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Bond Insurance

Bond Insurance. Guarantees bond principal in case of a credit event. Effectively “swaps” the rating of the bond for that of the insurer. Purchased by bond issuers at time of issue to help sell bond (often done with munis ).

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Bond Insurance

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  1. Bond Insurance • Guarantees bond principal in case of a credit event. • Effectively “swaps” the rating of the bond for that of the insurer. • Purchased by • bond issuers at time of issue to help sell bond (often done with munis). • bond holders interested in protecting themselves from bond default. • bond holders interested in upgrading the quality of the bonds they have on their books. • If financial soundness of insurance company comes into question, ability to upgrade quality of a security is diminished.

  2. Credit Default Swaps (CDS) • CDS typically quoted in terms of $10 million for 5 years. • Ex: Price to insure $10 million of XYZ bonds for 5 years is 150 basis points per annum. But like free money if no credit event. • Most CDS buyers didn’t own reference obligation. • Now more like a bet than insurance. • Several things went wrong: • Since don’t have to own reference obligation, notionalamount of outstanding CDSs can exceed the reference obligation’s total face value. • CDS coverage grew rapidly on mortgage-backed securities. Made them look, whatever their quality, good on the books of financial institutions. • When reference obligations went bad in large numbers, CDS writers (like AIG) unable to pay. • As a result of Commodity Futures Modernization Act, there were no regulations about having to put any money aside.

  3. Credit Event CDS writers have to pay when credit event occurs on reference obligation. • bankruptcy • default • failure to pay • repudiation/moratorium • restructuring

  4. Securitization (pp. 261-263) Prior to financial crisis, housing prices sometimes dropped regionally, but never all at once across the country. Securitization – conversion of a pool of assets (e.g., auto loans, student loans, mortgages) into securities that can be sold in the capital market. borrower investors lender Wall St firm SIV rating agencies

  5. Typical Situation Wall St firm buys $1 billion of mortgages from various lenders. Organizes a trust, often called special investment vehicle (SIV). SIV sells mortgage bonds to investors in tranches for money to pay back Wall St firm. SIV 80%, Senior tranche at 4%, AAA 5%, Equity tranche at 10%, unrated 15%, Mezzanine tranche at 8%, BB 6.5% mortgages Of monthly mortgage payments: Repayments of principal go (a) to Senior tranche holders first until paid off, (b) then to Mezzanine tranche holders until paid off; (c) then to Equity tranche holders. Interest goes to tranche securities not yet paid off, with any extra going to Equity tranche holders. It is the monthly cycle that causes MBSs to make payments monthly. Because of interest rate spread, for years, had been very lucrative for Wall St firms.

  6. Mortgage Bonds vs. CDOs Equity tranche securities often kept by the Wall St firms because so profitable. Investors like municipalities around the world, pension funds, individuals were ravenous for Senior tranche (ie, AAA) securities, even though never knew for sure what was in the pools. Investors thought: AAA, 1 out of 200 chance of failure. What is there to investigate? Where else can I get such a good rate on a AAA? After 2000, Wall St decided to get clever – tried to form as many 2ndand 3rd pools as they could. Securities issued by a 1st pool called mortgage bonds. Securities issued by 2nd and subsequent pools called CDOs.

  7. Tranche Securities of 2ndPools 2nd pools called CDOs. Formed out of Mezzanine securities from various 1st pools. 2nd poolsthen sold tranche securities (also called CDOs) to pay for them. In this way, with rating agency complicity, AAA securities could be manufactured out of BB. Senior (80%) Equity (5%) Mezz (15%) SIV investors Wall St firm Senior (70%) Equity (10%) Mezz (20%) CDO rating agencies Note: investors in CDO tranche securities are investing in securities whose payment depends upon other securities that depend on mortgages. CDOs more lucrative than SIVs, but a supply problem. Takes several SIVs to produce enough mezzanine securities to form a CDO. Somehow need to generate more mortgages.

  8. 3rd Pools (known as a CDOs-squared) Se(.80) Eq(.05) Me(.15) SIV investors Wall St firm Se(.7) Eq(.1) Me(.2) CDO Se(.6) Eq(.1) Me(.3) CDO2 rating agencies As SIV-pools became stuffed with subprime, collapse of CDO and CDO2 tranche securities just a matter of time. The few who saw this coming, bought CDSs on the whatever tranches securities they could (from AIG and others who were complacent from previous profits), and became rich. Why subprime? Because CDOs were clamoring for more product and there weren’t enough regular mortgages any more.

  9. Things for Final Last third of course. 5 Cs 3 base rate adjustments What TIPS stands for 6 typical types of MM instruments Names of 3 ratings agencies Latest National Debt and Social Security Trust fund figures Know meaning of the word “notional” – principal or face value amount Know about Commodity Futures Modernization Act Questions end Dec 4 midnight.

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