j. k. dietrich - fbe 524 - fall, 2005 fixed income market (3) week 15 – november 30, 2005

J. K. Dietrich - FBE 524 - Fall, 2005

Fixed Income Market (3)

Week 15 – November 30, 2005


Consumer Debt

Major household asset is housing, major liabilities are home mortgages

Second most important assets are consumer durable goods, mainly automobiles

Households borrow in the form of secured lending (e.g. installment loans for autos) and non-secured loans (e.g. revolving or credit-card loans)


Consumer Credit Regulation

Truth in Lending regulated by Federal Reserve in Regulation Z

Annual percentage rate (APR) includes all fees and points

Usury laws have existed in the past, usually imposed by the states

Community Investment Act (CRA) regulations require reinvestment of local funds


Home Financing Long-term government involvement,

including establishment of federally chartered home lenders in the Home Owners’ Loan Act (1935), namely savings and loans

Home have an important tax preference in tax deductibility of home mortgage interest

Until 1986, all consumer credit interest was deductible, mortgage deduction survived


Additional Home Loan Subsidies Government guarantees like FHA-VA or

GNMA guarantees Tax breaks to qualifying residential lenders

(e.g. savings and loans) Sponsorship of agencies (FNMA, FHLMC,

FHLB) reducing their cost of borrowing Authorization of agencies to develop active

secondary markets in mortgages and sponsorship of mortgage pools


Housing Policy Commitment to home ownership Reduce cost of home ownership

– Subsidies– Tax breaks– Standardize contract designs (30-year fixed,

variable rates, etc.) to facilitate transfers– Connect the institutional investor market (the

bond market) to the home mortgage market to increase liquidity and reduce the cost of funds


Mortgage Market 1970 to 2002 Mortgage Market 1970 1980 1990 2004

Total Home Mortgages 294.9 964.7 2,626.6 8,096.4 Savings Institutions 164.0 478.5 600.2 875.9

Commercial Banks 48.0 159.0 430.3 1,568.0 Insurance Companies 24.6 17.9 13.0 4.7 Government Agencies 15.5 57.8 115.3 366.8

Federally Related Pools 3.0 107.1 991.1 3,416.9 ABS Issuers - - 55.4 1,088.0

Share Savings Institutions 55.6% 49.6% 22.9% 10.8%

Commercial Banks 16.3% 16.5% 16.4% 19.4%Insurance Companies 8.3% 1.9% 0.5% 0.1%Government Agencies 5.3% 6.0% 4.4% 4.5%

Federally Related Pools 1.0% 11.1% 37.7% 42.2%ABS Issuers - - 2.1% 13.4%

Source: Flow of Funds


Pools & Asset-Backed Securities Many small loans pooled together can be

sold to institutional investors (mutual funds, pension funds)

Each loan may prepay or default providing risks to investors– Default produces losses– Prepayments occur when rates go down– Each event can be viewed as an option held by

borrower (prepay is a call, default a put)


Pass-Through MBS Cash FlowsMortgage Pool – No Pre-Payments/No Defaults

Time

Cas

h Fl

ows Principal

Interest

Mortgage Pool –Pre-Payments/No Defaults

Time

Cas

h Fl

ows

Principal

Interest


Options in Mortgages

Loan Balance Home Value

Default option as put

Op

tion

val

ue

Loan Balance

Prepay option as call

Op

tion

val

ue

Mortgage Value


Mortgage Valuation

Mortgage is present value of mortgage payments– Minus value of default put– Minus value of prepay call

Can be modelled as a two-state option (states are home values and interest rates) as opposed to stock-option single-state option (value of stock)


Risk and Pools and Asset-Backed Pooling allows diversification of default risks Government can eliminate default and late-

payment risks through guarantees (e.g. GNMA pass-throughs)

Private mortgage insurance (PMI) can mitigate default risk

Cash flows can either be passthroughs of interest and principal or divided into tranches of interest and principal in collateralized mortgage obligations (CMO’s)


Payments to a CMO

Interest

Principal

300

Pay

men

t=I+

P

Interest

Principal

300

Pay

men

t=I+

P

Interest rates fall


Cash Flows to CMO Tranches

Example: cash flows divided into three tranches: tranche A gets all principal payments until 1/3 of principal is paid off, C gets interest only until A and B principal is paid off, and B gets principal payments until 2/3 principal A paid off, C gets all cash flows after A and B paid off

A has short-duration, C a long duration


CMO’s Cash Flows to Tranches

Interest

Principal

300

Pay

men

t=I+

P

30

Pay

men

t=I+

P

0A C

Interest rates fall


PACs

0

1000000

2000000

3000000

4000000

5000000

2005 2010 2015 2020 2025 2030

PPMTS

PAC = Planned Amortization Class; Source: FNMA


PAC Bands (75%-150%)

0

1000000

2000000

3000000

4000000

5000000

6000000

7000000

04 06 08 10 12 14 16 18

PPMT150 PPMT75 PPMTS

PAC = Planned Amortization Class; Source: FNMA


PAC Payments

Payments of principal paid to PAC classes as defined by PAC bands

Other classes absorb differences between actual and payments defined by bands


Mortgage Servicing

Individual mortgages must be processed– Payments credited and cleared– Reports (e.g. monthly billings year-end tax

statements)– Late payments and delinquencies processed– Defaults litigated and managed

Master-servicers– Payments to investors in pools with different

tranches and risks


Servicing Income

Servicing Fee = % Balance

Servicing Costs

Time

Fees, Costs

Value of mortgage servicing portfolio depends on prepayments and defaults


Consumer Credit

Small transactions, heterogeneous borrowers, high default risk and problems with delinquency and monitoring

