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How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? Joseph R. Mason, Associate Professor of Finance, Drexel University Joshua Rosner, Managing Director, Graham Fisher & Co. Figure 1: U.S. Home Ownership 1965-2006 Source : Bureau of Census

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How resilient are mortgage backed securities to collateralized debt obligation market disruptions l.jpg

How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?

Joseph R. Mason, Associate Professor of Finance, Drexel University

Joshua Rosner, Managing Director, Graham Fisher & Co.

Criterion Economics L.L.C.


Figure 1 u s home ownership 1965 2006 l.jpg
Figure 1: U.S. Home Ownership 1965-2006 Collateralized Debt Obligation Market Disruptions?

Source: Bureau of Census

Criterion Economics L.L.C.


Figure 2 home equity extracted and available for extraction 1995 2005 l.jpg
Figure 2: Home Equity Extracted and Available for Extraction 1995-2005

Source: Joint Center for Housing Studies of Harvard University (2006).

Criterion Economics L.L.C.


Figure 3 refinancing behavior 1995 2005 l.jpg
Figure 3: Refinancing Behavior 1995-2005 1995-2005

Sources: Joint Center for Housing Studies of Harvard University (2006).

Criterion Economics L.L.C.


Figure 4 piggyback lending for home purchase 2001 2004 l.jpg
Figure 4: Piggyback Lending for Home Purchase 2001-2004 1995-2005

Source: SMR Research Corporation (2004).

Criterion Economics L.L.C.


Figure 5a investment homes share of total homes purchased l.jpg
Figure 5A: Investment Homes Share of Total Homes Purchased 1995-2005

Source: National Association of Realtors

Criterion Economics L.L.C.


Figure 5b prime market investor shares l.jpg
Figure 5B: Prime Market Investor Shares 1995-2005

Source: Harvard’s Joint Center for Housing Studies (2006)

Criterion Economics L.L.C.


Figure 6 five year bbb floating home equity spread to one month l.jpg
Figure 6: Five Year BBB- Floating Home Equity Spread to One-Month

Source: Bureau of Census

Criterion Economics L.L.C.


The complexity of securitization l.jpg
The Complexity of Securitization One-Month

  • Mortgages and Mortgage-backed Securities Are Complex and Difficult to Value

    • Complexity of Default vs Prepay Risk

    • Additional Complexity in MBS

      • Deep Tranching

      • Unique Securities

    • Examples

Criterion Economics L.L.C.


The complexity of securitization10 l.jpg
The Complexity of Securitization One-Month

  • Mortgages and Mortgage-backed Securities Are Complex and Difficult to Value

    • Complexity of Default vs Prepay Risk

    • Additional Complexity in MBS

      • Deep Tranching

      • Unique Securities

    • Examples

Criterion Economics L.L.C.



Figure 7 prepayment and default rates as a function of mortgage duration l.jpg
Figure 7: Prepayment and Default Rates as a Function of Mortgage Duration

Source: Calomiris and Mason (2007).

Criterion Economics L.L.C.


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Typically Mortgage DurationAdjust for Prepayment Speeds with PSA Models

Prepayment and Principal and Interest Cash flows arising from Selected Prepayment Scenarios

Source: Mathworks.com

Criterion Economics L.L.C.


Table 1 regression results dependent variable is prepayments l.jpg
Table 1: Regression Results Mortgage Duration(Dependent Variable Is Prepayments)

Source: Calomiris and Mason (2007)

Criterion Economics L.L.C.


The complexity of securitization15 l.jpg
The Complexity of Securitization Mortgage Duration

  • Mortgages and Mortgage-backed Securities Are Complex and Difficult to Value

    • Complexity of Default vs Prepay Risk

    • Additional Complexity in MBS

      • Deep Tranching

      • Unique Securities

    • Examples

Criterion Economics L.L.C.


Figure 8 tranches issued in european securitizations 1987 2003 l.jpg
Figure 8: Tranches Issued in European Securitizations 1987-2003

Source: Firla-Cuchra and Jenkinson (2005)

Criterion Economics L.L.C.


Slide17 l.jpg
Table 2: Issues with the Given Number of Tranches as a Percentage of All Issues Per Type (Mean Number of Tranches Per Issue)

Source: Firla-Cuchra and Jenkinson (2005)

Criterion Economics L.L.C.


The complexity of securitization18 l.jpg
The Complexity of Securitization Percentage of All Issues Per Type (Mean Number of Tranches Per Issue)

  • Mortgages and Mortgage-backed Securities Are Complex and Difficult to Value

    • Complexity of Default vs Prepay Risk

    • Additional Complexity in MBS

      • Deep Tranching

      • Unique Securities

    • Examples

Criterion Economics L.L.C.


