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Financial Institutions and Regulations > Structured Finance > Flashcards

Structured Finance Flashcards

1
Q

What is structured finance ?

A

Mainly about pooling of economic assets and issuing prioritized claims against collateral pools like :

  • Senior tranche
  • Mezzanine tranche
  • Junior tranche
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2
Q

What can structured finance achieve ?

A
  • Diversification
  • Broaden pool of potential investors
  • Improve liquidity
  • Lower transaction costs
  • Extend credit to many more customers than when banks would have to hold all loans on BS
  • Lower borrowing costs for corporations
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3
Q

What are many institutions demanded and who are they ?

A

Explicitly required to hold certain share of AAA-rated securities

  • Insurance companies
  • Pension funds
  • Mutual funds
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4
Q

How did Basel II and other regulations render AAA-rated securities and why ?

A

Highly attractive from capital requirement perspective, because :

  • Zero risk weight
  • AAA → pledged fully as collateral in day-to-day repo lending

→ however, natural AAA very limited

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5
Q

What are the two types of investors ?

A
  • Pension fund : lot of capital but risk averse + willing to hold investment-grade securities
  • Risk neutral investor : capital constrained + only invest one unit
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6
Q

What happens when structured finance products are absent ?

A

Production inefficiently low

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7
Q

What happens if bank buys two bonds to create collateralized debt obligation ? (CDO)
Characteristics :
• One senior and one junior tranche

  • Defaults after one year with p = 5%
  • Bonds = independent with each other
  • Rating of CCC+
A
  • Junior tranche defaults if at least one bond defaults with probability : 1 – (1-p)^2
  • Senior tranche defaults only if both bonds default with probability p^2

→Senior tranche = much safer than underlying asset + achieves investment-grade rating A-

→ sell senior tranche to pension fund and junior to risk-neutral investor

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8
Q

What is the economic benefit of structured finance ?

A

Welfare-enhancing as allows to create products matching demand side’s risk preferences and capital constraints
→ highly desirable

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9
Q

What are the two main pitfalls of structured finance ?

A

• Rating error : risk of understimating loss distribution of underlying asset pool
o Too many securities AAA-rated
o Compounded by more complicated products

• Pricing error : conditional on ratings alone not sufficient
o Senior tranches tend to default in economy’s worst states
o Important systemic component should be priced into asset but it’s not

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10
Q

What do the two main pitfalls create ?

A

Enormous profits for issuers of structured products

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11
Q

How do we calculate the probability PD (x,p= that tranche x defaults ?
There are 100 bonds

A

PD(x,p) = 1-∑(100;i) p^i (1-p)^(100-i)

where 100;i is the binomial coefficient

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12
Q

How is it possible to create a CDO-squared ?

A

By computing a CDO of another CDO

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13
Q

What is the problem with CDOs and especially CDO-squared ?

A
  • Extremely sensitive to changes in default probabilities of underlying assets
  • Default function highly non-linear

→ Rating errors hug effects, especially for CDO-squared

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14
Q

What are the main factors that contributed to rating error regarding mortgage-based structured products ?

A

• Extremely high demands for accuracy to rate structured product as AAA
o Uncertainty regarding some key estimates such as default rates of different mortgage products neglected

• Wrong key parameters forecasts
o Assumption based on post-war experience (house prices never decline)

• Rating structured products requires to take correlation between huge set of assets into account
o Rating agencies used to rate bonds of individual issuers lacked necessary experience

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15
Q

What did Coval et al. agrue ?

A

There is a huge systematic risk in senior tranches of structured products

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16
Q

What are the important difference between risk of individual bond and structured product made up of bonds ?

A

Economic conditions → small role for risk assessment of individual bond whereas it plays key role for prediction mass defaults of asset class.

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17
Q

Why are senior tranche so problematic in structured producs ?

A

Default in worst states of economy, marginal utility consumption highest:

  • Senior tranches should command risk premium over equally rated individual bonds
  • Using same rating-scale for structured products and individual bonds is misleading
18
Q

What was wrong with structured finance ?

