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STRUCTURED FINANCEAsset Backed Securities (ABS)Mortgage Backed Securities (MBS)Collateralized Debt Obligations (CDOs)Collateralized Mortgage Obligations
(CMOs)Collateralized Bond Obligations (CBOs)Collateralized Loan Obligations (CLOs)Credit Derivative Swaps (CDS)Asset Backed Commercial Paper (ABCP)
UNDERLYING ASSETS of STRUCTURED FINANCE
MortgagesCredit Card ReceivablesConsumer LoansAuto LoansStudent LoansCommercial Real Estate MortgagesCorporate BondsReinsuranceTrade Finance Receivables Junk BondsSovereign DebtProject Finance DebtLeveraged Buyout DebtAnd many, many more
KEY ASPECTS OF STRUCTURED FINANCE
Pooling of Assets either cash-based or synthetics
Delinking of Credit RiskTranching of Liabilities
THE PLAYERS IN STRUCTURED FINANCE
Arrangers, Originators and Asset Managers Banks Loan and Finance Companies Investment Dealers Investment Management Companies
Investors Hedge Funds Special Purpose Vehicles (SPV’s) Structured Investment Vehicles (SIV’s) Banks Insurance Companies Mutual Funds Pension Funds
Compliance Auditors Lawyers
Financial Guarantors Monocline or Bond Insurers
Servicers Trust Companies
The Rating Agencies
DERIVATIVES Exchange Traded
Futures - Index, Money Market, Bonds, Equity, Currency, Commodities, Precious Metals, Energy
Options – On Futures Over the Counter (OTC)
Swaps – Equity, Interest Rate, Currency, Energy, Commodity Forwards – Interest Rate, Repurchase Agreements, Currency Options – Interest Rate Cap/Floors, Basis, Bonds, Equity,
Warrants, Currency Credit – Default Swaps, Default Option Other – Economic, Freight, Inflation, Weather, Sports, Property
DERIVATIVES RISK and BENEFITS
RISK Market Price – Volatility, Exposure to changes in prices Counterparty Systemic – Payment system, regulation Agency - Rogue Trader Speculation – Huge Leverage Leverage – Allows for huge leverage of debt in the economy
BENEFITS Low cost and effective method to hedge against exposure in underlying assets
without selling off assets Allows for lower funding costs and diversification of funding sources Efficient transfer of risk to another party Ability to enhance asset yields and protect value of illiquid securities Increases credit value of assets Increases ability to manage risks in traditional portfolios Reduces risk of future financial stress Improves allocation of credit and sharing of risk in the global economy Increase of liquidity in the global economy
STRUCTURED FINANCE RISKS and BENEFITS
RISKS Conflicting/Competing interests with liability structure (Tranching) Credit risks in underlying pool of assets could lead to shortfall in flow of
receivables to meeting payments Exogenous factors related to standing of third parties Legal and documentation risk Other – similar to derivatives
BENEFITS Allows for working around balance sheet or capital constraints Shifting of risk or risk transfer Ability to leverage balance sheet at a lower cost of capital Adds value and leverage to buyouts, yield plays and other structured and
arbitrage driven debt or synthetic funding deals Convert illiquid assets to tradable securities Release of trapped equity
THE CRISIS TIMELINE 1985-1991 Savings and Loan Crisis 1995-2001 Dot-com Bubble Late 1999 Repeal of Glass-Steagall 2000-2003 Recession period varying depending on country – Fed lowers rates 11 times to 1.75% 2002 Home prices appreciating 10% or more particularly in California, Florida and Northeast States 2004 Home prices appreciating by over 25% in California, Florida, Arizona, Hawaii and Nevada 2000-2007 Mortgage market more than doubles in size – Share of sub-prime lending goes from
virtually nothing in 1996 to almost 25% of market by 2006 – Sub-prime lending hits $1.3 trillion and along with Alt-A mortgages and Jumbo mortgages the market is $2.8 trillion in a $10.4 trillion market.
2005 Housing boom ended in August 2005 2006 Housing prices flat, sales falling, inventory slowly rising 2007 February –March Sub-prime market collapses more than 25 sub-prime lenders go bankrupt 2007 April – New Century Financial collapses 2007 August – sub-prime loans discovered in portfolios of banks, hedge funds – stock market panic,
huge injections of liquidity 2007 September The crisis goes global with collapse of Britain’s Northern Rock and a run on the
bank 2007 Billions of dollars in losses announced by financial institutions including Citibank, Merrill
Lynch precipitating a further market panic in December and January 2008 – Fed slashes funds rate from 5.25% to 3% - A credit crunch ensues
Average U.S. Real Estate Price divided by CPI
Average US House Price/Gold