally banks have funded loans with depositsSecuritization is a way that loans can increase much faster than depositsOptions, Futures, and Other

2、Derivatives 9th Edition, Copyright John C. Hull 20142Asset Backed Security (Simplified) Options, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20143Asset 1Asset 2Asset 3Asset nPrincipal:$100 million SPVSenior TranchePrincipal: $80 millionReturn = LIBOR + 60bpMezzanine TranchePri

3、ncipal:$15 millionReturn = LIBOR+ 250bpEquity Tranche Principal: $5 millionReturn =LIBOR+2,000bpThe WaterfallOptions, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20144Equity TrancheSenior TrancheMezzanine TrancheAsset Cash FlowsABS CDOs or Mezz CDOs (Simplified)Options, Future

4、s, and Other Derivatives 9th Edition, Copyright John C. Hull 20145AssetsSenior Tranche (80%)AAAMezzanine Tranche (15%)BBBEquity Tranche (5%)Not RatedSenior Tranche (65%)AAAMezzanine Tranche (25%) BBBEquity Tranche (10%)The mezzanine tranche is repackaged with other mezzanine tranchesABSsABS CDOsLoss

5、es to AAA Senior Tranche of ABS CDO (Table 8.1, page 189)Options, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20146Losses on Subprime portfoliosLosses on Mezzanine Tranche of ABSLosses on Equity Tranche of ABS CDOLosses on Mezzanine Tranche of ABS CDOLosses on Senior Tranche o

6、f ABS CDO10%33.3%100%93.3%0%13%53.3%100%100%28.2%17%80.0%100%100%69.2%20%100%100%100%100%U.S. Real Estate Prices, 1987 to 2013: S&P/Case-Shiller Composite-10 IndexOptions, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20147What happenedStarting in 2000, mortgage originators in t

7、he 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 F

8、eatures of the market: 100% mortgages, ARMs, teaser rates, NINJAs, liar loans, non-recourse borrowingMortgages were packaged in financial products and sold to investorsOptions, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20148What happened.Banks found it profitable to invest i

9、n the AAA rated tranches because the promised return was significantly higher than the cost of funds and capital requirements were lowIn 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 fo

10、r them to exercise their put options.Foreclosures increased supply and caused U.S. real estate prices to fall. 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 very high levelsMany

11、 banks incurred huge lossesOptions, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 20149What Many Market Participants Did Not RealizeDefault correlation goes up in stressed market conditionsRecovery rates are less in stressed market conditionsA tranche with a certain rating canno

12、t be equated with a bond with the same rating. For example, the BBB tranches used to create ABS CDOs were typically about 1% wide and had “all or nothing” loss distributions (quite different from BBB bond) This is quite different from the loss distribution for a BBB bond from a BBB bondOptions, Futu

13、res, and Other Derivatives 9th Edition, Copyright John C. Hull 201410Regulatory ArbitrageThe regulatory capital banks were required to keep for the tranches created from mortgages was less than that for the mortgages themselvesOptions, Futures, and Other Derivatives 9th Edition, Copyright John C. Hu

14、ll 201411IncentivesThe crisis highlighted what are referred to as agency costsMortgage originators (Their prime interest was in in originating mortgages that could be securitized) Valuers (They were under pressure to provide high valuations so that the loan-to-value ratios looked good)Traders (They

15、were focused on the next end-of year bonus and not worried about any longer term problems in the market)Options, Futures, and Other Derivatives 9th Edition, Copyright John C. Hull 201412The AftermathA huge amount of new regulation (Basel II.5, Basel III, Dodd-Frank, etc). For example: Banks required to hold more equity capital with the definition of equity capital being tightenedBank