FRM schweser part 2 book 2 2013 (2of 2)

Residualin trust account: yÿl + rt~TOCt T=J Thesumof these terminal cash flowsiscomparedto theamountduetothesenior tranche, If diesumislargeenough, thesenior trancheis paid off and there

Topic26 CrossReferenceto GARPAssigned Reading-Malz,Chapter 9

Therefore, the totalamountdepositedinto thetrust accountinyeartis:

II follows that the totalamountaccumulatedin the trust accountin yeartis:

t-iR[+GCt+ÿ(l+r)t-TOCT

T=l

Now,ifexcessspread,isnegative(L(-B <0), the custodianmustcheck if die trust account

can cover the shortfall.Formally, thetestfordiecustodianis:

t— I

RL +ÿJ(1-l-t)t_TOCT >B— Lt

T=1

Note diat thereisnoOCt term toadd toRtsincethereisnoexcessspread thisperiod Ifthe

above testis true, then the trust account canmake the bondholders whole.Ifitisnot true,

t—I

then the fundisreducedto zeroandbondholdersreceiveRc -fÿ(l-fr)1-'

rOCTfrom die

Note diatdieupper condition representsinflows to thetrust accountwhile thelower

condition representsoutflowsfrom the trust account.

Finally,die equity cash flowscan beexpressedas:

max(Iÿ —B-QCt,0)for t = 1 ,T-1

The cash flowsin die finalyear must beexaminedseparately for severalreasons.First,the

surviving loans reach maturityand principal is returned.Second,diereisnodiversiontodie

trust accountbecause thestructureends and all proceedsfollowthe waterfall Third,since

diereisnodiversion to thetrust,there isnoneedto testovercollateralization triggers

Theterminal cash flowsaresummarizedasfollows:

CrossReferenceto GASPAssigned Reading—Mali,Chapter9

3 Recoveryinfinal year:R-j = 0.4dy x par

T

4 Residualin trust account: yÿ(l + r)t~TOCt

T=J

Thesumof these terminal cash flowsiscomparedto theamountduetothesenior tranche,

If diesumislargeenough, thesenior trancheis paid off and theremainderisavailablefor

dierestof thecapitalstructure.Ifthe remainderislargeenoughto coverdie junior tranche,

then the residualflows toequity.If die remaindercannot meetjunior claims, the juniorbonds receivetheaccessand equity holdersreceivenothing

Asanexample, determine die terminalcash flowsto senior, junior,andequity tranchesgiven thefollowinginformation.Theoriginalloan poolincluded 100loans with$1millionparvalueandafixedcouponof8%.The numberofsurvivingJoansis90 The par for theseniorand junior tranchesis75% and20%,respectively.The equityinvestorscontributed theremaining 5% Therewere twodefaults widirecoveryrateof40% recoveredat theend

of the period The value of the trust account atthe beginningof the periodis$16millionearning4% perannum.

1. Totalsizeof collateralpoolat origination:100 x $1,000,000= $100,000,000

2 Seniortranche par=$75,000,000

Junior tranche par = $20,000,000Equitytranche par-$5,000,000

3 Interestfromloans:90 x8% x$1,000,000=

4 Redemption at par:90 x $1,000,000=

5 Recovery infinal year: 2x40% x$1,000,000=

6 ValueofOCatendof finalyear:$16,000,000 x1.04 = $16.640.000

$114,640,000

$7,200,000

$90,000,000

$800,000

7, Total available tosatisfyall claims=

8. Seniorclaim -$75,000,000<$114,640,000 Senior claim issatisfied w/o impairment

9 Juniorclaim $20,000,000 <$114,640,000-$75,000,000sojuniorclaimissatisfied

10 Equity claim = $114,640,000-$75,000,000-$20,000,000 = $19,640,000Now,continuewith diesameexample, but change theinterest rate to5%and thebeginningOCvalueto$3million The first two stepswill be thesame asbefore

3 Interestfrom loans: 90 x 5%x $1,000,000=

4 Redemption at par:90 x$1,000,000=

5. Recovery in finalyear: 2 x40% x$1,000,000=

6 ValueofOCatendof finalyear:$3,000,000x 1.04=

7 Total availabletosatisfy all claims=

8. Senior claim = $75,000,000<$98,420,000 Senior claim issatisfiedw/oimpairment

9 Juniorclaim =$20,000,000<$98,420,000-$75,000,000sojuniorclaim issatisfied

10 Equity claim-$98,420,000-$75,000,000-$20,000,000 =$3,420,000

Topic26 CrossRetWenceto GARPAssigned Reading— Malz, Chapter9

Finally,continuewith thesameexample, butchange theinterestrate to4% and the

beginningOCvalueto$1 million.Assumea recoveryrateofzero.Again, thefirsttwo steps

arethesame ashefbre

3 Interestfrom loans:90 x 4% x $1,000,000=

4 Redemption atpar:90 x $1,000,000=

5 Recoveryin finalyear: 2 x 0%x $1,000,000 =

6 Value ofOCatendof final year:$1,000,000x 1.04=

7 Total availabletosatisfy all claims

H. Seniorclaim-$75,000,000< $94,640,000 Seniorclaimissatisfiedw/oimpairment

9 Junior claim = $20,000,000>$94,640,000-$75,000,000so junior claim isimpaired

Junior tranchereceives $19,640,000

10 Equity claim= $94,640,000-$75,000,000-$20,000,000< 0

Equity tranche receives$0SIMULATION APPROACH

AIM 26.6:Describea.simulation approach tocalculating credit losses for different

tranchesinasecuritization ofaportfolio ofloans

The prioranalysismadea few very importantsimplifyingassumptions Inparticular, the

analysis assumed that the default race was constant yearoveryear,eachloan exhibited the

samedefaultprobability,and the correlation between loanswasignored.In practice, these

assumptions needtobe broughtinto the analysisandthe only tractablewaytodosois via

simulation

Although the technical detailsarewellbeyond thescopeof theexam,wecan sketchout the

basicstepsandintuitionfor diesimulationapproach tocalculating creditlosses

Step1 : Estimate the parameters.

Step2: Generatedefault timesimulations

Step3: Compute portfoliocreditlosses

The firststep is toestimatethecriticalparameters,defaultintensity, andpairwise

correlations Thedefaultintensitycan be estimatedusingmarketspreaddatatoinfer

the hazard rate acrossvariousmaturities.This piecewise-bootstrappingmethodologyto

constructthecumulativedefault distributionwasdiscussedinTopic24 Estimating the

correlation coefficientsismorechallengingbecause ofalackof usable market data The

copulacorrelationcould he usefulin theory hutsuffersempiricalprecision in practice

Instead,asensitivityanalystsis performed forvariousdefault andcorrelationpairs

Thesecondstepidentifies if and when diesecuritydefaults.Simulation provides

informationonthe timingfor each hypotheticaloutcome.The thirdstep usesthe

simulationoutput to determine thefrequencyandtimingoI credit losses The credit

lossescan be"lined up”to assess the impactondiecapitalstructurelosses The tail of the

distribution willidentify die creditVaRfor each tranchein the securidzation

CrossReferenceto GARPAssigned Reading~ Mali, Chapter9

IMPACT O* PROEABILITY OP DEFAULTANO DEEAUIT CORRELATION

AIM26.7: Explain how the probability of default and default correlation among

theunderlyingassetsofasecuritizationaffects the value* losses and Credit VaR of equity* junior*andsenior tranches.

Thereareseveralimportant comparativestatisticsassociated withagenericsecuritization.Thefollowing results represent theeffect oftheaveragetranchevalues and writedowns.Tire

implications ofextremetaileventswill hediscussedshortlyusing VaR.The firstfactorto

consideris the probabilityof default It isstraightforwardto see that, foragivencorrelation,

increasing the probabilityof default will negativelyimpact the cash flowsand, thus, the

valuesof all tranches*

Theeffect of changing the correlation ismoresubde Consider the stylizedcasewhere die

correlation isvery low,sayzero, soloan performanceisindependent.Therefore,inalargeportfolio,itisvirtually impossible for noneof the loans todefault anditisequally unlikely

that diere will hea largenumberofdefaults.Rather, thenumber of defaults should he verycloseto the probabilityofdefaulttimesthe numberof loans.So*thepoolwotddexperience

a levelofdefaultsveryclosetoitsmathematicalexpectationandis unlikelyto impair the

seniortranches Theanalogoussituation isflippingacoin 1,000 times—the numberof

heads would beverycloseto500 Itwouldbevirtuallyimpossible forthe numberof heads

tobeless than400or greater than600 Now, ifthe correlationincreases,the defaultofone

creditincreasesthe likelihoodof another default.Thus, increasingcorrelation decreases thevalueofseniortranchesas the poolisnow morelikelytosufferextremelosses Thiseffectisexacerbated witha higherdefaultprobability

Nowconsiderdie equity tranche Recall chat the equity tranche suffers the first writedowns

in the pool.Therefore,alowcorrelation impliesa predictable,but positive, numberof

defaults.In turn, the equity tranche willassuredlysuffer writedowns.On die other hand,

ifthe correlationincreases,the behaviorof thepoolis more extreme, and there may be

high levels of related lossesortheremay bevery'few loan losses Insum,theequitytrancheincreases in value fromincreasingcorrelationas thepossibility'ofzero(orfew) credit lossesincreases from thehighcorrelation

The correlationeffecton themezzanine trancheismorecomplex When defaultrates are low, increasing the correlation increasesthe likelihoodof losses to the juniorbonds(similar

coseniorbonds) However,whendefaultrates arerelatively high, increasing the correlation

actuallydecreases the expected lossestomezzaninebondsasthe possibility of fewdefaultsis

now morelikely Accordingly, themezzaninebondmimicsthereturn patternof the equity

tranche Inshort, increasingcorrelationatlow defaultratesdecreases mezzaninebond

values,butac highdefault ratesit will increase mezzanine bondvalues

Convexityisalsoanissuefordefaultrates.For equity investors, asdefaultrates increasefrom low levels, the equity tranche valuesdecrease rapidly then moderately(a characteristic

ofpositiveconvexity).Sincetheequitytrancheisthin,smallchanges indefault rateswilldisproportionatelyimpact bond pricesacfirst.Similarly,seniortranches exhibit negativeconvexity Asdefaultsincrease,thedeclinein bond pricesincreases.As usual, die mezzanineimpactissomewherein between:negative convexityatlowdefault rates,positive convexity

at highdefault rates.

