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Fixed Income Analysis I | MSFA 722 | Spring 2017 University of San Francisco School of Management Professor Asensio Problem set 7 Read the questions carefully. Be brief but thorough in your responses. The questions are based on \"The Big Short\" (based on the book with the same title by Michael Lewis) and the class material posted to Canvas on Mortgage and Asset Backed Securities. For additional background, please refer to the Fixed Income Analysis textbook (Chapters 10-12 in 2nd edition or Chapter 7 in the 3rd edition). There are 10 points possible. 1) Describe how the valuation of a mortgage-backed security (MBS) is dierent from the valuation of a US Treasury bond? In particular, what additional inputs and information are needed for MBS security valuation? (1pt) 2) Briefly state the role of each of the following in causing the Financial Crisis of 2008: a) Homeowners, b) Real estate agents, c) The rating agencies, d) Insurance companies, e) Fannie and Freddie, f) Investment banks, g) Mortgage banks, h) Hedge funds. (2pt) 3) Describe the contract that was used by Scion Capital to 'short' the housing market. (1pt) 4) One type of MBS is a mortgage pass-through security. It is a bond created when an investment bank pools together a collection of mortgages and sell shares or participation certificates in the pool to investors. The investors are entitled to cash flows from the mortgage pool including net interest, scheduled principal repayments (i.e., scheduled amortization), and prepayments. All investors receive a pro-rata distribution. What are the risks involved in investing in an MBS? Think back to the class meeting 2 lecture on bond risks. Identify the risks that are common to all types of bonds, and those incurred only when investing in MBS bonds. (1pt) 5) Describe how faster than expected mortgage prepayments impact the value of an MBS. Are faster prepayments always a bad thing for the bondholder? (1pt) 6) A collateralized mortgage obligation (CMO) is a special type of MBS. CMO's are bonds created by redirecting the interest and principal from a pool of mortgage pass-throughs according to pre-defined rules and priorities for the purpose of oering investors dierent payos, risk profiles, and leverage. Pre-2008, what was riskier, a AAA-rated mortgage pass-through bond or a AAA-rated tranche of a CMO? Why? Assume the same rating agency has granted AAA status for both bonds. (1pt) 1 7) A collateralized debt obligation (CDO) is very similar to a CMO, with the exception that the former may be made up of pools of many types of loans including mortgages, auto loans, boat loans, credit card loans, commercial property loans, individual tranches of other CMO's, and even synthetic loans which didn't involve actual lenders and borrowers. For more, Selena Gomez explains CDO's very well in \"The Big Short\". Pre-2008, what was riskier, a AAA-rated tranche of a CMO or a AAA-rated tranche of a CDO? Why? Assume the same rating agency has granted AAA status for both bonds. (1pt) 8) What was the initial trigger that led to the Financial Crisis of 2008? In other words, what went wrong first? (1pt) 9) Have any other bubbles in asset prices formed such that a similar episode to the Financial Crisis of 2008 could happen again? Explain. (1pt) 10) Despite the mortgage and housing bubble being obvious to many in the years preceding 2008, why were only a few able to profit from \"The Big Short\"? In general, what are the practical diculties of shorting financial assets? (1pt) 2 1. For one to value a mortgage backed security; they would have to consider the discounting factor available in the market, the payment time of amount due, the risk-neutral measure and lastly the prepayments. However, to value a US treasury bond; the only considerations made are the face value of the security, the purchase price and the time to maturity. The purchase price mentioned above is determined by the demand and supply of the treasury debt. The factors non-existent in the valuation of a US Treasury bond but are a factor in the MBS valuation are: discounting factor available in the market, the risk-neutral measure and lastly the prepayments. 2. 1. Homeowners Home owners purchased houses they could barely afford with non-traditional mortgages with the hope that the prices will appreciate so that they could take the equity out of their home for use in other spending. This did not happen as prices dropped drastically and the home owners could not take the equity off their homes and were unable to pay back the mortgages hence defaulting them. This led to the resetting of the mortgage rates to lower rates. Eventually, they were forced to set their mortgages rates to be high will led to high default mortgage payments. 2. Real Estate agents The real Estate agents simply dealt with the real Estate products given to them without even questioning or understanding the products as long as they made sales. There were easy loans involved in the product therefore the real estate agents just became motivated with money. 3. The rating agencies It is argued that credit rating agencies should have been able to see and predict the high default rates for sub-prime borrowers and should have given the CDOs a lower credit rating for such people instead of an AAA rating that they gave. 4. Insurance companies There was an increased demand for these mortgages that came from the creation of assets that pooled together the mortgages into a collaterized debt obligation and in the process these insurance companies and investment banks bought these mortgages and converted them to bonds which were sold to investors through the CDO. 5. Fannie and Freddie They contributed to the housing crisis by making it easier for people to take loans especially for houses that they could barely afford They did this by giving loans with little or no down payments and hardly even documentation to prove that the person being given a loan could actually afford it. 6. Investment banks Securitization of loans by such banks simply made it hard for them to monitor the quality and the underwriting standards of such loans hence the high default risk of the loans then. 7. Mortgage banks This group simply financed the purchase of houses since there was availability of large amounts of subprime loans without consideration of the risk premium associatied with each individual borrowing. 