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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

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

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

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.

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

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)

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).

Other Assets Can be Securitized


Car loans

Student loans Credit card balances


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.

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.