Topic26 CrossReferenceto GARPAssigned Reading-Mail,Chapter 9The previoussection iocusedon theaverage (mean)value of die tranches while thissection

examines the distributionof possible tranche values (risk).Specifically, the goal Is toanalyze

the impact of default probabilityand default correlation underextremeconditions (farinto

the tail) The metricusediscredit VaR forvariousranges ofdefault probabilityanddefault

correlationfor thesenior, junior,andequitytranches.Themain resultis that increasing

defaultprobability,whileholdingcorrelation constant,generally decreases theVaRfor the

equitytranches(less variationin returns)andincreasestheVaRfor thesenior tranches

(more variation in returns) Asusual, themezzanineeffectismixed: VaRincreasesatlow

defaultlevels (like seniorbonds) then decreasesat highdefaultlevels (likeequity).These

resultsaresummarizedinFigure3

Figure3:Increasing Default Probability (HoldingCorrelationConstant)

Thenexteffect toconsideris dieimpactofa risingcorrelation.Asa reminder, increasing

correlationincreasesthe clustering ofevents,either highfrequency ofdefaultsorvery

lowfrequencyofdefaults.Increasing correlation decreasesseniorbond pricesasthe

subordinationIsmorelikelytobe breached ifdefaultsdo indeedcluster.Incontrast,equity

returnsincreaseas the low defaultscenario ismoreprobable relative tolow correlation

wheredefaultsarealniosLcertain

Asthedefault correlationapproachesone, the equity VaRincreasessteadily.The

interpretationisthaE although themean returnisincreasingsoisthe riskas thereturns are

morevariable (largelossesor very smalllosses).

Allelseequal,theseniorVaRalsoincreasesconsistentlywith correlation.However, we note

aninteresting effect: the incremental difference between highcorrelations (0.6versus0.9) is

relativelysmall In addidon, two pairwiseresultsarewordi highlighting.Ifcorrelationislow

and defaultfrequencyis relativelyhigh, then seniorbondsarewell insulated Infact,at the

10%subordinationlevel, diesenior bonds wouldbe unaffectedeven at a highdefault rate.

Atthe otherextreme, when correlationsare high(0.6orabove), dien the VaRsarequite

similar regardlessof the default probabilityHence,generally speaking, correlation isa more

important risk factor thandefaultprobabilitywhich maynotbeentirelyintuitive

The implicadonsfor the mezzanine trancheare, again,mixed.Whendefaultratesand

correlationsarelower, themezzanine tranche behavesmorelikeseniornoteswith low VaRs

However,when thedefault probabilitiesare higherand/orpairwisecorrelationishigh,

the risk profilemoreclosely resembles the equitytranche.These resultsaresummarizedin

Figure4

Cross Reference to GASPAssigned Reading—Mali,Chapter9

Figure4:IncreasingCorrelations (Holding Default ProbabilityConstant)

I(atlowcorrelation)

|(athighcorrelation)

MEASURING DEFAULT SENSITIVITIES

AIM26.8:Define and describe how defaultsensitivitiesfor tranchesaremeasured.

The previousdiscussionhighlightedtheeffect of increasing theprobabilityof default, which

decreases tranchetallies.However, thiseffectis notnecessarily linear and also dependson

the interaction with thedefaultcorrelation.Toanalyze themarginaleffectsin moredetail,

the definition ofDV01isextended todefault probabilities andiscalled“default'0LM

The defaultprohahilitywill be shocked upand downbythesame amount(byconvention

10 basis points) andeach tranche will be revalued through die VaRsimuladons.The

formulationfordefault*01 of each trancheisasfollows:

1/20 [(meanvalue/loss basedon TT +0.001)-(meanvalue/loss basedom-0.001)]

Fromthisequation, thereareseveral qualitadveimpacts to note First,die default

sensitivitiesarealwayspositive for anydefault probability-correlationcombination

This followsfrom thepreviousobservation that all tranchesare negatively affected from

increasingdefault probabilities.Second, the default '01willapproachzero asdefaultrates

become sufficientlyhighasdiemarginalimpactof increasing thedefault ratehas minimal

effect The third resultfollowsfrom thesecond.Therewill bemorevariation In thedefault

sensitivitieswhen thedefault rate generates losses close to the tranche’s attachment point

This resultissimilar to die high gamma (highsensitivity in delta)foroptionsat-the-money

RISESFOR STRUCTURED PRODUCTS

AIM 26.9:Summarizesomeofthedifferenttypesof risks that playarolein

structured products.

Asidefrom thecredit portfolio modelingissuesdiscussedbefore, thereare atleast threeotherrisks that deserve discussion: systematic risk, tranche thinness, andloangranularity

Similar to awell-diversifiedequityportfoliothatcannoteliminate systematic risk, the

sameholds truefor credit portfolios Unfortunately,evenwhen die collateral pooliswell-diversifiedamonglenders, terms,geography,andother factors,highsystematic risk

expressedin highcorrelationscan stillseverelydamagea portfolio.Aspreviouslydiscussed,with increases in pairwise correlations, the likelihoodofsenior tranchewritedownsincreases

aswell

Topic26 CrossReferenceto CARPAssigned Reading-Mail,Chapter 9

The equityandmezzanine tranchesarerelatively chin This also manifests itselfin the

relative closenessof the 55%and59% creditVaR.The implicationis thatgiven that the

tranche hasbeenbreached, die loss islikelyverylarge

Loangranularityreferences the loan leveldiversification. Forexample,ina collateralized

MBSpool, the portfoliocompositionisa few loanshut theloansareofsubstandalsize

This reduction insamplesize increasestheprobability of taileventsin relation to anequal

sized portfolioconstructedwithmoreloans of smalleramounts

IMPLIED CORRELATION

AIM 26.10:Define implied correlation and describe howit canbe measured.

The impliedcorrelationisavery similarconcept to theimplied volatilityofanequity

option For options, the Black-LScholes-Merton modelisawidely accepted valuation model

andso the observablemarket priceisassociated with aunique unobservedvolatility.For

securitized tranches, the processisexactlythesame.Starting with observed market prices

anda pricingfunctionfor the tranches, itis possibletoback outtheunique implied

correlation tocalibrate themodel price with die market price

The mechanicalpartof the process involvesseveralintermediatesteps First,theobservable

credit defaultswap (CDS) term structureis used to extract risk-neutral default probabilities

andpossiblyrecovery rates.Assumingconstan cpairwisecorrelationand market prices for

the respective tranches, the defaultestimatesand correlationestimatescan befedintoa

copula Theoutputis the risk-neutral implied correlation(i.e.,basecorrelation) per tranche

The correlationestimateswill vary between the tranchesand are not likelytobeconstant

givingrise tocorrelationskew.Asanexample,supposedie observed market priceof the

equitytrancheincreasesfrom $3 million to$3.2 million,but theestimatesof the

risk-neutralprobabilityof default remain thesame.It canbe inferred that the market’sestimate

of the implied correlationmusthave increased Theprecisevaluemust be extractedfrom

the pricingmodel butqualitativelythe direction iscorrectÿincreasingcorrelationsbenefit

equityholders

MOTIVATIONS FORUSING STRUCTURED PRODUCTS

AIM26.11:Identify themotivationsfor usingstructuredcredit products.

Identifyingthemotivationsof loanoriginatorsandinvestorscan provideabetter

understanding for whysecuritizationsareestablished

Loan originators,whohelpcreatesecuritizationsby sellingloans intoa trust, areattracted

toborrowingviasecuritization given itsabilityto providealowercostoffunding.Without

securitization, loanswould either be retainedorsold inthesecondarymarket.These

alternatives wouldlikely bemorecostly than securing fundingvia securitization.Alower

costoffundingcan be obtained given the diversification of the loanpoolanddie reputation

of the originator for underwriting high-quality loans.However,someloanpools,suchas

commercialmortgagepools,can be difficult todiversify.Thus,an elementof systematic risk

CrossReferenceto CARPAssignedReading—Mali, Chapter9

may stillexist, which couldlead to anunderestimation ofoverallrisk An additional henefit

ofsecuritizationfor loan originatorsisdie collectionofservicingfees

Investors,who purchase theassetsinasecuritization,areattractedtoinvestingin diversified

loan pools that theywouldnototherwise haveaccess towithoutsecuritization,suchas

mortgageloans andautoloans In addition, the abilitytoselecta desired fish-returnlevel

viatranchingoffers another advantageforinvestors.Equity tranches will offerhigher

risk-returnlevels, whilesenior tranches will offer lowerrisk-return levels.However, it isimportantforinvestorstoconduct the properduediligencewhenanalyzing potential

tranche investmentsinorder to understand theactual levelof riskinvolved.

©2013Kaplan,Inc.

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Topic26 CrossReferenceto GARPAssigned Reading-Malz, Chapter3

KEY CONCEPTS

AIM 26.1

Securitization is dieprocessof pooling cash flow generatingassetsandreapportioning

the cash flowsintobonds.Thesestructured productsgenerate awide rangeofrisk-return

profiles that varyin maturity, creditsubordination(equity,mezzanine,and senior),typeof

collateral (mortgages,autoloans,and credit card balances), activeorpassivemanagement,

andstaticorrevolvingassets.Atruesecuritization

balance sheet

theassetsfrom theoriginator’s

removes

AIM 26.2

Thecapitalstructureofasecuritization refers tothedifferentsizeandpriority of the

tranches.Ingeneral, thesenior tranchesare the largest,safest,andlowest yielding bonds

inthecapitalstructure.The mezzanine tranche has lower priority dian diesenior tranche

andispromised ahighercoupon.The lowest prioritytranche that bears the first loss is die

equitytranche Thesizeof theequityandmezzanine tranchesprovidessubordinationfor

thesenior tranche.Internal credit enhancement, such asovercollateralization andexcess

spread, buffersthesenior tranchesfrom losses.Likewise,externalwrapsand insurance also

protect the senior bondholders

AIM26.3

Awaterfallstructuredetails the distributionof collateral cash flows to the different classes

of bondholders The equity tranchetypicallyreceives theresidualcash flowsoncethe senior

andmezzanineinvestor claimsaresatisfied.If the cash flows toequityholders exceed the

overcollateralizadon trigger, dieexcessis divertedto a trust account.FeesanddeJaults will

reduce thenetcashflowsavailablefor distribution

AIM26.4

LSecuridzation isacomplicated processand typicallyinvolvesan originator,underwriter,

creditrating agency, servicer,and manager.The originatorcreates dieinitial liability; the

underwriter poolsandstructures thetermsof the dealas wellasmarkets theissue;the credit

rating agencyisanactive participant suggesting/ requiringsufficientsubordinationand

enhancementstojustifythe ratings; theservicer collects and distributes the cash flowsto

investorsandmanagesdistressresolution; managers, hothstaticandactive, usually bear the

first losstomitigateconflictofinterestinassetselection and credit monitoring

interestowedtosenior+ mezzanine).The overcollateralizationaccountincreasesfrom

recovery ofdefaultedassetsanddiversionofspread (usually a maximum ispredetermined)andearns themoneymarketrate.Ifexcessspreadis negative(i.e.,interestcollected <

interestowedtosenior+ mezzanine), theOCaccountwill useall ofitsavailablefundsuntil

depleted.The terminal cash flowsare morecomplicated: redemptionsat par+ interestfrom

surviving loans + recovery infinal period+terminalOCaccount. Nofundsarediverted

in thefinal yearasitall isaggregated and disbursed.Seniorclaimsare paid first;ifsenior is

paid in full, mezzanineclaimsare paid; ifmezzanine is paidin full, the residualaccrues to

equityholders

AJM26.6

Simulationisa useful techniquetoprovidemoreinsightinto theperformance of the

collateral and, hence, cash flows tothe tranches In particular, thedefaultintensitycan betime-varyingand estimated usingahazard distribution.The correlation hetween loans iscriticaltotire performanceof the pool, sovariousdefault prohability/correlationpairsare

used.Copulascould he usedtosimulate the timing of diedefaults.Finally,simulations allowcomputationofVaRsfor each tranche