Development of credit scoring with huge consumer credit data bases– Credit bureaus and department stores– Growth of TRW, Transunion, Equifax– Fair-Isaac analysis (FICO)


Recent Developments Advances in computer analysis and

customer communication– Data warehousing and data mining– Call service centers and other channels

Risk-based pricing– Credit scoring– Regulatory encouragement/approval

Dynamic underwriting– Performance based fees and charges– Feedback from the market


Mortgage Market Led the Way Selling claims on pools of consumer loans

was fostered by government agencies in the 1970’s creating active secondary markets

CMO’s were developed by investment banking industry together with government-sponsored agencies

Bank of America first securitized auto loans Recent years have seen a major growth in

asset-backed securities based on unsecured consumer credit (credit-card receivables)


Consumer Credit1982 1990 2004

Consumer Credit 390.3 805.1 2,140.7 Savings Institutions 26.6 49.6 91.3

Commercial Banks 190.9 382.0 711.4 Credit Unions 48.8 91.6 215.4

Finance Companies 93.2 138.1 365.6 ABS Issuers - 76.7 592.9

Share Savings Institutions 6.8% 6.2% 4.3%

Commercial Banks 48.9% 47.4% 33.2%Credit Unions 12.5% 11.4% 10.1%

Finance Companies 23.9% 17.2% 17.1%ABS Issuers 0.0% 9.5% 27.7%

Source: Flow of Funds


Unsecured ABS Issuances

To be made attractive to investors, must have investment-grade or higher ratings (e.g. AAA)

Must resolve problems of lenders selling lowest quality credits

Vehicle is master trust with lender keeping equity portion and investors lending amounts that are over-collateralized


ABS Structure Individual loans placed in a trust Notes or other claims are debt obligations

of the trust High-rated notes represent senior claims on

cash flows from principal and interest into the trust

Reserve accounts and subordination of claims of senior notes to residual (equity-like) participations retained by seller means effectively over-collateralized


Asset-Backed SecuritiesBorrower

Borrower

Borrower

Borrower

Borrower

Borrower

Borrower

Borrower

Loans (held in trust)(Over-Collateralized)

Principal Payments

Interest PaymentsLow Risk

Cash Flows From

Interest

Higher RiskCash Flows

From Principal

High RiskCash Flows(Residual) N

/RB

AA

AA

A


Growth in Consumer CreditRevolving and Non-Revolving Consumer Credit

0

200000

400000

600000

800000

1000000

1200000

1400000

1600000

Jan-70 Jun-75 Dec-80 Jun-86 Nov-91 May-97

Time

Ou

tsta

nd

ing

Total Revolving Non-RevolvingSource: Federal Reserve


Growth in ABS IssuancesABS Outstandings

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

500,000

Jan-89 May-90 Sep-91 Feb-93 Jun-94 Nov-95 Mar-97 Aug-98

Time

Ou

tsta

nd

ing

Total UnsecuredABS SecuredABSSource: Federal Reserve


Consumer Loan Credit RiskBank Consumer Credit Charge Offs

0

1

2

3

4

5

6

Time

Pe

rce

nt

Ch

arg

ed

Off

CreditCard OtherConsumerSource: Federal Reserve


Providian and Bank Risk Providian Financial was a $18-$20 billion

bank– Very rapid growth (earnings in 2000 up 44%)– Growth came from innovation

» Specialized in unsecured lending (credit cards)» Financed growth with securitization of credit-card

receivables (2000 $27 billion managed, $13 billion on balance sheet)

» Used extensive market-risk hedging

Providian same size as SeoulBank (Korea), Bumiputra-Commerce (Indonesia), Dao-Heng Bank (Hong Kong)


Risk Characteristics

Innovative lending products to untested market: sub-prime lending

Sophisticated approach to market– Risk-based pricing– Dynamic underwriting– Extensive data analysis and control

State-of-the-art customer management systems, call centers, marketing


U.S. 2001:III

U.S experiences a slow-down or a recession (debate continues)

Unemployment rates increase slightly Sub-prime delinquency and default

increased sharply Providian experienced unexpectedly large

loan losses and down-grades in securitized loans


Providian Losses

2001:IV loss of $481 million, about 25% equity

Stock price from $59 to $2

YearPeriod Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Credit Loss Rate 7.62 7.16 6.4 6.94 7.18 7.42 7.61 7.7130+Day Delinquency 4.91 4.7 5.2 5.66 5.72 6.48 6.71 7.52

YearPeriod Q1 Q2 Q3 Oct Nov Dec Jan Feb Mar

Credit Loss Rate 9.34 10.3 10 12.2 12.9 13.1 15.2 16 17.630+Day Delinquency 7.64 8.04 8.7 8.95 9.24 8.81 10.4 10.5 10.2

1999 2000

20022001


Important Implications

Providian did not hedge credit risk as consumer credit-risk market not as developed as commercial credit risk market

Providian’s risk exaggerated because of securitization where it retained higher risk tranches of cash flows and downgrades forced early amortization of loans

No historical precedent


Trends in Credit-Risk

Cannot rely on historical estimates of variability and covariability in markets characterized by innovation or recent emergence

Stress tests capture the problems but management must imagine the unexperienced problems


Final Exam: December 7, 2005 Examination is comprehensive with 1/3 on

material covered before the midterm, 2/3 on material covered since the midterm

Five long answer questions or problems with equal weight

Questions based on weekly objectives, important vocabulary, in-class problems

Suggestion: Review Wall Street Journal article listing to identify key issues this semester

j. k. dietrich - fbe 524 - fall, 2005 fixed income market (3) week 15 – november 30, 2005

Documents

loans u home

dietrich fbe

home mortgages u

home ownership u

mortgage valuation u

securities u

home mortgage market

u tax breaks