Overview of Financial Management and the financial environment Flashcards Preview

Finance and Investment > Overview of Financial Management and the financial environment > Flashcards

Flashcards in Overview of Financial Management and the financial environment Deck (10)
Loading flashcards...
1
Q

Home Mortgages Before S&Ls

A
  • 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
Q

S&Ls Before Securitization

A

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
Q

Problems faced by S&Ls Before Securitization

A
  • 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
Q

Taxpayers to the rescue

A
  • 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
Q

Securitization in the Home Mortgage Industry

A
  • 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
Q

Fannie Mae Shifts Risk to Its Investors

A
  • 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
Q

Collateralized Debt Obligations (CDOs)

A
  • 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
Q

Other Assets Can be Securitized

A

Car loans

Student loans Credit card balances

9
Q

The dark side of securitization

A
  • 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
Q

The collapse

A
  • 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.