AJM26.7

Increasingdefault probabilitywilldecrease alltranches unconditionally Incontrast,

increasing correlation willimpact each tranchedifferently.Ingeneral, increasing default

correlationincreases thelikelihood ofextremeportfolio behavior(veryfewormanydefaults)

CreditVaRcan be usedto measurethevalueof the tranchesin the left tail.Increasing

theprobabilityof default,increasesthe VaR of all tranches Incontrast:,increasingthe

correlationdecreasesequity VaR andincreases seniorVaR

AJM26.8

Defaultsensitivitiesaremeasured analogouslytoDV01 andspread‘01 byshockingthe

defaultprobability up and down by10 hasis points Defaultsensitivitiesarealwayspositiveandarelargest when the resultinglossisclosetothe attachment point

©2013 Kaplan,Inc

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Topic26 CrossReferenceto GARPAssignedReading-Mali,Chapter 9AIM26.9

Similar toequity portfolios,systematicrisk ispresent incredit portfolios.Extremeloss

events arecaptured byhigh defaultcorrelations The thinnessof the equity and mezzanine

tranches implies that conditional lossesarelikely tobelarge.Aless granular pool(fewer but

largerloans) ismorelikelytoexperiencea tailevent,all elseequal

Implieddefaultcorrelationsforeach tranchecanhe backedout of thetranche pricing

modelsimilartohow theimplied volatilityiscalculated for die Black-Scholes-Merton

model.

AIM26.il

Loan originatorshelpcreatesecuritizationsby sellingloansintoa trust.Theyareattracted

tosecuredborrowingvia securitization because it providesalowercostoffunding

than alternativessuch asretaining loans Investorspurchase the bondsandequityina

securitization.Theyareattracted tosecuritization becauseitallows them toinvestin

diversified loan pools thataretypically reservedfor banks

CrossReferenceto GARPAssignedReading-Mali, Chapter9

CONCEPT CHECKERS

How manyof thefollowingstatementsconcerning die capital,structureina

securitizationare mostlikelycorrect?

I Themezzaninetrancheis typicallythesmallest tranchesize

II Themezzanineand equitytranches typically offer fixedcoupons

Ill, Theseniortranche typicallyreceives the lowest coupon

A Nostatements are correct.

B Onestatementiscorrect.

C Twostatements are correct.

D, Threestatementsarecorrect.

1.

Assume thereare 100identicalloanswitha principal balance of$500,000each

Basedon acreditanalysis,a300basis pointspreadisapplied tothe borrowers.LIBOR iscurrently4% andthecouponratewill resetannually Thesenior,junior,

and equitytranchesare75%, 20%,and5% of thepool, respectively.The spreads

ontheseniorandmezzaninetranchesare2% and 6%.Excesscash flowisdivertedabove$1,000,000 Assume[hedefaultrateis2%.Whataredie cash flows todie

mezzanineand trust account in the first period?

A Creditratingagency andservicer,

B Servicerand underwriter.

C Custodianandtrustee,

D, Trusteeandmanager

3

Whichof thefollowingstatementsabout portfoliolosses and default correlationare

mostlikelycorrect?

1 Increasing default correlation decreasessenior tranche values butincreasesequity tranchevalues,

II Athighdefault rates,increasing default correladondecreasesmezzaninebond

prices

4

A Ionly

B IIonly

C Both IandII

D Neither Inor II,

Topic26 CrossReferenceto GARPAssignedReading-Mali,Chapter9Whichof thefollowingstatementsbest describes the calculation of implied

D The risk-adjusteddefaultprobabilitiesareused inmodel calibration

Foradditional Book2 Topic26practice questionssee:

5

Self-TestQuestions:#7(page248)

CrossReferenceto GARPAssignedReading-Mail,Chapter9

CONCEPT CHECKER ANSWERS

1. B Seniortranchesarcperceivedtobe the safest,sotheyreceivethe lowestcoupon.The equity

tranchereceivesresidualcash flows andnoexplicitcoupon.Althoughthemezzaninetranche

is often thin, the equitytranche Lstypicallythe thinnest slice

2. A Theinterest rate on the loans=4%(LIBOR)+3%(spread)=7% Therefore, the total

collateral cash flowsin thefirst period=100 x $500,000 x7%x(1-0.02)=$3,430,000.

Theseniortranchereceives$50million x0.75x(4%4 2%)=$2,250,000.Similarly,themezzaninetranchereceives $50million x 0.20 x(4%4 6%)=$1,000,000 Next,thetcsidualcash flowsarc calculated; $3,430,000-$2,250,000-$1,000,000=$180,000 Since

$180,000<$1,000,000,allcashflews arcclaimedhythe equityinvestorsand thereis no

diversion tothetrust account.

3 C Thecustodianandtrusteeplaythe least important rolesinthesecuritization process.The

servicer,originator,underwriter,credit rating agency, and manager all face conflicts of

interest tovaryingdegrees

4 A StatementIis true.Increasing default correlationincreasesthelikelihoodofmore extreme

portfolioreturns(veryhighor verylow numberofdefaults).The increased likelihoodofhighdefaultsnegativelyimpacts the seniortranche.Onthe other hand, the increasedlikelihood

of few defaults benefits the equity trancheas itbears first loss.Statement IT isfalse.Athighdefault rates,increasingthe correlation increasesthe likelihoodofmore extremeportfolio

returnswhich benefits equityinvestorsandmezzanine investors.

5 G Startingwithobserved market prices and-apricing function for tbctranches, it Ispossihlc

to backouttheimpliedcorrelationtocalibrate the model price with the market price

Thecomputation ofimpliedcorrelation assumes constantpairwisecorrelation Both

credit defaultswap andtranche valuesarcobserved Observedtranchevaluesareusedin

conjunctionwithrisk-neutral defaultprobabilitiesto computeimpliedcorrelation.

©2013 Kaplan,Inc

Page 156

Thefollowingis a review of llie Gretfii Risk Measuremefu and Managementprinciples designedto address tlie

AIM staiemenis set forth byGARP®.This topic is also covered in;

SECURITIZATION

Topic 27

EXAM FOCUS

Securitization is [he process of selling cash-flow producing assets to a third party (special

purpose entity), which in turn issues securities backed by the pooled assets.Securitizations

areoften structured withinternal(e.g., overcollateralization) orexternal (e.g., letters ofcredit)

enhancements.Mortgage-hackedsecurities securitizeresidentialmortgages wheredie property

serves as the collateral.For theexam,be able todescribe thesecuritization processand he able

toidentify thevariousinternal andexternalcredit enhancementsdiscussed.

AIM27.1:Definesecuritizationand describe the process and the role the

participants play.

Securitization isthe process ofsellingcredit-sensitiveassets(i.e.,debt obligations) to a

thirdparty that subsequentlyissues securitieshackedby the pooled cash flows (principal

and interest) ofthesameunderlyingassets.Cashis transferred to thesellingparty andthe

obligation iseffectively removed from the seller’s balance sheet if the saleismade without

recourse(i.e.,a truesale).Hence,securitization represents an off-balance-sheet transaction

Further, thereexistsawiderangeofassetsthatcan be securitized (eg.,mortgages, credit

cardreceivables,autoloans),bur thecommon featureisthat die underlyingassetsgenerate

cash flows In die process just described, it isimportantto note that the third party was not

involvedin theoriginal transaction

PARTICIPANTSIN THE SECURITIZATION MARKET

Thefollowingisacomprehensivelistof participantsinatypicalsecuritization.However,all

parties neednothe involved tocompleteasecuritization

• Originator/Transferor.The originatoristhe entity thatseeks to convertits

credit-sensitiveassetsintocash(“monetize”theasset).Thecredit riskis then transferredaway

from die originator

• Sponsor.The sponsoristheinitiatorof thesecuritization.Ifahankwantstosecuritize its

ownloans,thehankisbodi thesponsorandoriginator Foranon-financialcompany, the

company mayinitiatethe processuomonetize itsaccountsreceivable(serveas ownsponsor),

or anoutside financialinstitutionmayinitiate thesecuritization (externalsponsor)

CrossReferenceto GARPAssignedReading-Culp, Chapter16

• Asset punchaser/Transieree/Securitized productissuer.Thisrefersto the thirdpartywho

stands between theoriginatorand theeventual purchaser of thesecurities.Asdie name

implies,dieasset purchaser literally buys theassetsfrom theoriginator Thetransferee

isadistinctlegal entityfrom the originator When thestructure iscreatedsolelyfor thepurposeofbuyingtheassets,itiscalledaspecial purpose entity (SPE).TheSPE may

heacompanyor trust (moreon this in thenextAIM).Freddie Macand FannieMaeare

transfereesin themortgagemarket

» Trustee.Thetrusteeischargedwidithefiduciary responsibilitytosafeguarddieinterests

of dieinvestorswhopurchase thesecuritizedproducts.The trusteewill monitor the

assetsbasedon prespecifiedconditionsof theasset pool suchasminimumcredit quality

anddelinquencyrates.

* Custodian.Historically, thecustodialrolewas tosafeguard the physicalsecurities,buthas evolved toalso collectanddistribute die cashHowsofassetslikeequitiesandbonds.

