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Flashcards in Overview of Financial Management and the financial environment Deck (10)
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1

Home Mortgages Before S&Ls

- The problems if an individual investor tried to lend money to an aspiring homeowner:
-> Individual investor might not have enough money to fund an entire home
-> Individual investor might not be in a good position to evaluate the risk of the potential homeowner
-> Individual investor might have difficulty collecting mortgage payments

2

S&Ls Before Securitization

Savings and loan associations (S&Ls) solved the problems faced by individual investors
- S&Ls pooled deposits from many investors
- S&Ls developed expertise in evaluating the risk of borrowers
- S&Ls had legal resources to collect payments from borrowers

3

Problems faced by S&Ls Before Securitization

- S&Ls were limited in the amount of mortgages they could fund by the amount of deposits they could raise
- S&Ls were raising money through short-term floating-rate deposits, but making loans in the form of long-term fixed-rate mortgages
- When interest rates increased, S&Ls faced crisis because they had to pay more to depositors than they collected from mortgagees

4

Taxpayers to the rescue

- Many S&Ls went bankrupt when interest rates rose in the 1980s.
- Because deposits are insured, taxpayers ended up paying hundreds of billions of dollars.

5

Securitization in the Home Mortgage Industry

- After crisis in 1980s, S&Ls now put their mortgages into “pools” and sell the pools to other organizations, such as Fannie Mae.
- After selling a pool, the S&Ls have funds to make new home loans
- Risk is shifted to Fannie Mae

6

Fannie Mae Shifts Risk to Its Investors

- Risk hasn’t disappeared, it has been shifted to Fannie Mae.
- But Fannie Mae doesn’t keep the mortgages:
-> Puts mortgages in pools, sells shares of these pools to investors
-> Risk is shifted to investors.
-> But investors get a rate of return close to the mortgage rate, which is higher than the rate S&Ls pay their depositor.
-> Investors have more risk, but more return
- This is called securitization, since new securities have been created based on original securities (mortgages in this example)

7

Collateralized Debt Obligations (CDOs)

- Fannie Mae and others, such as investment banks, can also split mortgage pools into “special” securities
-> Some securities might pay investors only the mortgage interest, others might pay only the mortgage principal.
-> Some securities might mature quickly, others might mature later.
-> Some securities are “senior” and get paid before other securities from the pool get paid.
-> Rating agencies give different
- Risk of basic mortgage is parceled out to those investors who want that type of risk (and the potential return that goes with it).

8

Other Assets Can be Securitized

Car loans
Student loans Credit card balances

9

The dark side of securitization

- Homeowners wanted better homes than they could afford.
- Mortgage brokers encouraged homeowners to take mortgages even thought they would reset to payments that the borrowers might not be able to pay because the brokers got a commission for closing the deal.
- Appraisers thought the real estate boom would continue and over-appraised house values, getting paid at the time of the appraisal.
- Originating institutions (like Countrywide) quickly sold the mortgages to investment banks and other institutions.
- Investment banks created CDOs and got rating agencies to help design and then rate the new CDOs, with rating agencies making big profits despite conflicts of interest.
- Financial engineers used unrealistic inputs to generate high values for the CDOs.
- Investment banks sold the CDOs to investors and made big profits.
- Investors bought the CDOs but either didn’t understand or care about the risk.
- Some investors bought “insurance” via credit default swaps.

10

The collapse

- When mortgages reset and borrowers defaulted, the values of CDOs plummeted.
- Many of the credit default swaps failed to provide insurance because the counterparty failed.
- Many originators and securitizers still owned sub-prime
securities, which led to many bankruptcies, government
takeovers, and fire sales, including:
- New Century, Countrywide, IndyMac, Northern Rock, Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and Merrill Lynch.