Credit Crisis - Academics and Analysis - 4

This blog is next in the series of blogs ‘Credit Crisis – Academics and Analysis - 3’. Please read previous blogs for a better sense of flow.

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Here I will try to analyze Risk Elements with MBS securities and attempt to build a sense of what could have gone wrong.

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Borrowers pay a rate of interest for their mortgage loans. This rate includes Risk Free Rate + Risk Premium to compensate risks associated with those loans.

• We know the bubble was created because home prices kept going upwards to a point of burst. No argument on that!
• Upward movement in prices was due to lower interest rates paid by borrowers and a larger investor base making increased supply of loan-able funds. Again no argument on that!
• Larger Investor base is what we desire and going forward, we would aim to maintain/increase that. So, there is no problem with that part of equation.
• Lower Risk Free Rates, we know were controlled by FED’s Monetary Policy. Analysts have already pointed that out as one of the strong reasons for the bubble. FED kept these rates too low for too long. Again no arguments!

Now, the remaining variable in the equation is Risk Premium added to Risk Free Rate. Let’s analyze this to see, if this premium could have been cheaply charged to borrowers.

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I will organize contents of this analysis as:

• Risks for End Investors
• Risks for MBS Issuers/Guarantors
• Total Risks Analysis as against conventional Home Loans

Risks for End Investors

• Credit Risk: Since there was Guarantor party present (i.e. Ginnie Mae, Fannie Mae, Freddie Mac), Credit Risk to Investors was quantified by creditworthiness and credit ratings of these guarantor parties.
• Interest Rate Risk: Same as with any other fixed income security. Security Prices will go down when Risk Free Interest Rates go up in the market. Its quantification is to be based on whether coupon is fixed or floating.
• Prepayment Risk: Higher when Interest Rates are going down.
• Liquidity Risk: Quite low as there was active secondary market for these securities.
• Unknown Product Risk: Since Investors are not so knowledgeable on these new complex structured securities, they should charge a premium for any associated uncertainties.
• Systematic Risk: With increased de-regulations from govt. combined with complex and relative unknown nature of these securities, did expose Investors to added systematic risk, which should have been accounted for in their premium.

Risk for MBS Guarantors/Issuers

• Credit Risk: Guarantors faced risk of defaults from actual borrowers.
• Impairment Risk: Collateral for safeguarding default was the home purchased by borrower. Any devaluation in the value of collateral should be a risk to account for.

Total Risk Analysis as against Conventional Home Loans

• Total Credit Risk: Since end borrower is still the same without any additional collateral, Total Credit Risk is same for this new Instrument.
• Total Interest Rate Risk: Is the same as with conventional loans. It is just transferred from Loaning Bank to End Investor.
• Total Prepayment Risk: For CMOs, this Risk has been reduced (or the combined premium demanded for this is lower), as the instrument has been able to create better matches of demand for prepayments.
• Total Liquidity Risk: This Risk has been reduced too. Earlier, Bank loans were pretty much illiquid, but these loan securities are much more liquid as they are traded in secondary markets.
• Total Impairment Risk: This risk was increased, because of high Loan to Value ratio. De-regulation allowed this ratio to go high, meaning borrowers could borrow with lowered down payments. Together with inflated home prices (collateral), this risk was increased. As Price to Cost ratio increases, so does the Impairment Risk. Supernormal Profits are difficult to be sustained in long run.
• Total New Product Risk: This was an additional risk component added with complex and innovative CMOs.
• Total Systematic Risk: This too had increased with increased deregulations.

So, we see, in Total Risk Premium to be charged to borrowers, there are downward factors like Prepayment Risk and Liquidity Risk and upward factors like Impairment Risk, New Product Risk and Systematic Risk.

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Questions forthcoming from this analysis are:

• Were all these risks and their premiums duly considered?
• Were Credit Rating agencies able to correctly indentify and quantify these Risks and rate these Securities accordingly?
• Did borrowers got away with paying lower interest rates with heavy costs to end Investors and Capital Markets as a whole?

On the hindsight of the Crisis, we know we can answer first 2 questions in negative and the last one in affirmative.

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To summarize, I cannot claim this analysis to be complete. But the idea is to expose more dimensions and create added inputs to your existing thought process.

Credit Crisis - Academics and Analysis - 3

This blog is third in the series of blogs ‘Credit Crisis – Academics and Analysis’. Please read previous blogs first, for a better sense of flow.

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Here I will try to build a basic understanding for another component of ‘Securitized Loans’, which is ‘Asset Backed Securities (ABS)’.

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Asset Backed Securities are similar in structure to Mortgage Backed Securities (MBS), which we discussed earlier. The differences are:

• For MBS, underlying assets are mortgage loans, whereas for ABS, underlying assets are most of other kind of loans. e.g. Credit Card Loans, Auto Loans, Home Equity Loans, Corporate Receivables, Student loans etc.
• Security Issuer is generally a Special Purpose Vehicle (SPV) for ABS, as against govt. or govt. sponsored agencies for MBS.
• ABS securities are generally shorter term securities as compared to MBS securities, so they are less prone to interest rate fluctuations and re-financing. To illustrate, Home Loans are generally for 30 years, whereas say Auto Loan would typically be for 1 to 5 years.
• When MBS is further structured into Tranches, they are known as CMOs. And when ABS is further structured into Classes/Tranches, they are known as CDOs (Collateralized Debt Obligations).

Let’s take an example of Corporate Receivables and see how ABS works for this underlying asset.

• Corporate has some Receivables. It sells them to a SPV and receives a discounted sum.
• SPV securitizes this asset and sells it to end investors.
• During the life of asset, Corporate collects receivables from its customers and pays them to SPV.
• SPV pays them back to Investors.