• Servicer.The rolesof theservicerand custodianhave blurredinrecentyeans and they

may, in fact, be thesame party.The servicerwill collectanddistribute the cash flows

from theassetpool.The originator mayretain theservicingrights,whichcan be

valuable

* Structuringagent.Thestructuringagentis thedefitcto advisorforthesecuritizationissue.The agent will belargely, ifnotentirely,responsiblefor the securitydesign(e.g.,maturity',desired creditrating,creditenhancement) andforecastingdieinterest and

principalcash flows Thestructuringagentmay also be thesponsoras thetworoleshave

naturaloverlap

* Underwriter.The underwriter isresponsibleformarketinganddistributing the issue

* Ratingagency7.While thereisnoexplicitrequirement foracredit rating,mastissues,

particularly the high-grade tranches,will be rated by Standard&t Poor’s, Moody’s,and/or

Fitcb Ratingscan beassignedfor both theissuerand the particularissue

Lawfirm Legal counselprovidesinvaluable adviceonstructuringtheassets(tohe legallydistinctfrom the originator), jurisdictionalissues, proper accountingand regulatorycompliance,andtire like

• Regulatoryagency Dependingontheassetssecuritizedandoriginator (e.g., bank),

regulatorsmay become involved

* External RiskTransfer and RiskFinanceCounterparties.Thesecuritization process

itselfcan generate newrisks If external risk transferisdeemednecessary,thenadditional

counterparties may become involvedinthesecuritization process

ISSUING SECURITIZED PRODUCTS

AIM27.2: Analyze the differences inthe mechanics of issuing securitized products

usingatrustvs.special purpose entity

The primary purpose of the transfereeis tofacilitate thesecuritization transaction.In themortgagemarkets,FannieMaeand FreddieMacare pre-existing companiesthatareactive

assetpurchasers.For most transactions,however,anentirelynewlegalentitycalledaspecial

purpose vehicle (SPV) orspecial purpose entity(SPE)isconstructed-TheSPEmay be

designatedas acorporationor a trust.

If dieSPEissetupas acorporation, theoriginatorsells dieassets todieSPE inexchange

forcash TheSPE in turn issuesclaims direedy against theassetsof theSPE.This methodmay notdistance dieoriginator from dieassetsenoughforaccounting purposes

©2013 Kaplan,Inc

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CrossReferenceto GARPAssigned Reading—Culp, Chapter16

Undera trust arrangement, twodistinctSPEsarecreated The additional entiryiscreated

tofurther distance theoriginatorfrom dieissuerand the underlyingassets.Acommon

arrangement willinvolvea master trust, orspecial purpose company (SPC), anda grantor

trust.Incontrast to thepreviousapproach(i.e.,corporadon),theassetsdonotservedirecdy

ascollateral Underthisarrangement,dieoriginatorsells theassets to themaster crust(SPE

1) for cash, hut diemaster crustin turn depositstheassetsinthegrantortrust(SPE 2).The

master trust receivesa beneficialinterestin thegrantor trust,whichrepresents diesame

economicpositionasif onlyoneSPEwasemployed.Nowdie claimsof the securitized

productsarehacked by the beneficial claimon themaster trust rather dianon dieassets

themselves

If all of diisseemsneedlessly complex:,restassured there isagood reasonforit.The

additionalSPEsufficiendyseparatesthe originator from the issueso theassets can trulyhe

considered “offbalance sheet.”

CREDIT ENHANCEMENTS

AIM27.3:Describe the various typesof internal and external credit enhancements

and interpret asimple numerical example.

Distributionof credit riskisfundamental tostructuringasecuredzedissue Forexample,

subordinatedclasses ofsecuritieswill bearadisproportionate share of diecredit risk

However, thewidevarietyofassetssecuritized, particularrisk tolerancesofinvestors,desired

credit ratings,andotherfactors alsocreate the needfor other methods toallocate credit risk

Internalcredit enhancement is additionalprotection provided internallytothe

securitization structure.Themost commoninternal enhancementisovercollateralization

(01C),whenmore assets arepledged toback thestructureandexceeddie liabilities

Imaginea mortgage pool thatwassecuritized basedon100 mortgages, butthe originator

included101 mortgages.Theissue isovercollateralizedbyone mortgage(he,,theinvestor

can absorbonedefault beforesufferinganyeconomiclosses)

Let’slookat anexampleto illustrate howovercollateralization enhances the creditworthiness

ofanABS.Consider thefollowingABS structure:

* Seniortranche-$300,000,000

* Subordinated trancheA=$80,000,000

* Subordinated trancheB= $30,000,000

• Total=$410,000,000

The collateral valuefor thestructureis $450,000,000, andTrancheBisfirst toabsorb

losses (the first loss tranche) Theamountof overcollateralization for thisstructureis the

difference between thevalueof the collateral and thecombinedvalueof all die tranches

Thatis:

overcollateralization= $450,000,000-$410,000,000= $40,000,000

CrossReferenceto GASPAssignedReading-Culp,Chapter16

Thismeans that losses up to$40million will beabsorbedbycheovercollateralization, and

noneof the trancheswill experiencealoss*Lossesbetween $40millionand$70million will

be absorbed byTranche B*Lossesbetween $70 million and $150 million will be absorbed

byTranche A*Lossesgreater than $150 millionwill beabsorbedbythe senior tranche*Severalother internal creditenhancementsarediscussedas follows:

• Directequityissue TheSPE issuesdehtwithafacevalueless than the collateralin the

pool.The differencecouldhe madeupbyissuing equity; however, thedemandfor such

slicesof theasset poolissmall* Tire originatormaywishtoretain asmall portionof the

equity, but this equitymay violate theindependenceneededfor transferencetotheSPE

* Holdback IftheSPEpays fairvaluefor theassetsin thepool,thereisno

overcollateralization*However,if theSPEpayslessthan fair value for theassets,diereiseffectiveovercollateralization.

• Cashcollateralaccount (CCA)*The cash collateralaccountisreserves, not unlikean escrow account, setasidebytheoriginatorto cover lossesin thepool.Ofcourse,ifthere

are nolossesin the pool, theoriginatorwouldwantitsreservesreturned.However, the

CCArunsinroasimilar problemasthedirectequity issuemethodindiat the originator

is tied totheperformanceof theassetsitsoldandthetransactionmaynotqualityas a

truesale

• Excess spread An alternative mediod toO/Cis to generate a positiveexcessspreadbetween die collateralassetsanddie liabilities(coupons)of theSPE,les*s fee*sand

expenses.The processissimilar to adepositoryinstitutionfunding loans with lower

costdeposits*Theexces*sspreadcanaccumulateina CCAandcan even accrue toequity

holdersafter theSPEdehtmatures.

Example: Computingexcessspread

Suppose that theinterestearnedon thecollateralassetsis 7.5%, and interestpaidontheliabilitiesof dieSPE is6.25%.With feesandexpensestotaling0.4%,calculate chegross

andnet excess.spread*

Answer:

Thegro.ssexcessspreadis die differencebetween the collateralassetandliabilitycoupon

rates,

grossexcess.spread-7*5%—6.25%-1.25%

Thenet excessspreadis the differencebetween the grossexcessspreadandfees and

expenses*

net excessspread =1.25%-0.4% =0.85%

©2013 Kaplan,Inc*

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CrossReferenceto GARPAssigned Reading—Culp,Chapter1(3

External credit enhancement involvesexplicit creditrisktransfer to anoutside party,

Examplesincludeinsuranceandguaranties, letters of credit, credit default swaps, and put

options

• Insurance, wraps, andguaranties.TheSPEeffectivelypurchases protectionfor the

seniorbondholderswithaninsurancepolicy (guaranty)wherethe deductibleisthe

amountallocated tothesubordinatedinvestors.In thiscase,any losses that affect the

seniorholderscan be recoveredviathe insurance policy

• Lettersofcredit(LOG).TheSPE obtainsaletterof credit for thesenior dollaramount.

If lossessurpassdie subordinated threshold, thecreditlineisdrawndown to a maximum

of die fullseniordebt level

• Credit default swaps Structuringacreditdefaultswaponthe full portfoliowith

adeductibleset atthesubordinateddebt level will accomplish thenecessarycredit

enhancement*

• Put opdonson assets.Theputoptionallows theSPE tosell the collateralassets to

dieputwriterfora predetermined price.Tf dieputstrikeisset atthe loss levelof die

subordinated tranche, then losses thatwouldaccrue totheseniorholders (i.e.,larger

dian the junior claims)areoffset by the gainsontheput position

LIQUIDITYRISK,INA SECURITIZED STRUCTURE

AIM 27.4: Explain the impact liquidity,interestrateandcurrencyrisk hason a

securitizedstructure,and listsecurities thathedge these exposures.

Liquidity riskis the risk that thecash flowsfrom the underlyingassets areinsufficient

to meet thepromisesof thesecuritizedproduct Thismaystem from timingdifferences

between theassetsand liabilitiesorfrom cash flowshortages.An example of the former

would besemiannualcoupon-payingnotessecuritized tofundquarterly floatingnotes.

The latter mayresult ifdie trade receivable collateral experiences higher than expected

delinquenciesso thatdie pooledcash(low maybe insufficientto meet die fixedrate bonds

issued against them

Similartocredit enhancement,internaland externalstructures can be usedtoprovide

liquiditysupportfor theissue.Two common internalsupport mechanismsarebasedon

maturitystructureand reserves.

Maturitystructuringisanalogous to managing credit riskviasubordination.Ifthematurity

oftheliabilitiesismatched with the cash inflowsfrom die collateral pool, the tuningissue

isresolved*However, thisapproachis toosimple because late payments can unravel die

cash flowmatchingeven though thereis nodefault perse. Onesoludonistoissuean

extendablenote, a notewithan intermediate and final maturitydate.At theinterimdate, if

the principal and interestwaterfallstructureissufficientlystrong, thenote can beredeemed.

Otherwisethe securitycontinuestofinal maturity

Professor's Note:Recall thatinaprincipal waterfallstructure, the mostsenior

tranchereceives itsproportion of principal beforeany other class. Onlyafter

theseniortrancheispaid offdoesprincipal waterfallto thenext most senior

tranche, andso on.

Topic 27

Cross Reference to CARPAssigned Reading—Culp, Chapter16

Liquidity reserves aresimilar LO dieCCAdiscussed previously Cash Lssecasidefor thesole

purposeof smoothing liquidity prohlems thatmayarise.In particular, thefundsare used to

guarantee that cheliquidityratioscanconform to thedesignatedcredit rating The reserve

may he created byfundingat theinitiationof theasset-bachedsecurity (ABS)ormay

accumulatefrom dieexcessspreadearnedon thestructure,

Externalliquiditysupportisobtainedfromoutsidethestructure vialettersofcreditwith

recourse or assetswaps An importantdistinction between creditsupportandliquidity

supportis thatliquiditysupportdoes not guarantee performanceandisnotresponsiblefor

making up shortfalls

Lettersof credit with recourseallow theSPEtodrawdownalineofcredit tocontinueto

makeits promised payments toinvestors However, theoriginator,nottheLSPE, isliable

to repay dieprincipalandinterestfrom all draws ondiecreditline Recent regulationhas

reduced theuseofrecourseLOCsforseveral reasons.First, thenewBaselAccordrequires

capital tohe heldagainstshort-termLOCs,which wasnotrequiredunder die original

Basel Second,conditioning thepayment of the originator basedontheperformanceof theLSPE questionsthe independence between the originator and theSPE

Asset swapsarederivativesecurities thatswapfixed payments for floating paymentswhere

thefixed payments are basedon areferenceasset.Thefloatingside paysa fixedamount

(assetswap rate) overLIBOR Asset swapsareusefulfor converting fixed rate assetsinto

floatingrate assets.