A

Ability to create nearly safe products = overstated

  • Rating error → underestimated probabilities of default
  • Pricing error concealed senior tranches default in worst states of economy

→ Correcting for rating and pricing error will greatly reduce number of AAA-rated securities created with given pool of assets

19
Q

What is the puzzle that extraordinary boom and bust of MBS finance posed ?

A

Why mkt participants :

  1. ignore rating + pricing issues associated with MBS products
  2. react very strongly to first signs of declining house prices
20
Q

What did Gennailoli et Al present ?

A

Behavioral explanation based on “local thinging” = agents’ inability to take all but most likely states into account.

21
Q

What are Gennaioli et al. main intuition ?

A
  1. Simple setup with two types agents
    • Investors = extremely risk avers + only interested in safe (AAA) securities which are scarce
    • Financial intermediary = risk neutral + can create substitutes for safe securities by trancheing risky assets
  2. Investors + financial intermediary both local thinkers
    • Only focus on booms and downturns but ignore risk of severe recession

→ Financial intermediary issues too many structured products safe only in booms & downturns but not recession
→ Bad news makes agents suddenly aware of risk of recession
→ Flight into safe assets + sell off of structured products

22
Q

What is Gennaioli et al.’s model structure ?

A

• Three periods

•	2 assets : 
      o	A = risky pays y(i) with probability π(i) with i = g (growth), d (downturn), r (recession) s.t
             	Y(g) > 1 > y(d) > y(r) 
             	π(g) > π(d) >= π(r) 
      o	B = safe and pays R > 1 for sure

• Assets = only way to transfer wealth to period 2

23
Q

Who are Gennaioli’s two agents ?

A

• Investors : initial wealth w and infinite risk aversion
o U = C + C(1) + θmin(C(2g), C(2d), C(2r))
o θ > 1 (investors like to consume in period 2)

• Financial intermediary : owns both assets and maximizes expected profit over all periods

24
Q

What are the gains from trade in Gennaioli’s model ?

A
  • Investors prefer to consume in period 2 (θ > 1), FI sells claims on B and A to allow transferring wealth
  • Investors prefer safe claim on B due to risk aversion
25
Q

What is Gennaioli’s model timing ?

A

1 : t = 0, trading of claims at prices p(b) and p(a) takes place

  1. t = 1, all agents observe signal s with two possible realizations
    • If s = û : probability of growth higher
    • If s = u: probability growth lower & recession more likely than downturn
    → after observing signal, new trading at prices p(b1) and p(a1)
  2. t = 2, assets pay off
26
Q

What are the three assumptions of competitive markets ?

A
  • Rational expectations with traditional claims
  • Rational expectations with financial innovation
  • Local thinking and financial innovation
27
Q

What is the model under rational expectations with traditional claims ?

A

• Investors’ reservation price for buying
o Safe bond = θR
o Risky assets = θy(r)

• Financial intermediary’s reservation price for selling
o Safe bonds = R
o Risky assets = E(y)

→ Assumption that investors value risky assets always less than intermediary ( θy(r) < E(y|u) ) = only trading in safe bonds

→ financial intermediary keeps all risky assets

28
Q

When does the model under rational expectations with traditional claims achieve equilibrium in t = 0 ?

A

Investors wealthy and “shortage” of safe bonds

29
Q

What happens after the signal is observed in t = 1 in the model under rational expectations with traditional claims ?

A

Nothing happens to portfolios and consumption levels :

  • Price of safe bonds stays at p(b) = θR
  • Only price of risky asset p(a) fluctuates as expectations adjusted to realized signal s
30
Q

What is the model under rational expectations with financial innovation ?

A

• Shortage of safe bonds → social benefits from creating additional safe assets
o Investors value consumption in t = 2 more than intermediary (θ > 1)
o Investors infinitely risk averse → consumption in t = 2 certain

• Financial innovation → form of structured product intermediary creates by tranching risky assets’yield y
o Intermediary sells senior tranches that guarantee payoff R in t = 2 and keeps remaining junior tranches
o Maximal amount of senior tranches : f = y(r)/R
o Senior tranches = perfect substitutes for safe bonds B

31
Q

When does the model under rational expectations with financial innovation achieve equilibrium in t = 0 ?