Motivation for Corporate

• Lower cost of credit to Corporate, as Credit Ratings of SPV are higher than the Corporate itself.
• Working Capital gets freed for further Operational Activities.

Risk Analysis

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Credit Risk to Investors

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To Investors, credit risk is based on Credit Rating of the SPV. Higher the rating, lesser would be the premium charged by investors on that security.

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Credit Risk to SPV

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SPV is exposed to Credit Risk from the Corporate itself. But, there could be Credit Enhancements agreed to by Corporate in the form of Recourse Option and Bankruptcy Remoteness. Recourse Option means, in case of any default on receivables, Corporate would be responsible. And Bankruptcy Remote option keeps these Receivable Assets away from other Creditors, in case Corporate ever files for bankruptcy. Because of such credit enhancements, Credit Ratings of SPV would always be higher than that of the Corporate itself. This reduces the cost of Credit to Corporate.

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Prepayment Risk

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Because underlying Assets in ABS have lower maturity periods (as compared to MBS), time duration of their exposure to Interest Rate fluctuations is lower. This results in lower chances of re-financing by end borrowers and hence a lower Prepayment Risk to ABS investors.

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To summarize, ABS is a structured security which enables individual and institutional investors to provide credit for various consumer and corporate loans.

Credit Crisis, Academics and Analysis - 2

This blog is a continuation of the previous blog ‘Credit Crisis, Academics and Analysis -1’. As mentioned there, I will try to build up an understanding for ‘Securitized Loans’, which held the biggest share in US Credit Markets up until the Credit Crunch.

Securitized Loans have been one of the greatest innovations in the recent history of Financial Markets. This Asset Class can broadly be put under 2 categories, categorized by their underlying Assets.

• Mortgage Backed Securities (MBS) – with underlying asset as Home Mortgage Loans.

- Pass Thru Securities
- Collateralized Mortgage Obligations (CMOs)

• Asset Backed Securities (ABS) – with underlying assets such as Corporate Receivables, Credit Card Receivables, Auto Loans, Student Loans, Home Equity Loans etc.

This blog, I will discuss MBS and leave ABS for next blogs.

Understanding MBS Structure

• Home Buyers are the borrowers, borrowing loans against their purchased homes.
• Banks and Financial Institutions provide them with those mortgage loans.
• Subsequently, these individual home loans are pooled together (there need to be a minimum of 300 individual loans to form one such pool) and an MBS issuer will issue securities against that pool. Once Securities have been issued and subscribed, Banks’ (Loan Issuers’) Capital is freed and they are ready to issue more loans.
• MBS issuers in the US are agencies like Ginnie Mae, Fannie Mae and Freddie Mac. These agencies also act as guarantors for their issued securities. Out of the three, Ginnie Mae is a Govt. Agency and its creditworthiness is backed by full faith of the US Govt. While, Fannie Mae and Freddie Mac are Private Agencies and their creditworthiness is rated by Credit Rating Agencies like S&P and Moody’s.
• These securities are then bought by Individual and Institutional Investors. They are similar to other coupon paying Fixed Income Securities, but could be prepaid early, and will not have any embedded options.

For Pass Thru Securities, Security Investors would get periodic Interest and any Prepaid Principal, in direct proportion to their Investment in that Mortgage Pool.

For, CMOs (Collateralized Mortgage Obligations), there are defined Tranches. That is, any prepaid Principal in the pool will first go to investors in the uppermost Tranche, till that tranche is exhausted. Investors opt for investing in specific Tranches, based on their Investment Requirements. That is, relative short term investors may prefer investing in upper tranches, whereas, long term investors like Pension Funds, Insurance Companies etc, could invest in lower tranches. Interest Payments are proportional payments to investors in all tranches, which is same as that for Pass Thru Securities.

Risk Analysis for MBS

Credit Risk

There are 2 parts to Credit Risk here.

1. Credit Risk to Investors: Credit Risk to Investors is creditworthiness of its Security Guarantor. Investors will include a premium to their asking rate, based on Credit Ratings of their Security Guarantor/Issuer. Also, understand that Credit Ratings of Guarantor may get downgraded in future. If that happens, as an investor, price of your securities will go down in secondary market.
2. Credit Risk to Guarantor: This risk to guarantor is from borrowers defaulting on their monthly payments. Since, the underlying pool is a big pool of loans (at least more than 300), cost of premium for this risk is lowered, as the risk is considered distributed over a big pool.

Prepayment Risk

For Pass Thru Security Investors, Prepayment risk will always be there, especially when Interest Rates are going down. Now, why Prepayment is considered a Risk? Because, when Interest Rates go down any prepaid amount would have to be re-invested by Investor at lower rates, thus reducing overall yield on his Security Investment.

For CMOs, however, Prepayment Risk is lower for deeper Tranches and higher for Investors in upper Tranches. For upper tranches, Prepayment Risk is higher and Credit Risk is lower. Whereas, in lower tranches, Prepayment Risk is lower at the cost of higher Credit Risk. As there is a tradeoff available between Prepayment and Credit Risk here, and there are matching requirements (demand) available among investors, combined premium for both Risks together is lowered for the Pool as a whole.

To summarize MBS:

• Home loans are financed by a wider base of investors, including individual investors. Thus more Capital is available for lending. In a conventional scenario, where a Bank lends home loan to a borrower, bank’s lending capacity is limited by Fed controlled RRR (Required Reserve Ratio).
• Financing is much more liquid, as these securities can be traded in Secondary Markets.
• Overall cost of borrowing is reduced, as risk perception is lowered for the pool as a whole.

In subsequent blogs, I will discuss ABS and analyze the crisis.