The key tothe useofassetswapsfor liquiditysupportisbasedon thetimingflexibility

of theassetswap TheSPE pays theprincipalandinterest to die swapdealeras the cash

flowsare received The dealer sends diefloatingrate payment tocoincide with die floatingobligationsof theSPE,The swapdealerwould providecredit protectionin theeventof

one or moredefaults(theassetswap Lsnow atotal returnswap).Toadjustfor providingliquiditysupportonly, thenotional principalLsadjusted downwardfordefaults,

INTEREST RATE RISK AND CURRENCY RISK

Interest rateriskcanarisefrom either structural differencesormaturitydifferences between

the underlyingcollateral and theobligationsof chesecuritizedstructure First,let us

considerdieimpactof structural differences Supposeafloating-rateliabilityisIssuedagainsta poolof fixed rate assets.Therefore, an increase in diereferencerate will narrow

thespreadbetween die fixed rateof dieassetsandfloating-rateof dieliability Iftheinterest

rarerisessufficiently higher,it Lspossible diat thefloating-rareliability willexceedthe cash

flow provided bythe collateral inany particular period

Interest rateriskcanalso result when the collateralandABShavedifferentmaturitiesor

effective lives.Changesin theunderlyinginterestrare can narrowthe effectivespread

Currency riskis the risk resultingfrom acurrency mismatch between theassetsand

liabilitiesof diesecuritizedstructure.

©2013Kaplan,Tnc.

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CrossReferenceto CARPAssigned Reading—Culp,Chapter16

Thesamerisk managementtools thatareavailabletohedgeinterest rateandcurrency risk

for traditionalfixed incomeproducts and portfoliosareavailableforsecuritizedassets,

includingswaps, futures,and forward rateagreements

MORTGAGE-BACKED SECURITIESANDASSET-BACKED COMMERCIAL PAPER

AIM 27.5:Describe thesecuritizationprocess for mortgage bachedsecurities and

assetbached commercial paper.

Mortgage-bachedsecurities(MBS) aresecuritizedassetsbached bya poolof residential

mortgages However, thesecuritizationprocessfor residential mortgagesisaliidedifferent

than for odierassets First, the bankissuesa mortgage to the homeownerwho pledges

the homeascollateralonthe loan Hence,the collateralisnot placedin thecareof the

trustee.Second, the homeowner purchasesinsuranceto coverpotential losses die bankmay

suffer Third, thethreegovernmentsponsoredentities(GSE), Fannie Mae, Ginnie Mae,

andFreddieMac,arelarge purchasers ofmortgageswho then issuebonds bachedbythe

principal andinterestof the underlyingmortgages TheGSEsserve ascredit enhancersso

thereisvirtually nodefault risk in theissue However, MBSare not risklessbecausedieyare

verysensitivetochangesin prepaymentsand interestrates (i.e.,the timingof the cash flows

received)

MBSexhibitconsiderablevarietyin the cash Howdistribution promised throughthe

securitization.For example, the pooled cash flowsmaybedistributedon a pro-ratabasis

orby tranchingthe cash flows (e.g., principal onlyandinterestonlystrips) Acommon

MBSstructureisacollateralized mortgageobligation(CMO)wherebydifferentclassesof

securitieshave differentseniorityWhile all classes of theCMOreceive periodicinterest,

principal payments aredisbursed basedon thewaterfall distribution

Asset-backed commercial paper (ABCP) follows thesamebasicsecuritization process Trade

receivablesfromone or morecompaniesarepooled together,andshort-termcommercial

paper isissuedto investors.Incontrast tootherABS,ABCP doesnot tradeinan active

secondary market.Hence,the typicalinvestorhasashortinvestmenthorizonsince they

hold thesecurityto maturity.Another key differenceisdiatABShaveasingleconveyance

ofassets; oncedie liabilitiesare paidoff, thestructure terminates.ABCPonthe other hand,

continuallypurchasesnew assetsandoffers newissues.Receivablestypicallydonothavea

staredmaturityor bearinterest, so thereexistssignificantliquidityriskbecauseof die fixed

obligationsof the commercial paper

CrossReferenceto GARPAssignedReading-Culp, Chapter16

AIM27.1

Securitization isdie processof issuingsecuritiesagainstan asset pool The proceeds of the

securitysalecollateralize the purchase of theassetsfrom the originator, therebyremovingtheliabilityandinvolvementof die originator

Thesecuritization processinvolvessome,ifnot all,of thefollowing:originator (transferor],sponsor,asset purchaser (transferee), trustee, custodian,servicer,structuringagent,

underwriter,ratingagency, law firms, regulatoryagencies,andrisk finance counterparties

AIM27.2Thesecuritization process mayuseeitheracorporationor trust astheSPE

Claimsareissued against themaster trust,effectively separating theassetsfrom the

originator

AIM27.3

Subordination andovercoilaterlizationare commoninternalcreditenhancements

Insurance,lettersofcredit, credit defaultswaps,andput optionsareexternalcredit

Interest race riskmay resultfrom timingdifferences betweenassetsand liabilitiesorfrom

structural differences.Currency riskis the riskresultingfromacurrencymismatchhetweentheassetsandliabilitiesof the securitizedstructure

AIM27.5Mortgage-backedsecuritiesaresecuridzed assetswhere residential mortgages serve as the

underlyingcollateral

ABCPisshort-term commercial paperbacked bya pool of receivables The asset-liability

mismatchcreatessignificant liquidityrisk

CrossReferenceto CARPAssigned Reading—Culp,Chapter16

CONCEPT CHECKERS

Atransaction inwhich the originator transfersapool ofloansto aspecial purpose

entityandhasnoremaining liabilityisa:

A truepurchase

B truesale

C subordinate transfer

D, partial transfer

Fivetranchesofautoloan asset-backedsecuritiesareissuedwithaface value of

$6,000,001)and payanaveragecoupon of 5.2% The value of theautoloansis

$6,800,000,and they haveanaverageinterestrateof5.4%.Thefee for servicing

theABS is0.2% Which of thefollowingarecreditsupportsinvolvedwidi this

transaction?

A Excessspread

B Cashreserve account.

C Directequityissue

D Overcollateralization

1.

2

Whichof die following typesof riskisnot apotential risk associated with

securitizingcredit-sensitiveassets?

A Liquidityrisk

B Interestraterisk

C Currency risk

D Maturityrisk

WhaListhe firststepin thesecuritization processfor residential mortgagjes?

A The homeownerpurchases insuranceto cover potentiallosses the bank may suffer

B Governmentsponsoredentities issuebonds backed by principal andinterest

C The bank usesthereinsurance markettohelphomeownersinsurethenew

property.

D The bank issuesa mortgage tothe homeowner who pledgesthe homeas

collateralonthe loan

Foradditional Book2, Topic 27practice questionssee:

Self-Test Questions:#8(page249)

PastFRMExam Questions:#32—34(page259)

5,

Topic 27

CrossReferenceto GARPAssignedReading—Cufp, Chapter16

CONCEPT CHECKER ANSWERS

1. B A‘‘truesale,”orabsolutetransfer, of theassets must takeplaceinorderforanypotential

benefitsfrom risk transferto occur,

2, D TheABS issupported byovercollateralizationsincethe valueof theassetpool isgreaterthan

no excessspread involvedsincetheinterestfrom tire asset

poolisequaltotheweightedcoupon ontheABSplusservicing fees Neither cashreserve account nordirectequity issuearcmentionedinthe question

3 D Maturity riskis not ariskdirectlyassociated witha securitization structure.Liquidityrisk

isthe riskthatthe timing ofthe cashflowsfromthe collateral will he unabletosatisfythe issued claims (c.g,, collateral with semiannualpaymentsthatisfunding monthlycoupon-payingbonds).Interestrate risk can occurfromamaturitydifferentialbetween

assetsand liabilitiesaswell asstructural differences(c.g,,fixed-rateassetsfunding floating

rateliabilities) Currency riskcan ariseif the collateral andissuedclaimsarc indifferent

currencies.

thevalueof thesecurities.Thereis

4 D The firststep inthesecuritization processfor residentialmortgages isthe bankissues a

mortgage tothe homeowner who thenpledgesthehome ascollateralon the loan,

5 D Thefollowingis apartiallistof participantsin a securitization: sponsor, trustee,rating

agenty,structuringagent,andlawfirm

©2013Kaplan,fnc.

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The lolkiwilÿ is i review of the Credit Riflk Measurement and Managementprinciples designed LLJ address die

AIM statements set forth byGARP®.This topic is also covered in:

Topic28

EXAM FOCUS

This topicdescribesmany importantaspectsof thesuhprimemarkets*Sevenfrictionsbetween

marketparticipantsarediscussed involvingmortgagors,originators,arrangers,ratingagencies,

asset managers, and investors You should understand the information problem (moral

hazardor adverse selection) for each friction Characteristics of subprime mortgagesare also

discussedincludingloan terms, performance, and subordination For theexam, he familiar

withsubprimemortgagesecuritization,the frictionsin thesuhprimemarket, and the process

of ratingsubprimesecurities

THE SUHPRIME SECURITIZATION PROCESS

AJM28.1:Explain the sub primemortgagecredit securitization process in the

UnitedStates

The subprime securitization process in theUnitedStatesinvolves several differentparties

heginningwith the borrowingneeds of thehomebuyer The borrower (mortgagor) applies

foramortgageand,conditionalon theduediligence of thelender,isextendedaloan

with the residence servingascollateral.Borrowersrangeinquality from prime(i.e.,strong

credithistory)toAlt-A(i.e., borrowers with goodcredit butmoreaggressive underwriting

standards) eosubprime(i.e., borrowers withpoorcredit history) Lenders sellasignificant

portion of their loans to athird-party (special purpose vehicle) andreceivecashin return.

Primeloans thatmeetconforming standardsaresold to governmentsponsoredenterprises

(GSEs).Theremainingloansareincreasingly being soldand taken off theoriginators’

balance sheet.Approximately75% ofnewlyoriginatedsubprimemortgages weresecuritized

in2005 and2006

FRICTIONSINSUBPRIMEMORTGAGE SECURITIZATION

AJM28.2:Identify" and describe hey frictionsinsubprime mortgagesecuritization,

andassessthe relative contribution of each factor tothe suhprimemortgage

problems.