8. Hedge funds With credit arbitrage strategy where subprime bonds are purchased and hedged with credit swaps. This process increased the demand for CDOs by using leverage thereby pusing the interest rates further down hence accelerating the problem. . This led to a geat amount of leveraged losses and many of these hedge operations were shut down completely as they ran out of funds. 3. In the year 2005 Burry did a research on the subprime market where he discovered that subprime mortgages; especially those with teaser rates will begin loosing value in as little as two years after initiation. Since a short position normally increases in value as the security prices in question fall, Burry decided to short the market by Goldman Sachs to sell him credit default swaps against subprime deals. In the end; he was to liquidate his credit swap short positions .This did not work out at first but it gave him an the investors a fortune when the real estate market and the financial crisis finally reduced after the 2008 crisis. 4. The following are the risks common to all types of bonds: Reinvestment risk Call risk Default risk Inflation risk Interest rate risk Rating down grades Liquidity risk However, below are those that are common in Mortgage Backed Securities: a) Prepayment risk This is the risk that comes up as a result of declining interest rates or a strong housing market that will lead to the mortgage holders refinancing or repaying their loans sooner than expected thereby leading to an early return of principal. This eventually reduces the amount of money to be earned by the issuers of the Mortgaged Backed Securities as interest wil not be paid for the period that the issuer and the take had earlier on agreed. b) Extension risk This is the risk associated with the fear that rising interest rates will slow down the assumed payment speeds on the loans taken on mortgage. This will in turn delay the return of the principal to the investors thereby leading to them missing the opportunity to reinvest their funds at higher yields. This risk is the opposite of the prepayment risk an average time taken for the investor to the principal back is extended. c) Contraction risk This is the risk that the declining rate of interest will increase the prepayment risk for the mortgage loans thereby giving back the principal to the investors sooner than expected and compelling them to reinvest the principal backs ta lower rates. 5. When payments are made earlier than expected; the value of the bond goes down. This is simply because the bond holder will finish making their payments earlier and will therefore not pay the interest rates that would have accrued as a result of paying interest for the period between when the finish the payments to the period when they were supposed to have finish payments had they not increased their monthly or annual payments. Payment of mortgages earlier is a good thing to the bond holder as it saves them the money that would have spent on interest and also cushions them from increase in interest rates as a result of inflation. 6. Pre-2008; the one which was riskier was the AAA-rate mortgage pass through because unlike AAA-rated tranche of a CMO, it did not have the different trenches that were an indication of the riskiness according to the interest rates and the default risk of each bond holder. Prediction of the interest rates to be charged is made easier by an assessment of the risk of the bond holder. 7. Pre-2008; the AAA-rated tranche of a CDO was riskier because it provided cash flows from a many mortgages areas e.g. automobile loans, credit card loans, commercial loans some from CMO. This is unlike CMO that provided cash flows from a specific pool of mortgages. CDO was even buying the pool of mortgages from some of the lowest tranches of CMO; something that made them suffers a lot pre-2008 financial crisis. Later they all regained their working capacity and functionality after the crisis. 8. The factor that really caused the 2008 financial crisis is the issuance of loans by banks with little or no restrictions at all; something that created an influx in the money supply in the economy. There was therefore a lot of money for people to Invest in the building of the real estate and also a lot of it available for people to buy home (that they could not afford). 9. No; there have not been serious asset bubbles after the 20078 financial crises except for recent sharp increases in the prices of the assets that have affected the economic activity of the country. To curb this and its effects; banks have been encouraged to control their interest rates together with their lending so that it doesn't blow out of proportion like the 2008 crisis. 10. It is simply impossible to benefit from the 2008 financial crisis because since then; the mortgage market has stabilized and the rate of inflation has raised the cost of mortgages. There are many difficulties in shorting financial assets and the following are some: regulatory risks, skewed payoff risk, contrary to long-term market trend and risks associated of short squeezes and buy-ins