www.bionicturtle.com“Learning Risk & Finance”

Whodunit?

“Debt-fueled US households …

PrivateNet

Savings

PrivateNet

Savings

Net Exports

Net Exports

Net GovernmentExpenditures

Net GovernmentExpenditures- =

-2 to -3%GDP

-2 to -3%GDP

+2 to +3%GDP

+2 to +3%GDP

-5 to -6%GDP

(i.e., 5% to 6%

imports)

-5 to -6%GDP

(i.e., 5% to 6%

imports)

2007 estimates2007 estimates

…went on an unparalleled spending binge by dipping into their housing ‘piggy banks’”

Net Exports

Net Exports =

-5 to -6%GDP

-5 to -6%GDP

Huge foreign surplus funds private and government deficits

Much of it ($1+ trillion) channeled into subprime

Net CapitalInflow

Net CapitalInflow

- Martin Wolf

What is a subprime borrower?

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

* If risk is understood and priced correctly. A diversified portfolio wants some high-risk exposure

Subprime loans in MBS PoolsSubprime loans in MBS Pools

Subprime loans in MBS PoolsSubprime loans in MBS Pools

Borrower

Originator

Arranger/issuer

WarehouseLender

Rating Agencies

AssetManager

Long chain from borrower to investor

Originator sources (underwrites) loan

Borrower Originator

It is hard to price risk without data

See No Documentation

(Full Doc dropped to 57% in 2006)

See No Documentation

(Full Doc dropped to 57% in 2006)

Hear No Silent 2nd Lien (28% of subprime in

2006)

Speak not about the ARM reset

(82% of subprime)

Originators

Arranger/Issuer buys loans from originator

Arranger orIssuer

Originator

Warehouse lenders fund mono-line arrangers. Arranger creates SPV

Arranger

WarehouseLender

SpecialPurposeVehicle

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

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

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

All investments are derivatives (our contact with the underlying is always indirect)

BoardBusiness

… but CDOs are 2 or 3+ layers of abstraction

* 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?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

We own a CDO. It’s a note* collateralized by another note which itself is collateralized by a pool of loans

Typical Subprime Securitization Structure

ClassNotional

($MM) Width S&P Moody’s CouponA-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

Class Width S&P Moody’sA 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+ Ba1B-2 1.00% BB Ba2X 1.40% NR NR

Risky loans became collectively safe

Question: How do lemons become lemonade? *

* i.e., how does 96%+ of a $1 billion pool of subprime mortgages become investment-grade?* i.e., how does 96%+ of a $1 billion pool of subprime mortgages become investment-grade?

A copula codifies dizzying complexity with a single “elegant” formula

DizzyingComplexity

Elegant formula *

++ ==• Macro economy• n(n+1)/2 pairwise

correlations (a lot!)• Local real estate• Financial Markets• Human nature• Geopolitical etcetera

Totally incorrect

rating

* Plug-in critical assumptions where either “we don’t know” or we blindly assume “history will continue”

Copula isn’t valid if default correlation isn’t

Thou shall not covet and/or make idols of your models(esp. the Gaussian copula)

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

“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

Lemons lemonade grenade

“The ratings methodologies for some of these [securitized]products are so sloppy thatI reject the ratings of all three‘nationally recognized’ rating agencies… tranches of securitizations rated using flawed methodologies are

themselves used as collateral in other securitizations causing the errors to compound and spiral out of control. Ratings on these products are based on smoke and mirrors.” Janet Tavakoli, memo to S.E.C. (Feb 13, 2007)

Links in the process

Links in the process

Informationasymmetry

Principal-agent problem

Moral hazard

Names for stuff we already know

“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

Sources:• Martin Wolf, columns @ www.ft.com• Wynne Godley, Levy Economics Institute of Bard College• Subprime structure case: GSAMP TRUST 2006-NC2

(originated by New Century Financial, sold to subsidiary of Goldman Sachs) in “Understanding the Securitization of Subprime Mortgage Credit” by Adam Ashcraft & Til Schuermann

• Christopher Whalen, IRA including “Reassessing Ratings”• Janet Tavakoli, Structured Finance & CDOs

www.bionicturtle.com“Learning Risk & Finance”

by David Harper, CFA, FRM, CIPM