Ingeneral,when twoparties do not have thesameinformation (which is usually thecase),

asub-opdmaloutcomeresults.The twobroad classesof information problemswewill

discussherearemoralhazard and adverseselection Moral hazard denotes theactionsone

partymay taketo thedetrimentof the other A classic exampleistheshareholder-manager

relationship where the managersmay usedieirposition for personalgain radter dianfor

CrossReferenceto CARPAssigned Reading-Ashcroft Sch nermann

theshareholders towhom theyowe afiduciary duty.On theotherhand,adverseselection

iswhen one party possessesimportanthiddeninformation.Forexample,a personsdriving

ahilityisprivateknowledgeandapotential buyer ofautoinsurancewill have dieincendve

to represent themselvesasgood driverseven if theyare not. Mechanismsaredesigned

tominimize theseiniortnadon problems such asboard oversight for the managersand

examinationofdriving recordsfor thoseseekingauto insurance,

Thereare sevenfrictionsin themortgagesecuritization process.Each frictionisdiscussedas

follows

FrictionIt Mortgagorandoriginator.The typicalsubprimeborroweristypically

financially unsophisticated.Asa result, the borrower maynotselect the best

borrowingalternadvefor themselves Infact, the borrowermaynot evenbe

awareof thefinancingopdonsavailable.On the other hand, thelendermay

steer theborrower to products thatare notsuitable

Friction2: Originatorand arranger.Thearranger(issuer)purchasesthe loansfrom

theoriginators for die purposeof resale throughsecuritizedproducts The

arranger will perform duediligencebut stilloperates at an information

disadvantage todieoriginator.Thatis, theoriginator hassuperior knowledge

about the borrower (adverse selecdon problem).In addition, die originatormayfalsifyorstretch die boundsof theapplication resultingin largerdianoptimallending(predatorylendingor predatory borrowingasdiscussedinAIM2K.9).

Arrangerandthird-parties.Thearrangerof the pool ofmortgageswill possess

better information about die borrower than third partiesincluding ratingagencies, assetmanagers,and warehouse lenders The adverse selectionproblem gives thearranger the opportunityto retain diehigher quality

mortgagesandsecuritize the lower qualitymortgages(i.e.,lemons)

Friction3:

The warehouse lender temporarilyholdsandfinances the underlying

purchases.Asa precaution,the warehousewill hind lessthan 100% ofits

estimatedcollateral value forcingthe arranger to retain aequityposition onits

balance sheet

Theasset portfoliomanagerpurchases theassetsfor the poolfrom the

arranger.Onceagain, thearrangerhas superior information about the

creditworthinessof themortgage pool.Tominimizedie potentialadverse

selection problem, theassetmanager must useadequateduediligence, use

reputable arrangers, and force credit enhancements from thearranger

Similarly, the rating agencies determine theamountof credit enhancementnecessary toachieve die desired creditrating.Thus, therating agencyis

dependenton theinformationprovided by thearranger.Typically, thedue

diligenceon thearrangerand originatorisrushed.

Friction4: Servicerand mortgagor Theservicer’sroleisto managethecashflowsof the

pool and follow upondelinquencies and foreclosures.AconflictofInterestarisesfordelinquentloans The homeownerin financial difficultydoesnot

have theincentive to upkeeptax payments, insurance,ormaintenanceoil the

©2013 Kaplan,Inc

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Topic28 CrossReferenceto GARPAssignedReading~j\shcioft &Schuermann

property.Escrowedfundscan minimizethis problemhut ultimately efficient

foreclosure muse comply with federal regulations.

Servicer andthird-parties.Theservicerfacesa moral hazard problembecause

their(lackof)effortcanimpact theasset manager and credit ratingagencies

widiout directlyaffectingtheirowncash flow distribution In delinquency

theservicer isresponsiblefor the propertytaxesandinsurance premiums

These fundsarereimbursable upon foreclosureso thereisa temptation to

exaggerate thefees andexpenses particularly withhigh recoveryrates.

Friction5:

Theserviceralso hasanincentivetokeep theproblemloanonitsbookshymodifying loan terms rather than foreclose(investor preference).Sincemost

of diecosts areunrecoverable (escrowanalyst payment set up, etc.) the

propertyneedstoheactiveto generateanyadditionalfunds to theservicer

It isapparentdiat thequalityof theservicercan direedyimpactthecash

flowsof the pool whichin turnaffects the credit rating Changes in credit

ratings reflect poorlyondieagency.Therefore, thecredit rating agencies

musL nseduediligenceinanalyzing theserviceraswell as the underlyingcollateral

Assetmanagerandinvestor.Theinvestor relies ondieasset manager’s

expertisetoidentifyandanalyze potentialinvestments.It isdifficultfor

theinvestor tocomprehend theinvestmentstrategyand the investor will

notbe abletoobserve theeffort of themanagement team (same moral

hazard problemasshareholder-manager) Investmentmandatesand proper

benchmarkingcan mitigatesomeof thedistortion.

Friction 6:

Investorand creditrating agencies.Ratingagenciesarecompensatedbythe

arrangerandnot the end user,the investor.To theextent that therating

agenciesarebeholden to thefeestructureof the arranger, aconflictof

interest arises.In addition,it isvery difficultto judgethe accuracy of dieir

models particularly withcomplex products and rapid financialinnovation

Friction 7:

Fiveof die above factorsaredirectcontributors to therecentsubprimecrisis First,the

complexityof the product and naive natureof the borrower ledtoinappropriateloans

(friction 1) Second, managerssought the additionalyieldfromstructuredmortgageproducts

without fullyassessing the associated risks(friction6).Third,die problembecamemore

expansiveas underperforming managersmadesimilar investmentswithless duediligence

onthearrangerandoriginator (friction 3).Fourth,astheassetmanagersreduced their

oversight,itwasnatural that thearrangerwould followsuit(friction2).This left thecredit

rating agenciesas the lastlineofdefense hut theyoperatedat asignificantinformational

disadvantage Finally, theassignedrating?werehopelesslymisguided(friction 7)

CrossReferenceto GARPAssigned Reading—Ashcroft& Schuermann

CHARACTERISTICSOF THESUBPRIME MORTGAGE MARKET

AIM28.3:Describe the characteristics of the subprime mortgage market,including

the creditworthiness of the typical borrower and the features and performance ofa

subprime loan.

Subprime borrowershavea historyof eitherdefaultorstrong indicators ofpossiblefuture

default,Past incidentsinclude 30-or60-day delinquencies, judgments, foreclosures,repossessions, charge-offs,or bankruptcy filings.LowFICOscores(660or below}ora high

debtservice ratioof 50% or more arelikelyindicatorsoffuture default.

Thevast majority of subprime loansareadjustable rate mortgages The loan offersa teaser rateforashort period of time,and then adjustseachyearrelativeto a floatingrateindex:

(usuallyLIBOR}.The2-and3-year teaser rates arecalled 2/28 and 3/27hybridarms

denoting the fixedand floatingterms,respectively (e.g., fixed termis2 years,floating term

is28years).Since rhe majority of dietermof themortgageisfloating,die borroweris

bearingdieinterest rate riskincontrast to a traditionalfixed rate mortgagewhere thelender

bears theinterest raterisk

Theperformance of subprime pools indicatesdefaultsand foreclosureswayabove historical

levels.Asa point of reference, theaudiorsofthe reading analyzeaNew Century pooloriginatinginMay2006andestimatea23% cumulativedefault rate through August 2007

AIM 28.4: Explain thestructureof the securitization process of the subprime

mortgageloans

Securitized poolsincorporatestructures to provide protection toinvestorsfrom lossesin die

collateralincludingsubordination, excessspread, shiftinginterest, performance triggers,andinterest rateswaps

Subordinadoninvolves creating tranches ofdifferingprioritylevels.Lossesareapplied first

to themostsubordinated tranche, the equity tranche.Theequity trancheis usuallycreatedfrom overcollateralization(i.e.,assetsinexcess of facevalue).Ifthe lossesexceed thesizeof

this tranche then losseswillreach thenexthighest subordinatedlevelcalled themezzanine

Creditradngsonmezzaninedebt typicallyvary from AAtoB.In this fashion, themost

senior trancheis protected by all diejuniortranches and offersthelowest return.

Mortgagespoolsare typically constructedso that dieweightedaveragecoupon(lessservicing,hedging, andodter expenses) exceeds theweighted average payout.The difference

iscalled dieexcessspread, which ispaid toequity traildieinvestors when available Thus,

theexcessspreadprotectsall tranches

Undershiftinginterest, thesenior investors receiveall principal indiepool while the

mezzanine investors receiveonlyinterest.Theseniorholders mayreceivetheprincipalfora

setperiod of time(“lockoutperiod*)or untilacutoffratio isreached.

Performancetriggersdenote the releaseof overtoilateralizion which isapplied from thebottomof the capitalstructure up

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Topic28 CrossReferenceto GARPAssigned Reading—Ashcroft &SchuermatmSincethe firstfew years of thepoolarefixed, the poolfacesinterestraterisk.Asprotection,

interestrateswapsare used where die pool will payafixed rateand receiveafloating rate,

THE CREDIT RATINGS PROCESS

AIM 28.5: Describe the credit ratings process with respecttosubprimemortgage

backedsecurities

Acredit rating isdefinedas an opinionon the creditworthinessof the specific bondissue,

Notethat die assigned ratingisspecificto thesecurityandin nowayareflectionon the

originator.Theratingsrepresent ait unconditionalviewof the ratingagencyas they rate

"thnough-the-cyde.”

Therating processinvolvestwo steps:(l)esdmationof loss distribution and(2)simulation

of the cash flows.Once theestimatesareobtained, theagencyindicates the levelof credit

enhancementnecessary toachieve thedesiredrating If the projected ratingis toolow,the

originatorcan provideadditional enhancement to raise therating

AIM28.6:Explain the implications of credit ratings onthe emergence of sub prime

relatedmortgage backedsecurities

Assigning credit ratings forsecuritizedassets presentsadditional challenges.Credit ratings

for subprimesecurities,andmoregenerallyasset-backedsecurities(ABS),differfrom

corporateratings inseveral important ways.First,corporatebond ratingsarebasedonthe

firm-specific characteristics of dieissuerwhereasABS isaclaimon a portfolio.Hence,

systematic risk and degreeof correlation between assetsisimportant in the latter butnot

dieformer.ABSrepresentsclaimson astaticpooland cannotinfuse additionalcapital

or restructure as acorporationcan.In addition,dieforecasts forABSincorporatefuture

economicconditionssincethe cash flowstream istiedtothemacroenvironment.Finally,

whilecorporatesandABSswith thesamerating mayindicate similar default probabilities,

theABSwill exhibit much widervariation in losses

AIM 28.7:Describe the relationship between the credit ratings cycle and the

bousing cycle.

