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1、The Credit Crisis of 2007 Chapter 6 1 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 U S Real Estate Prices 1987 to 2011 S P Case Shiller Composite 10 Index 2 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 What happened lStartin
2、g in 2000 mortgage originators in the US relaxed their lending standards and created large numbers of subprime first mortgages lThis combined with very low interest rates increased the demand for real estate and prices rose lTo continue to attract first time buyers and keep prices increasing they re
3、laxed lending standards further lFeatures of the market 100 mortgages ARMs teaser rates NINJAs liar loans non recourse borrowing 3 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 What happened lMortgages were packaged in financial products and sold to investors lBa
4、nks 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 lIn 2007 the bubble burst Some borrowers could not afford their payments when the teaser rates ended Others had negative equity an
5、d recognized that it was optimal for them to exercise their put options lU S real estate prices fell and products created from the mortgages that were previously thought to be safe began to be viewed as risky lThere was a flight to quality and credit spreads increased to very high levels 4 Risk Mana
6、gement and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 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 Tran
7、che Principal 20 million Return 10 Equity Tranche Principal 5 million Return 30 5 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 ABS The Waterfall Equity Tranche Senior Tranche Mezzanine Tranche Asset Cash Flows 6 Risk Management and Financial Institutions 3e Chap
8、ter 6 Copyright John C Hull 2012 ABS CDOs or Mezz CDOs Simplified Subprime MortgagesSenior 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 7 Risk Mana
9、gement and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 ABS s ABS CDO 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 A
10、BS CDO 10 25 100 100 0 15 50 100 100 33 3 20 75 100 100 66 7 25 100 100 100 100 8 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 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
11、A BBB NR Senior AAA Junior AAA AA A BBB NR 81 11 4 3 1 ABS High Grade ABS CDO Mezz ABS CDOCDO of CDO 62 14 8 6 6 4 88 5 3 2 1 1 60 27 4 3 3 2 9 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 BBB Tranches lBBB tranches of ABSs were often quite thin 1 wide lThis mea
12、ns that they have a quite different loss distribution from BBB bonds and should not be treated as equivalent to BBB bonds lThey tend to be either safe or completely wiped out cliff risk lWhat does this mean for the tranches of the Mezz ABS CDO Risk Management and Financial Institutions 3e Chapter 6
13、Copyright John C Hull 2012 10 Regulatory Arbitrage lCapital required for securities created from a portfolio of mortgages was considerably less than capital that would be required if mortgages had been kept on the balance sheet Risk Management and Financial Institutions 3e Chapter 6 Copyright John C
14、 Hull 2012 11 Role of Incentives lArguably the incentives of valuers the creators of ABSs and ABS CDOs and rating agencies helped to create the crisis lCompensation plans of traders created short term horizons for decision making Risk Management and Financial Institutions 3e Chapter 6 Copyright John
15、 C Hull 2012 12 Importance of Transparency lABSs and ABS CDOs were complex inter related products lOnce the AAA rated tranches were perceived as risky they became very difficult to trade because investors realized they did not understand the risks lOther credit related products with simpler structur
16、es eg credit default swaps continued to trade during the crisis 13 Risk Management and Financial Institutions 3e Chapter 6 Copyright John C Hull 2012 Lessons from the Crisis page 133 134 lBeware irrational exuberance lDo not underestimate default correlations in stressed markets lRecovery rate depends on default rate lCompensation structures did not create the right incentives lIf a deal seems too good to be true eg a AAA earning LIBOR plus 100 bp it probably is lDo not rely on ratings lTranspar