The complexity of securitization19 l.jpg
The Complexity of Securitization Percentage of All Issues Per Type (Mean Number of Tranches Per Issue)

  • Mortgages and Mortgage-backed Securities Are Complex and Difficult to Value

    • Complexity of Default vs Prepay Risk

    • Additional Complexity in MBS

      • Deep Tranching

      • Unique Securities

    • Examples

Criterion Economics L.L.C.


Figure 9 examples of actual mbs funding structures l.jpg
Figure 9: Examples of Actual MBS Funding Structures Percentage of All Issues Per Type (Mean Number of Tranches Per Issue)

Source: ABSnet

Criterion Economics L.L.C.


The complexity of securitization21 l.jpg
The Complexity of Securitization Percentage of All Issues Per Type (Mean Number of Tranches Per Issue)

  • Point: Mortgages are complex and difficult to value, and MBS are built upon that complexity.

  • Fundamental changes to underwriting and servicing standards are not easily identifiable in the inherent complexity of mortgages and MBS, posing risk to mortgage funding.

Criterion Economics L.L.C.


Cdos add complexity to mbs and other constituent credit instruments l.jpg
CDOs Add Complexity to MBS and Other Constituent Credit Instruments

  • Complexity of CDO Structures

  • Growth of the CDO Market

Criterion Economics L.L.C.


Figure 10 basic cdo security structure l.jpg
Figure 10: Basic CDO Security Structure Instruments

Source: JP Morgan, CDO Handbook 5 (2001).

Criterion Economics L.L.C.


Figure 11 typical tranche sizes and coupon rates l.jpg
Figure 11: Typical Tranche Sizes and Coupon Rates Instruments

Source: Lucas, Goodman and Fabozzi (2005)

Criterion Economics L.L.C.


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Key Differences between MBS and CDOs Instruments

  • CDO pools are actively managed.

  • CDO transactions close before the pool of underlying assets is fully formed.

  • CDOs are heterogeneous with respect to granularity.

  • CDOs illustrate more ratings volatility than ABS or MBS.

  • CDO collateral heterogeneity increases opacity.

  • Secondary market trading (liquidity) is limited.

Criterion Economics L.L.C.


Figure 12 examples of actual cdo funding structures l.jpg
Figure 12: Examples of Actual CDO Funding Structures Instruments

Source: Bennett and Mason (forthcoming 2007)

Criterion Economics L.L.C.


Cdos add complexity to mbs and other constituent credit instruments27 l.jpg
CDOs Add Complexity to MBS and Other Constituent Credit Instruments

  • Complexity of CDO Structures

  • Growth of the CDO Market

Criterion Economics L.L.C.


Figure 13 annual cash cdo issuance l.jpg
Figure 13: Annual Cash CDO Issuance Instruments

Source: Lucas, Goodman, and Fabozzi (2006)

Criterion Economics L.L.C.


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Fast Growth: Lessons from 1999-2003 Instruments

The CDO market is opportunistic in the way it drops collateral types that are out of favor with investors and picks up collateral types that are in favor with investors. The best example of this is the switch out of poor-performing high-yield bonds and into well-performing high yield loans between 2001 and 2003. Also, certain types of ABS present in SF CDOs from 1999 through 2001 disappeared from later vintages: manufactured housing loans, aircraft leases, franchise business loans, and 12b-1 mutual fund fees. All of these assets had horrible performance in older SF CDOs. In their place, SF CDOs have recently focused more on RMBS and CMBS. (Lucas, Goodman and Fabozzi 2006, at 5).

Criterion Economics L.L.C.


The link from mortgages to mortgage backed securities to collateralized debt obligations l.jpg
The Link from Mortgages to Mortgage-Backed Securities to Collateralized Debt Obligations

  • CDO rating changes follow other ratings changes.

  • An extremely high proportion of current CDO collateral is MBS.

  • 1999-2003 redux?

Criterion Economics L.L.C.


Figure 14 number of cdo rmbs and abs ratings changes three month ma l.jpg
Figure 14: Number of CDO, RMBS, and ABS Ratings Changes, Three-month MA

Criterion Economics L.L.C.


The link from mortgages to mortgage backed securities to collateralized debt obligations32 l.jpg
The Link from Mortgages to Mortgage-Backed Securities to Collateralized Debt Obligations

  • CDO rating changes follow other ratings changes.

  • An extremely high proportion of current CDO collateral is MBS.

  • 1999-2003 redux?

Criterion Economics L.L.C.


How much and what kind of mbs are in cdos l.jpg
How much and what kind of MBS are in CDOs? Collateralized Debt Obligations

  • The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products. (FDIC Outlook, Fall 2006)

Criterion Economics L.L.C.


