Chapter 8

Securitization and the Credit Crisis of 2007

Practice Questions

Problem 8.8.
Why did mortgage lenders frequently not check on information provided by potential
borrowers on mortgage application forms during the 2000 to 2007 period?

Subprime mortgages were frequently securitized. The only information that was retained
during the securitization process was the applicant’s FICO score and the loan-to-value ratio
of the mortgage.

Problem 8.9.
How were the risks in ABS CDOs misjudged by the market?

Investors underestimated how high the default correlations between mortgages would be in
stressed market conditions. Investors also did not always realize that the tranches underlying
ABS CDOs were usually quite thin so that they were either totally wiped out or untouched.
There was an unfortunate tendency to assume that a tranche with a particular rating could be
considered to be the same as a bond with that rating. This assumption is not valid for the
reasons just mentioned.

Problem 8.10.
What is meant by the term “agency costs”? How did agency costs play a role in the credit
crisis?

“Agency costs” is a term used to describe the costs in a situation where the interests of two
parties are not perfectly aligned. As described at the end of Section 8.3, the interests of
valuers, mortgage originators, the creators of ABS and ABS CDO structures, the investors in
the structures, traders, and the financial institutions for which traders worked were not
perfectly aligned.

Problem 8.11.
How is an ABS CDO created? What was the motivation to create ABS CDOs?

An ABS CDO was frequently created from the BBB-rated tranches of ABSs. This is because
it was difficult to sell the BBB-rated tranches of an ABS to investors in a direct way.

Problem 8.12.
Explain the impact of an increase in default correlation on the risks of the senior tranche of
an ABS. What is its impact on the risks of the equity tranche?

Consider the structure in Figure 8.1. Assume that there are 1000 assets each with a principal
of $100,000. Suppose that all the assets have a 5% chance of defaulting during the life of the
ABS and there will be a 50% recovery. For the senior tranche to be affected there have to be
at least 400 defaults. When default correlation is zero there is virtually no chance of this. As
default correlation increases, 400 defaults becomes more likely. In the limit as the correlation
approaches one there is a 5% chance that all 1000 will default.
As default correlation increases, the equity tranche becomes less risky. When the default
correlation is low some defaults are almost certain to happen so that the equity tranche
experiences losses. As the default correlation increases it becomes less likely that there will
be defaults. In the limit as the correlation approaches one there is a 95% chance that there
will be no defaults and the equity tranche experiences no losses.

Problem 8.13.
Explain why the AAA-rated tranche of an ABS CDO is more risky than the AAA-rated
tranche of an ABS.

As indicated in Table 8.1, a moderately high loss rate will wipe out the mezzanine tranches of
ABSs so that the AAA-rated tranche of the ABS CDO is also wiped out. A moderately high
loss rate will at worst wipe out only part of the AAA-rated tranche of an ABS.

Problem 8.14.
Explain why the end-of-year bonus is sometimes referred to as “short-term compensation.”

The end-of-year bonus usually reflects performance during the year. This type of
compensation tends to lead traders and other employees of banks to focus on their next bonus
and therefore have a short-term time horizon for their decision making.

Problem 8.15.
Add rows in Table 8.1 corresponding to losses on the underlying assets of (a) 2%, (b) 6%,
(c) 14%, and (d) 18%.

Losses to Losses to Mezz Losses to equity Losses to Mezz Losses to senior

subprime tranche of ABS tranche of ABS tranche of ABS tranche of ABS
portfolio CDO CDO CDO
2% 0% 0% 0% 0%
6% 6.7% 67% 0% 0%
14% 60.0% 100% 100% 38.5%
18% 86.7% 100% 100% 79.5%

Further Questions

Problem 8.16
Suppose that the principal assigned to the senior, mezzanine, and equity tranches is 70%,
20%, and 10% for both the ABS and the ABS CDO in Figure 8.3. What difference does this
make to Table 8.1?

