Transcript Class 2 - University of Southern California

Fixed Income Market (3)
Week 15 – November 30, 2005
J. K. Dietrich - FBE 524 - Fall, 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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Mortgage Market 1970 to 2002
Mortgage Market
Total Home Mortgages
Savings Institutions
Commercial Banks
Insurance Companies
Government Agencies
Federally Related Pools
ABS Issuers
1970
294.9
164.0
48.0
24.6
15.5
3.0
-
1980
964.7
478.5
159.0
17.9
57.8
107.1
-
1990
2,626.6
600.2
430.3
13.0
115.3
991.1
55.4
2004
8,096.4
875.9
1,568.0
4.7
366.8
3,416.9
1,088.0
Share
Savings Institutions
Commercial Banks
Insurance Companies
Government Agencies
Federally Related Pools
ABS Issuers
55.6%
16.3%
8.3%
5.3%
1.0%
-
49.6%
16.5%
1.9%
6.0%
11.1%
-
22.9%
16.4%
0.5%
4.4%
37.7%
2.1%
10.8%
19.4%
0.1%
4.5%
42.2%
13.4%
Source: Flow of Funds
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
Pass-Through MBS Cash Flows
Mortgage Pool – No Pre-Payments/No Defaults
Principal
Interest
Time
Mortgage Pool –Pre-Payments/No Defaults
Principal
Interest
J. K. Dietrich - FBE 524 - Fall, 2005
Time
Default option as put
Loan Balance
J. K. Dietrich - FBE 524 - Fall, 2005
Option value
Option value
Options in Mortgages
Prepay option as call
Home Value Loan Balance Mortgage V
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)
J. K. Dietrich - FBE 524 - Fall, 2005
Risk and Pools and Asset-Backed
 Pooling
allows diversification of default risks
 Government can eliminate default and latepayment 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)
J. K. Dietrich - FBE 524 - Fall, 2005
Payments to a CMO
Principal
Interest
0
30
Principal
Interest
0
Interest rates fall
J. K. Dietrich - FBE 524 - Fall, 2005
30
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
J. K. Dietrich - FBE 524 - Fall, 2005
CMO’s Cash Flows to Tranches
Principal
Interest
0
30
Interest rates fall
A
0
J. K. Dietrich - FBE 524 - Fall, 2005
C
30
PACs
5000000
4000000
3000000
2000000
1000000
0
2005
2010
2015
2020
PPMTS
PAC = Planned Amortization Class; Source: FNMA
J. K. Dietrich - FBE 524 - Fall, 2005
2025
2030
PAC Bands (75%-150%)
7000000
6000000
5000000
4000000
3000000
2000000
1000000
0
04
06
08
PPMT150
PAC = Planned Amortization Class; Source: FNMA
J. K. Dietrich - FBE 524 - Fall, 2005
10
12
14
PPMT75
16
18
PPMTS
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Servicing Income
Fees,
Costs
Servicing Fee = % Balance
Servicing Costs
Time
Value of mortgage servicing portfolio
depends on prepayments and defaults
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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 governmentsponsored 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)
J. K. Dietrich - FBE 524 - Fall, 2005
Consumer Credit
Consumer Credit
Savings Institutions
Commercial Banks
Credit Unions
Finance Companies
ABS Issuers
1982
390.3
26.6
190.9
48.8
93.2
-
1990
805.1
49.6
382.0
91.6
138.1
76.7
2004
2,140.7
91.3
711.4
215.4
365.6
592.9
Share
Savings Institutions
Commercial Banks
Credit Unions
Finance Companies
ABS Issuers
6.8%
48.9%
12.5%
23.9%
0.0%
6.2%
47.4%
11.4%
17.2%
9.5%
4.3%
33.2%
10.1%
17.1%
27.7%
Source: Flow of Funds
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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 (equitylike) participations retained by seller means
effectively over-collateralized
J. K. Dietrich - FBE 524 - Fall, 2005
Asset-Backed Securities
Borrower
Borrower
Loans (held in trust)
(Over-Collateralized)
High Risk
Cash Flows
(Residual)
Principal Payments
Higher Risk
Cash Flows
From
Principal
Borrower
Borrower
Borrower
Borrower
Borrower
Borrower
J. K. Dietrich - FBE 524 - Fall, 2005
Interest Payments
Low Risk
Cash Flows
From
Interest
Growth in Consumer Credit
Revolving and Non-Revolving Consumer Credit
1600000
1400000
1200000
Outstanding
1000000
800000
600000
400000
200000
0
Jan-70
Jun-75
Dec-80
Source: Federal Reserve
Total
J. K. Dietrich - FBE 524 - Fall, 2005
Jun-86
Time
Revolving
Non-Revolving
Nov-91
May-97
Growth in ABS Issuances
ABS Outstandings
500,000
450,000
400,000
350,000
Outstanding
300,000
250,000
200,000
150,000
100,000
50,000
Jan-89
May-90
Sep-91
Feb-93
Jun-94
Nov-95
Time
Source: Federal Reserve
J. K. Dietrich - FBE 524 - Fall, 2005
Total
UnsecuredABS
SecuredABS
Mar-97
Aug-98
Ja
n85
Ju
l-8
Ja 5
n86
Ju
l-8
Ja 6
n87
Ju
l-8
Ja 7
n88
Ju
l-8
Ja 8
n89
Ju
l-8
Ja 9
n90
Ju
l-9
Ja 0
n91
Ju
l-9
Ja 1
n92
Ju
l-9
Ja 2
n93
Ju
l-9
Ja 3
n94
Ju
l-9
Ja 4
n95
Ju
l-9
Ja 5
n96
Ju
l-9
Ja 6
n97
Ju
l-9
Ja 7
n98
Ju
l-9
Ja 8
n99
Ju
l-9
Ja 9
n00
Percent Charged Off
Consumer Loan Credit Risk
Bank Consumer Credit Charge Offs
6
5
4
3
2
1
0
Time
Source: Federal Reserve
J. K. Dietrich - FBE 524 - Fall, 2005
CreditCard
OtherConsumer
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), DaoHeng Bank (Hong Kong)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Providian Losses
Year
1999
2000
Period
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 7.71
30+Day Delinquency 4.91 4.7 5.2 5.66 5.72 6.48 6.71 7.52
Year
2001
2002
Period
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 17.6
30+Day Delinquency 7.64 8.04 8.7 8.95 9.24 8.81 10.4 10.5 10.2
 2001:IV loss
of $481 million, about 25%
equity
 Stock price from $59 to $2
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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