Lecture 24Loan Securitization – Market Risk

Chap 26, Chap 17 -19, Chap 10

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You are responsible for all the material presented in class and in the book since the previous exam.

This is a review of some elements of that information. It is not a comprehensive review of all the information you will be responsible for on the Exam!

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Loan Securitization

Liquidity Risk

Liability and Liquidity Management

Depository Insurance

Market Risk

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Loan Securitization

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Securitization Process◦ Vehicles: SPV, SIV, similarities/differences, Procedure Advantages &

Disadvantages

Pass-Through Securities◦ What are they, how are they created, payments, ownership

Agencies◦ GNMA, FNMA, FHLMC – what do they do, how are they similar/different

Costs and benefits of securitization

Cash flows◦ Payments, value, pre-payment risk

Other Securitizations ◦ CMOs, CDOs, RMBS

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Bank of America purchased 6000 mortgages with an average principal of $143,000 each. BoA intends to finance the purchase by raising deposits and want to maintain its current risk profile. Currently BoA has a Tier I risk-based capital ratio of 5.8%, The Federal Reserve requires 10% of deposits to be held in reserve, and the FDIC charges 27 bps annual premium to insure deposits. Find the total regulatory tax BoA is exposed to from these mortgages. If the risk weight on residential mortgages is 50%, they currently have a 20% default rate and pay an aggregate coupon of 4.3%.

6$119,950,020.67

Deutsche Bank purchases a pool of 1000 mortgages with an average principal value of $323,500 each. The mortgage pool has an aggregate mortgage coupon rate of 4.3% and the average time to maturity is 30 years. Deutsche Bank sells the pool to an SPV who collects a 38bp annual servicing fee. GNMA Charges an 18bp annual fee to insure the pass-through security payments. a)Find the aggregate monthly payment to GNMA bondholders assuming no pre-payment risk.b)Find the value of the issue after 12 years have past if a similar pool of mortgages yields a 2.3% mortgage coupon

7$1,496,343.87

How much should Carlyle Capital expect to get for the sale of a newly originated GNMA securitization with $703M of residential mortgage principal. The pool of mortgages has 30 years left to maturity. Currently, a 30-year Treasury note with face value of $1,000 sells for $98.23. A 30-year BBB rated corporate bond with $1,000 sells for $56.23 and the OAS for a 30-year GNMA pass-through bond is $0.002 per dollar of face value.

8$67,649,690.00

UBS originates a CMO backed by interest only GNMA bonds with $20M of Class A principal, $150M of Class B principal and $200M of Class C principal. The Class A, Class B and Class C bonds pay an annual coupon of 12%, 5% and 3% respectively. Find the payments to the Class A, B and C bond holders at the end of month 3 if: (assume all payments are made in arrears)a)$5M of principal is pre-paid each monthb)$5M of residential mortgage principal defaults each monthc)$5M is prepaid each month but $500,000 of the interest payment is delinquent in month 3

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A) Class A = 5,100,000 Class B = 625,000

Class C = 500,000B. No Change C. No Change

1. Regulatory tax – cost of holding mortgages on balance sheet

2. Pass Though bond payments – No prepayment riska) No Fees b) With GNMA & Servicing Fees

3. Pass Through bond value – No prepayment risk

4. Pass through bond payments – with prepayment risk (interest only)

5. Option Adjusted Spread (OAS)

6. CMO Payments – interest only loan pool

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Liquidity Risk

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Types of liquidity◦ Asset-side Liquidity◦ Liability-side Liquidity

Managing Liquidity◦ Stored Liquidity – sell assets◦ Purchased Liquidity – borrow funds

Measuring Liquidity

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Suppose a customer of a bank takes down $100 million of a loan commitment. How would the banks balance sheet, shown below, change if the DI: (i) Uses stored liquidity to meet its commitment (ii) Uses purchased liquidity to meet its commitment

Assets   Liabilities and EquityCash $50 Deposits $168 Loans 50 Borrowed Funds 125Marketable Securities 200  Equity 7Total assets $300 Total liabilities and equity $300

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(i) Cash = 0, Loans = 150, MS = 150(ii) Loans = 150, Borrowed = 225

Suppose a bank with the following balance sheet experiences a $100 million net deposit drain, how would the balance sheet change if the DI: (i) Uses stored liquidity to meet its commitment (ii) Uses purchased liquidity to meet its commitment

Assets   Liabilities and EquityCash $50 Deposits $168 Loans 50 Borrowed Funds 125Securities 200  Equity 7Total assets $300 Total liabilities and equity $300

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(i) Cash = 0, MS = 150, Deposits = 68

(ii) Deposits = 68 Borrowed = 225

1. Sources and uses of liquidity

2. Peer Group Comparison

3. Liquidity Index

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Example: use the following ratios to determine which bank is more exposed to liquidity risk (from external markets)

  Bank A Bank BBorrowed funds to Total assets 31.22% 21.43%Core deposits to total assets 26.28% 45.82%Loans to deposits 22.63% 15.23%Loan Commitments to total assets 19.87% 17.52%

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The table shows estimates of fundamental asset value and the value that could be recovered for immediate sale. Use this information to calculate the liquidity index of the bank.

