The process from origination to investors in MBS and CDOs

1. www.bionicturtle.com “ Learning Risk & Finance”

2. Whodunit?

4. … went on an unparalleled spending binge by dipping into their housing ‘piggy banks’” Net Exports = -5 to -6% GDP Huge foreign surplus funds private and government deficits Much of it ($1+ trillion) channeled into subprime Net Capital Inflow - Martin Wolf

5. What is a subprime borrower?

6. A subprime loan to a subprime borrower is not itself bad * * If risk is understood and priced correctly. A diversified portfolio wants some high-risk exposure

7. Subprime loans in MBS Pools

8. Subprime loans in MBS Pools

9. Long chain from borrower to investor Borrower Originator Arranger/issuer Warehouse Lender Rating Agencies Asset Manager

10. Originator sources (underwrites) loan Borrower Originator

11. It is hard to price risk without data See No Documentation (Full Doc dropped to 57% in 2006) Hear No Silent 2 nd Lien (28% of subprime in 2006) Speak not about the ARM reset (82% of subprime) Originators

12. Arranger/Issuer buys loans from originator Arranger or Issuer Originator

13. Warehouse lenders fund mono-line arrangers. Arranger creates SPV Arranger Warehouse Lender Special Purpose Vehicle

14. SPV makes securitization possible (off balance sheet if “true sale”)

15. SPV pools loans (left). SPV issues mortgage-backed securities (MBS, right)

16. CDO is another SPV that pools tranches of MBS. CDO issues tranches to investors.

17. All investments are derivatives (our contact with the underlying is always indirect) Board Business … but CDOs are 2 or 3+ layers of abstraction

18. * The note comes with algebra that solves for our share of the cash flow waterfall. I think they will send us a check I don’t see the asset? What do we own again? We own a CDO. It’s a note * collateralized by another note which itself is collateralized by a pool of loans

19. Typical Subprime Securitization Structure Class Notional ($MM) Width S&P Moody’s Coupon A-1 to A-2 $699.5 79.35% AAA Aaa 0.15% M-1 $35.70 4.05% AA+ Aa1 0.30% M-2 $28.65 3.25% AA Aa2 0.31% M-3 $16.75 1.90% AA- Aa3 0.32% M-4 $14.99 1.70% A+ A1 0.35% M-5 $14.55 1.65% A A2 0.37% M-6 $13.66 1.55% A- A3 0.46% M-7 $12.34 1.40% BBB+ Baa1 0.90% M-8 $11.02 1.25% BBB Baa2 1.00% M-9 $7.05 0.80% BBB- Baa3 2.05% B-1 $6.17 0.70% BB+ Ba1 2.50% B-2 $8.82 1.00% BB Ba2 2.50% X $12.34 1.40% NR NR N/A

20. Risky loans became collectively safe Class Width S&P Moody’s A 79.35% 96.9% of the subprime structure rated investment grade (BBB- , Baa3 or above) M-1 4.05% M-2 3.25% M-3 1.90% M-4 1.70% M-5 1.65% M-6 1.55% M-7 1.40% M-8 1.25% M-9 0.80% B-1 0.70% BB+ Ba1 B-2 1.00% BB Ba2 X 1.40% NR NR

21. Question: How do lemons become lemonade? * * i.e., how does 96%+ of a $1 billion pool of subprime mortgages become investment-grade?

23. Copula isn’t valid if default correlation isn’t Thou shall not covet and/or make idols of your models (esp. the Gaussian copula) “ Credit risk transfer technology is … causing the emphasis in risk assessment to move from the credit characteristics of individual borrowers to the extent of correlation within the composite products being originated , warehoused and distributed” - Mohamed El-Erian

24. Lemons  lemonade  grenade

26. Links in the process

27. Links in the process Information asymmetry Principal-agent problem Moral hazard

28. Names for stuff we already know

29. “ Some businesses are built on a model that will always favor immediate sales revenues over effective product…. [but] Things that don’t work should not be sold—period. That’s good business.” - Stephen Few, author, Information Dashboard Design “ More than anything else, a financial professional is paid to be diligent.” - Christopher Whalen, MD, Institutional Risk Analytics