Collateralized Debt Obligation and John C .Hull Essay

Chapter 8
Securitization and the Credit
Crisis of 2007

Options, Futures, and Other Derivatives 9th Edition, Copyright
© John C. Hull 2014

1

Securitization
Traditionally banks have funded loans with deposits Securitization is a way that loans can increase much faster than deposits

Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

2

Asset Backed Security (Simplified)
Senior Tranche
Principal: $80 million
Return = LIBOR + 60bp

Asset 1
Asset 2
Asset 3


SPV

Mezzanine Tranche
Principal:$15 million
Return = LIBOR+ 250bp

Asset n
Principal:
$100 million

Equity Tranche
Principal: $5 million
Return =LIBOR+2,000bp

Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

3

The Waterfall
Asset
Cash
Flows

Senior
Tranche
Mezzanine Tranche
Equity Tranche

Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

4

ABS CDOs or Mezz CDOs (Simplified)
ABSs
Assets

The mezzanine tranche is repackaged with other mezzanine tranches

Senior Tranche (80%)
AAA

Mezzanine Tranche (15%)
BBB

ABS CDOs
Senior Tranche (65%)
AAA

Mezzanine Tranche
(25%) BBB
Equity Tranche (5%)
Not Rated
Equity Tranche (10%)

Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

5

Losses to AAA Senior Tranche of ABS
CDO (Table 8.1, page 189)
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
ABS CDO

10%

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%

Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

6

U.S. Real Estate Prices, 1987 to 2013:
S&P/Case-Shiller Composite-10 Index

Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

7

What happened…
Starting in 2000, mortgage originators in the 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
Features of the market: 100% mortgages, ARMs, teaser rates, NINJAs, liar loans, non-recourse borrowing
Mortgages were packaged in financial products and sold to investors Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

8

What happened...
Banks 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
In 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 for 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 risky
There was a “flight to quality” and credit spreads increased to very high levels
Many banks incurred huge losses
Options, Futures, and Other Derivatives 9th Edition, Copyright ©
John C. Hull 2014

Show More

Collateralized Debt Obligation and John C .Hull Essay

Related Documents: Collateralized Debt Obligation and John C .Hull Essay

Goldman Sachs Group: Global Banking Institutions And Issues