Asset Face Value True Value Market collapse

T-Bill 10M $9 $9

C&I 144M $8.5 $3.5

Real Estate 360M $58 $10

17L=25.6%

1. Asset/Liability side liquidity risk management

2. Peer Group Comparison

3. Liquidity Index

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Liquidity & Liability Management

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Costs and benefits of regulating reserve requirements

Monetary policy and RR

Costs and benefits of holding liquid vs illiquid assets

Calculating reserve requirements

Managing & manipulating reserve requirements

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Example: Over the period from February 14-27 a bank has: Cumulative transaction account balance of $12,430M They are owed 800M from other US DIs (cumulative) They have $500M of cash in the process of being delivered (cumulative) Cumulative vault cash of $200M. (i) Calculate the reserve requirement to be maintained at the fed

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Total = 76.083MAt the Fed = 61.793M

1. Find computation & maintenance period

2. Calculate Reserve Requirements◦ Total ◦ At the Fed ◦ In the vault

3. Over/under shoot reserve requirements & carry forwards

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Deposit Insurance

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Depository Insurance history and structure ◦ Agencies, Limits, Structure

Purpose of depository insurance

Costs and benefits of depository insurance

Problems and proposed solutions with depository insurance

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By how much will the premium for depository insurance change if the bank is forced to write down a loss of $15M on its mortgage portfolio. The Bank is classified as supervisory concerned

Assets   Liabilities & EquityCash 37 Deposits 458Mortgages 245 Short-term borrowing 135Consumer loans 145 Perpetual preferred stock (Qualified) 3C&I Loans 164 Common stock 15Securities 40   Retained earnings 20

631 631

Change = 1,099,200-137,400=961,800

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Total risk based capital ratio ≥ 10% and Tier I risk-based capital ratio ≥ 6% and Tier I Leverage ratio ≥ 5%

Total risk-based capital ratio ≥ 8% and Tier I risk-based capital ratio ≥ 4% and Tier I Leverage ratio ≥ 4%

First Boston Bank has total assets of $398M total deposits of $345M all of which are insured. They have estimated the volatility of returns on assets to be 0.12 pa. Suppose the one-year risk free rate is 1.6%. Find the depository insurance premium that First Boston should be charged.

27P(t) = 1,890,183.46

Find Φ(X1) = -1.38 on the table:

1.0000- 0.9162

0.0838

Find Φ(X2) = -1.26 on the table:

1.0000- 0.8962

0.1038

1. Find the deposit insurance premium using the table

2. Find the deposit insurance premium using options pricing

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Market Risk

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RiskMetrics – Variance Covariance

Estimates the risk of individual trading books using VaR

Combines the risk of all trading books accounting for diversification

Produces a daily earnings at risk (DEAR) that estimates the potential loss from the full trading book that occurs with a certain probability (1%, 5% ...)

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Example: Calculate the 99% DEAR for a bank with: (i) a $5M equity portfolio with beta equal to .8 (ii) a BBB portfolio of zero coupon bonds with maturity of 12.5 years, total face value of $20M and average YTM of 10.2%. Assume that the daily expected return and volatility of the market are 0.00012 and 0.0005 respectively. The risk free rate is 0.00001 per day. The mean and standard deviation of the daily changes in the yield on BBB bonds is 0.00 and 0.00082 respectively. Assume that the correlation between YTM changes and market returns is .23

33128,253.05

1. Calculate DEAR

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More Examples

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Securitization

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Allied Bank originates a GNMA securitization backed by $12M in residential mortgage principal. The pool of mortgages generates a 4.1% aggregate mortgage coupon pa. Find the interest payment to GNMA bond holders, the SPV and GNMA after the 4th month. The servicing fee is 28bp pa. and GNMA insurance costs 14bp pa. Assume 325% PSA.

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Service fee = 2,692.10GNMA insurance = 1,346.05Bond Holders = 35,381.84

IDBI Money Market Mutual fund purchased a newly originated GNMA pass-through bond 7 years ago. The bond pays $1.2M per month. There is a 45bp annual servicing fee on the pool and GNMA insurance costs 12bps pa. The current mortgage rate is 3.9%. Find the current value of the GNMA bond if there is 23 years left to maturity. Assume no prepayment risk.

38$231,174,604.3310