How much and what kind of mbs are in cdos34 l.jpg
How much and what kind of MBS are in CDOs? Collateralized Debt Obligations

  • The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products. (FDIC Outlook, Fall 2006)

  • Moody’s reports that among RMBS, 70%-75% below AAA-rated

Table 3: Top Collateral Types in Resecuritization CDOs, 2005 (All Vintages)

Criterion Economics L.L.C.


How much and what kind of mbs are in cdos35 l.jpg
How much and what kind of MBS are in CDOs? Collateralized Debt Obligations

  • The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products. (FDIC Outlook, Fall 2006)

  • Moody’s reports that among RMBS in CDOs, 70%-75% below AAA-rated. (Moody’s CDO Asset Exposure Report, October 2006)

  • $200 billion of RMBS in CDOs x 70% below AAA = $140 billion of lower-tranche RMBS in CDOs

Criterion Economics L.L.C.


How much and what kind of mbs are in cdos36 l.jpg
How much and what kind of MBS are in CDOs? Collateralized Debt Obligations

  • The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products. (FDIC Outlook, Fall 2006)

  • Moody’s reports that among RMBS in CDOs, 70%-75% below AAA-rated. (Moody’s CDO Asset Exposure Report, October 2006)

  • $200 billion of RMBS in CDOs x 70% below AAA = $140 billion of lower-tranche RMBS in CDOs

  • SIFMA puts total RMBS issued in 2005 at $1,326 billion.

Criterion Economics L.L.C.


How much and what kind of mbs are in cdos37 l.jpg
How much and what kind of MBS are in CDOs? Collateralized Debt Obligations

  • The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products. (FDIC Outlook, Fall 2006)

  • Moody’s reports that among RMBS in CDOs, 70%-75% below AAA-rated. (Moody’s CDO Asset Exposure Report, October 2006)

  • $200 billion of RMBS in CDOs x 70% below AAA = $140 billion of lower-tranche RMBS in CDOs

  • SIFMA puts total RMBS issued in 2005 at $1,326 billion.

  • Assuming 90% AAA in all 2005 RMBS, that leaves a total of $133 billion in lower-tranche RMBS issued in 2005

Criterion Economics L.L.C.


The link from mortgages to mortgage backed securities to collateralized debt obligations38 l.jpg
The Link from Mortgages to Mortgage-Backed Securities to Collateralized Debt Obligations

  • CDO rating changes follow other ratings changes.

  • An extremely high proportion of current CDO collateral is MBS.

  • 1999-2003 redux?

Criterion Economics L.L.C.


1999 2003 redux but with mbs l.jpg
1999-2003 Redux (but with MBS)? Collateralized Debt Obligations

  • Point: CDOs are buying a lot of lower-tranche RMBS

  • Point Point: The 10% of lower-tranche RMBS provide crucial credit support for the 90% of AAA securities.

    • If you can’t sell the 10%, can’t sell the other 90%!

  • Point Point Point: If CDOs exit RMBS as they did with other collateral after 1999-2003, that will leave a substantial hole in the market for crucial lower-tranche RMBS.

Criterion Economics L.L.C.


Table 5 cdo risk premiums and credit spreads and macroeconomic performance l.jpg
Table 5: CDO Risk Premiums and Credit Spreads and Macroeconomic Performance

Source: D’Amato (2005)

Criterion Economics L.L.C.


Figure 16 cdo issuance and u s home equity abs indices l.jpg
Figure 16: CDO Issuance and U.S. Home Equity ABS Indices Macroeconomic Performance

Source: BIS Quarterly Review, Dec. 2006

Criterion Economics L.L.C.


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Overview of Public Policy Implications: Information Problems across Financial Markets and Institutions

CDO Market is here

Want to move it this way

Adapted from Merton, “A Functional Perspective of Financial Intermediation,” Financial Management, Summer 1995.

Criterion Economics L.L.C.


Policy implications l.jpg
Policy Implications across Financial Markets and Institutions

  • Transparency

  • Stability

  • Continued Innovation

Criterion Economics L.L.C.


Policy implications44 l.jpg
Policy Implications across Financial Markets and Institutions

MBS Pioneer Lewis S. Ranieri, in an interview published in the American Banker last June, said:

"When you start divorcing the creator of the risk from the ultimate holder of the risk, it becomes an issue of, 'Does the ultimate holder truly understand the nature of the risk that you've redistributed?' " Mr. Ranieri said. "By cutting it up in so many ways or complicating it by so many levels, do you still have clarity ... on the nature of the underlying risk?"

"It's not clear that we haven't gone, in some ways, too far -- that we have not gone beyond the ability to have true transparency," he said. "That is a fair question many of us in the business and people in the regulatory regime are wrestling with."

Criterion Economics L.L.C.


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