K4

Question 1

FC - Economic Surroundings

Answer 1

1. Decreasing interest rates
   - FED wanted to spur economy (after burst of internet bubble)
   - interest rates fell dramatically 2001-2004
2. low credit requirements
   - very poor & very wealthy people borrowed money from banks to buy/build houses
   - house prices increased until 2006
   - banks required collaterals for loans
   -> borrowers could use their first house to purchase second house
3. use of variable interest rate loans
   a) Basic: normal loans
   - borrowers receive normal loan with a fixed interest rate

b) Advanced: variable interest loans (ARM)
- Real Estate Agents tried to spur the sale
-> instead of normal loans with fixed interest rates they developed ARM
-> no fixed interests
-> low or 0% interest rates in the first 1-3 years, then adjusted

 people were tempted and didn’t worry about the future (borrowed more money)

RESULT:
- new market developed: suprime credits (=credits are given to people with a very low credit quality; they probably won’t pay back)
- banks allowed loans with very low FICO-Score (=indicator for creditworthiness)

Question 2

FC - Securitization - Why?

Answer 2

= pooling of various contractual debt selling their related CF to third party investors as securities
- purpose: banks receive cash for the sold loans (used it to make more loans)
- banks sold these loans to other investors (didn’t have to monitor borrowers anymore)
 banks didn’t fulfill their function as financial intermediary

Question 3

FC - Securitization – ABS

Answer 3

a) Structure
- banks need cash to give out more loans
-> sell existing loans to special purpose entity (SEP)
-> assets either exists already or are expected in the future
- SPE purchases loans from bank
-> gets financed through sale of securities (securities are secured only by future receivables (asset backed))
- SPE receives money
-> directly transfer it to investor
b) ABS & waterfall structure
- banks created securities that were backed by payments of subprime houseowners
- expected CF were bundled (ABS papers), valued and sold to new investors
- bundles were sliced into different tranches (-> not sold in total)
1. senior tranche
-> low risk, 6% return
-> higher likelihood of repayment
2. mezzanine tranche
-> middle risk, 10 % return
3. equity tranche
-> high risk, 30% return
-> lower likelihood of repayment

Question 4

FC - Securitization - ABS CDO

Answer 4

= Collateralized Debt Obligation

• Difference normal ABS: Cash payments come from fixed interest loans
• banks created CDO structure to get a better rating for Mezzanine tranche (investors didn’t purchase because of risk)
• Rating (Payment):
  1. ABS Senior tranche
  2. ABS CDO Senior tranche
  3. ABS CDO Mezzanine tranche
  4. ABS CDO Equity tranche
  5. ABS Equity tranche

Question 5

FC - Securitization - Rating Agencies

Answer 5

= assess the risk of ABS CDO tranches
-> investors rely on rating from agencies
- agencies rated tranches false (misinterpreted)
-> gave both senior tranches AAA rating, although CDOs have a higher risk of default than normal ABS tranches
 rating agencies didn’t fulfill their function as financial intermediary

Question 6

FC – Ending

Answer 6

1. housing bubble bursts

1.1 houseowners defaulted
- interest rates increased after 1-3 years
- borrowers didn’t pay  had to default  lost house

1.2 banks were left with worthless houses
- prices for houses dropped
- banks had houses with low values as collateral / non collateral at all
2. ABS & ABS CDO (based on house loans) defaulted
Houseowner didn’t pay
-> ABS & ABS CDO tranches didn’t get payments
-> security values dropped
-> CDOs were not used anymore
3. Banks who invested in ABS & ABS CDO defaulted
- many banks had invested in these securities due to their AAA ratings
- banks had worthless securities and were insolvent (due to illiquidity & overindebtness)

Question 7

FC - Players, Reasons, Problems

Answer 7

• rating agencies have to rate correct
  -> they are not regulated by the state
  -> they can take money from banks and manipulate ratings
• FED held the low interest rates from the beginning for too long, raised them too fast; too many credit opportunities
• could happen again
  -> banks still sell loans
  -> SPEs still exists
  -> investors usually want high returns so they take high risks