Table 8.1 becomes:

Losses to Losses to Mezz Losses to equity Losses to Mezz Losses to senior

 subprime tranche of ABS tranche of ABS tranche of ABS tranche of ABS
portfolio CDO CDO CDO
10% 0% 0% 0% 0%
13% 15% 100% 25% 0%
17% 35% 100% 100% 7.1%
20% 50% 100% 100% 28.6%

Problem 8.17.
‘‘Resecuritization was a badly flawed idea. AAA tranches created from the mezzanine
tranches of ABSs are bound to have a higher probability of default than the AAA-rated
tranches of ABSs.’’ Discuss this point of view.

When the AAA-rated tranche of an ABS experiences default, the mezzanine tranche of the
ABS must have been wiped out. If all the mortgage portfolios used to create the mezzanine
tranches underlying an ABS CDO have similar default rates, it must therefore be the case that
the AAA-rated tranches of all underlying ABSs are safer than the AAA-rated tranche of the
ABS CDO. (This is because, if there are any losses on the former, the latter are completely
wiped out.) If there is a wide variation of the default rates on the underlying mortgage
portfolios, it is possible for the AAA-rated tranche of the ABS CDO to fare better than some
(but not all) of the AAA rated tranches of the underlying ABSs.

Resecuritization can only be successful if the default rates of the underlying ABS portfolios
are not highly correlated. But in this case a better approach than resecuritization is to redesign
the ABSs so that they are as well diversified as possible.

Problem 8.18.
Suppose that mezzanine tranches of the ABS CDOs, similar to those in Figure 8.3, are
resecuritized to form what is referred to as a “CDO squared.” As in the case of tranches
created from ABSs in Figure 8.3, 65% of the principal is allocated to a AAA tranche, 25% to
a BBB tranche, and 10% to the equity tranche. How high does the loss percentage have to be
on the underlying assets for losses to be experienced by a AAA-rated tranche that is created
in this way? (Assume that every portfolio of assets that is used to create ABSs experiences the
same loss rate.)

For losses to be experienced on the AAA rated tranche of the CDO squared the loss rate on
the mezzanine tranches of the ABS CDOs must be greater than 35%. This happens when the
loss rate on the mezzanine tranches of ABSs is 10+0.35×25 = 18.75%. This loss rate occurs
when the loss rate on the underlying assets is 5+0.1875×15 = 7.81%

Problem 8.19
Investigate what happens as the width of the mezzanine tranche of the ABS in Figure 8.3 is
decreased with the reduction of mezzanine tranche principal being divided equally between
the equity and senior tranches. In particular, what is the effect on Table 8.1?

The ABS CDO tranches become similar to each other. Consider the situation where the
tranche widths are 12%, 1%, and 87% for the equity, mezzanine, and senior tranches. The
table becomes:

Losses to Losses to Mezz Losses to equity Losses to Mezz Losses to senior

 subprime tranche of ABS tranche of ABS tranche of ABS tranche of ABS
portfolio CDO CDO CDO
10% 0% 0% 0% 0%
13% 100% 100% 100% 100%
17% 100% 100% 100% 100%
20% 100% 100% 100% 100%

Problem 8.20
Suppose that the structure in Figure 8.1 is created in 2000 and lasts 10 years. There are no
defaults on the underlying assets until the end of the eighth year when 17% of the principal is
lost because of defaults during the credit crisis. No principal is lost during the final two
years. There are no repayments of principal until the end. Evaluate the relative performance
of the tranches. Assume a constant LIBOR rate of 3%. Consider both interest and principal
payments.

The cash flows per $100 of principal invested in a tranche are roughly as follows

Tranch Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10
e
Senior 3.6 3.6 3.6 3.6 3.6 3.6 3.6 3.6 3.6 103.6
Mezz 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 1.1 21.1
Equity 23.0 23.0 23.0 23.0 23.0 23.0 23.0 23.0 0 0

When compared to a 100 investment the internal rates of return for the senior, mezzanine and
equity tranches are approximately 3.6%, -6%, and 16.0%. This shows that the equity tranche
can fare quite well if defaults happen late in the life of the structure.