Thegoalof theratingsystemis to ratethrough-theKtycle, meaningthat there shouldnot be

excessive upgrades (downgrades) ifdiehousingmarket heats up (slows down), Aproblem

may arise if the agency assigns,say,anAAA ratingduringa boom period As diehousing

marketslows down, the probabilityof defaultincreasesand the securityhasmigratedto

AAeven though the agency has notmadea publicpronouncement.The problemisfurther

exacerbated ifnewdealsare basedondiecredit enhancementsfromtheAAA rating in the

boom period

Aseconomicconditions change, itisexpected to see someupgradesor downgradesin

mortgage-backedsecurities However,theeffect mayamplifyupanddown markets For

example,in adownwardtrending market,additional enhancementsareneededtomaintain

thehighest ratings.This “crowdsouf the credit availablefor lower raced borrowers

increasingtherequired loan rate orraising qualificationstandards.The oppositeis truefor

bousing upturnsfreeingupcreditfor lower rated borrowers

CrossReferenceto GARPAssignedReading—Ashcroft& Sch nermann

Cash Flow Analysis of Excess Spread

In theratings processit isnecessarytosimulate the cash flowsof thestructure toforecast

the degree ofexcessspread usedforcreditenhancementAs youcan imagine, the forecasts

arecomplexanddependonseveral interrelatedfactorsincluding creditenhancement,

timingof losses, prepayment rates,interest rates, triggerevents,weightedaverage loan race

decrease, prepaymentpenaldes, pre-fundingaccounts,and hedginginstruments Themore

important factorsarediscussedasfollows

First, the credit enhancement identifies dieamountof collateral thatcan be impaired before

the tranchesuffersaneconomicloss The timingof lossesisalsoimportantbecauseas

lossesaccumulate,lessexcessspread will be available.Amoreconservativeapproachwould front-loaddie losses Prepaymentswilldirectlyimpact theexcessspread Prepayments

maybe voluntary(refinance,sales)or involuntary(default)so theprepaymentassumption

directlyimpacts thecash flowanalysis Prepayments typicallyfollow theCPR(conditional

prepayment rate)convention However, itisimportant to notethat hybrids will havehigher than predicted defaultson orabout thereset datedue to the suddenchangein

ratesand financial conditionof thesubprimeborrower A moreconservative viewwould

accelerateprepaymentsreducingfiirdierinterestcollections Finally, the path ofinterest

ratesintroduces uncertaintyinto dieprojected cash flowstream.Interest ratesdetermine the

adjustments(i.e.,cash inflows),and influence refinancing.

AJM28.8:Explain the implications of the subprimemortgagemeltdownon the

managementof portfolios.

Currendy, therating agenciescollectivelymonitorapproximately10,00t)mortgagepools

It would beimpractical to monitor each poolon a mondilybasis indetail Itiscurrent

practice toannuallyrevieweach individual poohAn important performancemeasureused

duringthisreview isthefosscoverageratio(LCR),definedas:(currentcredit enhancementfor tranche) / (estimated unrealizedlosses).An exampleofacredit enhancementisexcess

spread If dieLCR isbreached(he.,falls below whatisacceptable),afull review iswarranted.PREDATORY LENDING AND BORROWING

AIM28.9: Compare the difference between predatory lending and borrowing.

Predatorylending resultsin the borrowerbecomingworseoff aftertheJoan than before.This mayhappenbecause therates aredeceptively high,theappraisalsareinflatedallowingtheborrower to extractequityand then cannotrefinance,and prepayment penaltiesare

extreme,steering borrowersunnecessarily tosubprime productsandsimilar ruses Predatory

lendingmayalso include outrightfraudulentactivity inadditiontodeception

Predatory borrowingismisrepresentation inthe mortgageapplicationfromtheborrower

side The temptationisdriven by increasing housing priceswherebythe borrowerfeels that

hecannotcatch up widihousingprices Therefore, lyingon themortgageapplicationallows

theborrower to thebuydie house with the expectation that continued appreciation will

allow afavorable refinancing.Thefraudmay be perpetratedbythe buyer aloneorinconcert

withlawyers,broker, and appraisers

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Topic28 CrossReferenceto GARPAssignedReading—Ashcroft&Schuermann

AIM 28.1

Therecent pasthaswitnessed about75%ofsuhpriinemortgagessecuritized

AIM28.2

Frictions involve cheborrower,originator, arranger,assetmanager,investor,andrating

agency The frictionsarebasedon adverseselectionandmoral hazard problems

Ultimately, thelack ofduediligenceontheassetmanager andarrangerled to evenlooser

underwriting standards.Thecredit ratingagenciesissuedratings that lacked this key

information

AIM28.3

Subprimemortgages aremainlyhybridarms(2/28and3/27) where the term denotes fixed

and floating, respectively.Hence,the borrowerretains thevastmajorityof theinterest rate

risk

AIM28.4

The capitalstructureofapool places thesafestsecuritieson top (senior notes),junior

securities in die middle (mezzanine)and riskieston the hottom (equity)

Subordination,excessspread,andshiftinginterestprovideprotection for thesenior

tranches

AIM28.5

Creditratingsaredeterminedby theamountof collateralization inthestructure. If the

projectedcash flowsareinsufficient to warrant adesired rating,theoriginatorcansupply

additionalenhancement

AIM 28.6

Creditratings forABSsare morecomplex thancorporate ratingsbecauseof theunderlying

portfolionatureandcorrelation hetweenassets, dependenceon economicforecasts,and

static natureof the collateralpool

AIM28.7

Creditratingsaredesigned to ratethrough-the-cyclesothaLtliere are not excessive upgrades

(downgrades) during housingbooms (busts).However, changingrequiredenhancements

amplify theimpact onhousingmarkets byreducingcreditindown marketsandincreasing

creditin up markets for the lowest rated borrowers

CrossReferenceto CARPAssignedReading-Ashcroft& Schuermann

AJM28.8

Ratingagencies collectively monitorapproximately10,000 mortgagepools.It’simpractical

tomonitoreach poolon a monthlybasisin detail,soannualreview'sarepreferred

AIM28.9Predatorylendingiswhen die borrower’swellare is reducedafter undertakingthe loan

The key characteristicis that the borrower has enteredintoan agreementwith unfavorable

terms.Predatory borrowingis when the borrowerknowingly misrepresentshis financial

condition to secure aloan that heotherwise wouldnot qualify for

Topic28 CrossReferenceto GARPAssignedReading—Ashcroft&Schuermann

CONCEPT CHECKERS

Whichof thefollowingisnot afriction inthesubprimesecuritization market?

A Investorandrating agency

B Servicerandmortgagor.

C Mortgagorand arranger

D Assetmanager andinvestor

Whichof thefollowingfrictionsrepresents anadverse selection problem?

A Investorandmortgagor.

B Originator andarranger

C Servicerand ratingagency

D Servicerand mortgagor.

Whichof thefollowingstatementsaboutsubprime mortgagesistrue?Subprime

mortgages:

A aretypically Usedrateobligations

B oftenusethe2/28or3/27hybridstructure.

C force thelendertobear mostof theinterestraterisk

D aresimpler toanalyze than corporatebonds.

Whichof the followingistrueabout predatory lending and predatoryborrowing?

A Both underprovidecredit

B Bothoverprovidecredit.

C Predatory lendingunderprovidescreditandpredatory borrowingoverprovides

A Subordination, excessspread, andshiftinginterest

B Subordination, prepayments,and shiftinginterest

C Overcollateralization,excessspread,andtintingoflosses.

D Overcollateralization,excessspread,andprepayments.

Foradditional Book2, Topic28practice questionssee:

5

PastFRM Exam Questions:#35-37 (page260)

Cross Reference to GASPAssigned Rending—Ashcroft Schuermann

CONCEPT CHECKER ANSWERS

1. C Themortgagor and.arranger haivcnodirectcontact sothereis nofriction

2 B The originator has better informationahout thequalityof the borrowersso the arranger

issubjectto anadverse selection problem.Thatis,ifthe originatorkeepsthe highquality

mortgages,thearrangerwillreceivelemons

3 B Most suhprimesare 2/28 or3/27structureswhere the futedcomponent isfortwo orthree

years.Hence,theremainderof theterm (27 or 28years) isvariable and hears the majority oftheinterest rate risk.

4 B Predatoryborrowingis whenthe borrower misrepresents themselvestoobtain credit they

otherwise would be denied.Predatory lendingisproviding credit that iswelfaredecreasingand shouldnot beprovided-

5 A Subordination,excessspread, and shiftinginterestprovideprotectionforseniortranches

Overcollateralization alsoprovidesprotection forsenior tranches,Timing of losses impacts

excessspreads.Prepaymentscanaccelerateordecelerate the cash flows to senior tranches.

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Thefallowingis i review of ihe Credit Risk Measurement and Management.principles designed LO address Lite

AIM statements set forth by GART®, This topic is also covered in:

Topic 29

EXAM FOCUS

This topic examines die concept ofcounterparty credit risk and introduces techniques ior

mitigatingandmanagingcounterpartyrisk.Fortheexam,besuretoknow the basic terminology

related to counterpartyriskandhavean understandingof how institutionscan mitigateand

manage this risk* Also, know the definitionsanddifferencesamongthevariouscredit exposure

metricsthatarediscussed

COUNTERPART* RISK

AIM 29.1: Definecounterpartyriskandexplain howitdiffers from lending risk.

Counterpartyrisk isthe risk thata counterpartyis unableorunwillingtoliveupto its

contractual obligadons.Within thecontextof derivativescontracts,defaultoccurs at some

pointafterinception hutpriortothe endof thecontract term.Ifdefaultoccurs, current

and futurepayments required by thecontractwillnot be made

Lending riskhastwonotable characteristics: (1) theprincipalamount atriskis usually

known with reasonable certainty{e.g.,mortgage at afixed rate)and (2)onlyone party

(unilateral) takeson risk.Counterpartyriskgoesfurther dianlendingrisk becauseittakes

intoaccountdiat the valueof the underlyinginstrument is uncertain intermsof absolute

amountandintermsof which partywill beat asubsequent gain orloss In addition,

counterparty riskis bilateralin that eachparty takesonthe riskthat thecounterpartywill

default; die pany that is"winning* takeson the risk thatdie partythatis"losing*will

default

TRANSACTIONSWITHCOUNTERPART* RISK

AIM 29.2: Identifytypesoftransactions thatcarry counterpartyrisk.