A

investors wealthy + absorb all safe assets at price θR

32
Q

What happens after the signal is observed in t = 1 in the model under rational expectations with financial innovation ?

A

Nothing happens :

  • Price of safe assets (bonds + structured product’s senior tranches) stays at p(b) = θR
  • Price of risky asset p(a) fluctuates as expectations adjusted to realized signal s

→ Reason : Asset A structured very conservatively so that senior tranches pay R for sure even in case of recession

33
Q

What is the first result of Gennaioli’s model ?

A

Structure finance can ve welfare-enhancing in world with rational expectations

34
Q

What is the model under local thinking and financial innovation ?

A

All agents = local thinkers and take only two most likely states into account :

• T = 0 : most likely states = g and d

• T = 1 : states’ likelihood depends on signal s
o If s = û : g and d remain most likely states
o If s = u : g and r = two most likely states

• Key idea : agents neglect possibility of severe recession r until observe bad signal u

35
Q

What is the maximum amount of senior tranches intermediary can issue ?

A

f(L) = y(d)/R > y(r)/R = f

→ agents ignore possibility of server recession, believe risky asset A yields at least y(d)

→ intermediary can now issue too many senior tranches that perceived as perfect substitutes for safe bonds B

→ local thinking causes rating error

36
Q

When does the model under local thinking financial innovation achieve equilibrium in t = 0 ?

A

investors not wealthy enough to absorb all safe assets at price θR

37
Q

What happens after the signal is observed in t = 1 in the model under local thinking and financial innovation ?

A

Signal s’s realization determines what happens

• If s = û
o Structured product’s senior tranches perceived as perfect substitutes for safe bonds B

• If s = u : things go terribly wrong
o Agents suddenly realize recession r possible and senior tranches may only pay : (y(r)/y(d))R < R
o No longer perceive senior tranches as safe assets
o Mkts for senior tranches and safe bonds B separate

38
Q

What happens once mkts for senior tranches and safe bonds B separate under local thinking and financial innovation ?

A

• Investors’ reservation price for trading
o Safe bonds is θR
o Senior tranches is θ(y(r)/y(d))R

• Financial intermediary’s reservation price for trading
o Safe bonds = R
o Senior tranches is [P(L)(y(r)|u)(y(r)/y(d)) + P(L)(y(g)|u)]R = w(L)R

39
Q

What if θ(y(r)/y(d))R > w(L)R ?

A

• Investors value senior tranches higher than intermediary

•	Not trading takes place, but prices must adjust to
      o	P(b1) = θR > p(B) 
      o	P(ST1) = θ(y(r)/y(d))R < p(b)
      o	Investors = indifferent between buying or selling

• Flight into secure assets: price of safe bonds p(b1) raises and price of senior tranches p(ST1) plunges

40
Q

What if θ(y(r)/y(d))R < w(L)R ?

A
  • Investors value senior tranches less than intermediary
  • Intermediary eager to buy back senior tranches
  • Intermediary may not be wealthy enough to buy back all previously issued senior tranches
  • Any case, price of safe bonds p(b1) raises and price of senior tranches p(ST1) plunges
41
Q

What is the second result of Gennaioli’s model ?

A

Mkts for presumably safe structure products = fragile

  • When investors get surprising news about unattended risks, sell off false substitutes and flle into traditional safe assets
  • Sell-off of structured products may come in addition to fire sales driven by high leverage
  • Overissuance of structured products = source of risk
42
Q

What is the third result of Gennaioli’s model ?

A

When risk averse investors sell off structured products, risk neutral intermediaries may be willing to buy them back

  • Explain why banks, after having been recapitalized wanted to buy back MBS instead of providing additional credit
  • Intermediaries wealth provides insurance vs collapsing prices of structured products

Financial Institutions and Regulations (11 decks)

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