Exchange-tradedderivatives donotcarrycounterparty risksince theexchangeis usually the

counterpart}'.Therefore,diefocusherewill beonsecurities financing transactionsand

over-the-counter(OTC) derivatives

Securitiesfinancing transactionsincluderepos and reverserepos, and securitiesborrowing

and lending

Reposareshort-term lendingagreements(asshortas oneday) secured by collateral The

lender receivesthe reporate,calculatedas arisk-freeinterestcharge, plusa counterpartyrisk

chaige.Collateralis usuallyin theform ofliquidsecurities.A haircutisapplied tomitigate

Topic 29

CrossReferenceto GASPAssignedReading—Gregory, Chapter2

against thecounterpartyrisk thattheborrower willnotrepay thecashand tomitigate

againstadeclineIn thevalueof the collateral*Toillustratetheuseofahaircut,assume a2%haircuton a$100 million loanamount.Thismeansdiatapproximately $102.04million

ofsecurities is requitedascollateralon a $1()0millionloan[$100 million /(l-0*02)

-$102*04 million]

OTCderivatives includeinterestrate products (the bulkof thetransactions),foreign

exchange transactions,and credit defaultswaps (CDS)

When comparinganinterestrateswapto aregular loan,counterparty riskis reducedfor theinterest rateswapbecause thereisnoexchangeof principal The risk liesin theexchangeoffloatingcash payments versusfixedcash payments.Thenotionof “netting1’ furtherreduces

counterpartyrisksinceonly the difference between thetwo payments(the netamount) is

exchanged periodically.Assoon asdiecounterpartydefaultson payments, thereis noneed

for the other party tocontinue makingpayments.

Foreign exchangeinstrumentscarrylargecounterpartyriskdueto the need toexchangenotionalamountsanddue tolongmaturities(thereby increasing the probability thata

defaultwilloccur at least once)

Creditdefault swapscarrylargecounterpartyrisksduetowrong-way risk and significant

volatility (thereby increasing the probability that there will hea''losing'1party that will

default).Wrong-way risk refers to an increase inexposure whencounterpartycreditquality

worsens.Itcan beillustrated inaverysimplified example wherebyafirminvestedin Greeksovereign deht wishes to protectits positionbypurchasingaCDSoilGreeksovereign

debtfrom aGreek bank.Assumingareduction in the ratingof Greek sovereign debt, the

buyer of theCDSis “winning*”However, die ability of the “losing”counterparty(theGreekbank) to meetitsobligations will further be impairedas aresultof die credit rating

decrease.

MITIGATING COUNTERPARTY RISK

AIM29.3:Explainsomewaysinwhichcounterparty riskcan be mitigated.

Asmentioned,nettingiscommonly usedto mitigatecounterparty risk Each party's

requiredpaymentiscomputedandthen offsetsothat only the partythat "owes”a net amountisrequired to make thatpayment to thecounterparty.Hie success ofnettingdependson thenatureof the paymentsinvolvedand whether theyateeasytooffset Legalriskmaybe involved with netting

Asecondwaytomitigatecounterpartyriskistheuseof collateralization Taking collateralequal

allcounterpartyrisk However, by takingcollateral, thereare someadministrativecosts

involvedinaddition to takingonliquidityrisk (i.e.,collateral may havetohe soldat a

significant discountin the shortterm) andlegalrisk (i.e*,attemptingto cake titleon the

collateral maybealonganddrawnout legalprocess)

greater than the notionalamountofprincipalshould theoreticallyeliminate

to or

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CrossReferenceto GARPAssignedReading—GregoryChapter 2

A third way tomitigatecounterpartyriskis throughhedging(discussed inAIM29.8)

Using credit derivativesallowsanorganization toreducecounterparty exposure toitsown

clientsinexchangefor increasingcounterpartyexposuretoclientsofacompetitor

Centralcounterparties(e.g., exchangesandclearinghouses) frequendy takeon die role

of thecounterparty,whichoffersanotherwaytomitigatecounterpartyrisk.Theyare a

convenientwaytocentralizecounterpartyrisks,settle transacdons, and reducethe bilateral

risks inherentinmany derivadvescontracts.However, the useof central counterpardes does

reduce theincentiveofpartiestocarefullyassessandmonitorcounterpartyrisks

COUNTERPARTY RISK TERMINOLOGY

AIM29.4: Define the following terminology relatedto counterpartyrisk: credit

exposure* credit migration.) recovery, mark-to-market, replacementcost,asymmetric

exposure, and potential future exposure.

Credit exposure(orsimply exposure)is the loss diatis'‘conditional” on thecounterparty

defaulting.Itcan heillustratedwithafinancial instrumentcontract between twoparties*

Afterinception, assumeCounterparty Ahasa positivevafue{it isdie creditor andisowed

money),andCounterparty B hasanegadvevalue(it isthedehtor andowesmoney) If

CounterpartyB defaults, Counterparty Awillsufferalosson theamountowed.

Inquantifyingexposure, itisnotalways thecase that thefull principal amountisatrisk

Therefore,a morerelevant calculationisreplacementcost togetherwithanassumpdonof

a zerorecovery value Furthermore, calculationsmustconsidercurrentexposure (current

claims andcommitments),futureexposure (potentialfutureclaims), andcontinent

liabilities

Regardingcredit migration, thecounterpartymaydefaultoritscredit radngmay

deteriorateoverthe termof thecontract,especially for longtimehorizons Alternatively,

there may beanimprovementincredit ratingover time.Toassesscreditmigration,we must

considerthetermstructureofdefault probability:

* Futuredefaultprobabilitywilllikelydecreaseover time,especiallyfor periods farintothe

future Thisisdueto die higher likelihood that the default will have alreadyoccurredat

someearlier point

* An expecteddeteriorationincredit qualitysuggests anincreasingprobability of default

overtime

• An expectedimprovementincredit qualitysuggests adecreasing probabilityoldefault

overtime

Empirically, thereismean reversion increditquality,so theimplicationisthat

counterpartieswith strongcreditratingstendtodeteriorate (increasing default probability

overtime).Thosewith weak creditratings Lend toimprove (morelikelytodefaultearlier

andlesslikelylater) Defaultprobabilityofa counterparty canbecomputedin twoways:

areal (historical) measure(identifying die actual default probability) anda risk-neutral

measure (computingthe theoreticalmarket-implied probability)*

Recoveryismeasured bvthe recoveryrate, whichisdie portiou of theoutstandingclaim

actually recovered after default.Forexample,a recoveryof 70%suggests a30% loss As

CrossReferenceto GARPAssigned Reading-Gregory;Chapter2

discussedearlier in thedefinitionof exposure, recoveryisnot usuallyconsidered when

pricing credit risk Related totheconcept ofrecoveryislossgivendefault(LGD),which is

calculatedas: 1 -recoveryrate.

Mark-to-market(MtM) isanaccrualaccounting measure drat isequaltothesumof theMtMvaluesof allcontractswith agiven counterparty.Although intheory itrepresents

thecurrent potential loss,itdoesn’t considerotherfactors suchasnetring,collateral,or

hedging MtM Is equal to thepresentvalueof all expectedinflows less the present valueof

expectedpayments(positiveifinfavor of thepartyand negative ifnot).MtMisameasure

of replacementcost.However, althoughgenerallyclose,current replacementcost isnot

theoreticallythesame as die MtM value duetofactors suchas transactioncostsandbid-ask

spreads

Theunderlyingcontracts between thepartiesaresettled basedondieMtMvalueatthe

timeofdefault.Asymmetricexposurein theeventofdefault.Isillustratedasfollows:a party

loses ifits MtM is posidveand hasnogain ifitsMtMisnegative.PositiveMtMrepresents

the claim againsta defaultingcounterparty.Any recovery value will helpreducedefaultloss Negative MtMrepresents an amountstilllegallyowed to adefaultingcounterparty.

Thisasymmetric exposurerisk profileissimilar todiatofashortoption position,soin

quantifyingexposure,one needs toconsider thevolatilityof the MtM value

Potentialfuture exposure(PFE) Isan estimateof MtMvalueat aspecificpoint inthe

future.Itis usually basedon ahigh confidencelevel, takingintoaccount theworst-case

scenario.Thecurrent MtM may followa numherofdifferent possible pathsInto the future,

so aprobabilitydistributionof PFEcan be derived (as shownin Figure1).PositiveMtM(theshadedarea) is the partof theexposure thatisatrisk.Any points inthis shadedarea can representPFE

Figure1:PotentialFutureExposure

CrossReferenceto GARPAssigned Reading—Gregory, Chapter 2

MANAGING COUNTERPARTY RISK

AJM29.5: Describe the differentways institutionscanmanagecounterpartyrisk.

Methods tomanagecounterpartyrisk include: tradingonly with high-quality

counterparties,cross-productnetting, close-out, collateralization,walkawayfeatures,

diversifyingcounterpartyrisk,andexchangesand centralized clearinghouses.

Trading onlywithhigh-qualitycounterparties isasimple andstraightforward mediodfor

managingcounterpartyrisk All of thesecounterparties would haveAAAcredit ratings and

may not herequired to providecollateral

Cross-product netting works with derivativetransactionsthat canhave bothapositive

anda negative value In thecaseofadefaultbyeithercounterparty, anettingagreement

will allowtransactionstobeaggregatedandreduce die riskfor both parties Thelegaland

operational risks thataccompany nettingmustbeconsidered.Anexample of cross-producL

netdngisasfollows(fromCounterpartyA’sperspective):

CounterpartyA CounterpartyB

Trades with positiveMiM

Trades with negativeMrM

Exposurewith nonetting

Exposure with netting

+$20 million-$17million+$20 million+$3million

—$2.U million+$17million+$17million

$0

Close-out is the immediate closing of allcontractswith die defaultedcounterparty.When

combined with nettingof McM values,aninsdtudon may offset whatitowes to the

counterparty (anegativeamount)against whatitisowed hythecounterparty(a posidve

amount)*Ifthenet amountisnegative,die institution will makea payment,butifthenet

amountispositive, it will makea claim Thisresultsinanimmediate realizationof netgains

or losses for the insdtudon

Collateralization(i.e*,margining)occursin theform ofacollateralagreementbetween

twocounterparties that:reducesexposurebyrequiringsufficientcollateral to be posted by

eithercounterparty to supportthenetexposurebetween them.LSufficientcollateral does

theoreticallyreduce thenetexposureto zero. Posting collateralisdoneon a periodicbasis to

minimize transactioncosts*However,collateralization doescomewith market, operational,

andlegal risksaswellassignificantworkrequirements to ensuretheprocessisdone

properly

Awalkawayfeature allowsa party tocancel the transactionif thecounterpartydefaults.It is

advantageousifa partyhasa negative MtMand thecounterpartydefaults

Diversificationofcounterpartyrisk limits creditexposure toanygivencounterparty

consistentwith thedefault probability of thecounterparty.When aninstitution tradeswith

morecounterparties, thereismuch less exposuretothefailureof anygivencounterparty.

Asdescribedpreviously,exchanges and centralizedclearinghousestakeondieroleof

thecounterpartyandguaranteeall trades hy removingall counterpartyrisk from trades.