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Ch08HullOFOD10thEdition.pptx
Ch08HullOFOD10thEdition.pptx
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Ch08HullOFOD10thEdition.pptx-Chapter 8 Securitizat...
Ch08HullOFOD10thEdition.pptx-Chapter 8 Securitization and the Credit
Ch08HullOFOD10thEdition.pptx-Chapte...
Ch08HullOFOD10thEdition.pptx-Chapter 8 Securitization and the Credit
Page 9
What happened...
Banks found it profitable to invest in the AAA rated tranches
because the promised return was significantly higher than the
cost of funds and capital requirements were low
In 2007 the bubble burst. Some borrowers could not afford
their payments when the teaser rates ended.
Others had
negative equity and recognized that it was optimal for them to
exercise their put options.
Foreclosures increased supply and caused U.S. real estate
prices to fall. Products, created from the mortgages, that were
previously thought to be safe began to be viewed as risky
There was a “flight to quality” and credit spreads increased to
very high levels
Many banks incurred huge losses
Options, Futures, and Other Derivatives 10th Edition,
Copyright © John C. Hull 2017
9
Page 10
What Many Market Participants
Did Not Realize…
Default correlation goes up in stressed market
conditions
Recovery rates are less in stressed market conditions
A tranche with a certain rating cannot be equated
with a bond with the same rating. For example, the
BBB tranches used to create ABS CDOs were
typically about 1% wide and had “all or nothing” loss
distributions (quite different from BBB bond)
This is quite different from the loss distribution for a
BBB bond from a BBB bond
Options, Futures, and Other Derivatives 10th Edition,
Copyright © John C. Hull 2017
10
Page 11
Regulatory Arbitrage
The regulatory capital banks were required to
keep for the tranches created from mortgages
was less than that for the mortgages
themselves
Options, Futures, and Other Derivatives 10th Edition,
Copyright © John C. Hull 2017
11
Page 12
Incentives
The crisis highlighted what are referred to as
agency costs
Mortgage originators (Their prime interest was in
in originating mortgages that could be securitized)
Valuers (They were under pressure to provide high
valuations so that the loan-to-value ratios looked
good)
Traders (They were focused on the next end-of
year bonus and not worried about any longer term
problems in the market)
Options, Futures, and Other Derivatives 10th Edition,
Copyright © John C. Hull 2017
12
Page 13
The Aftermath…
A huge amount of new regulation (Basel II.5,
Basel III, Dodd-Frank, etc). For example:
Banks required to hold more equity capital with the
definition of equity capital being tightened
Banks required to satisfy liquidity ratios
CCPs and SEFs for OTC derivatives
Bonuses limited in Europe
Bonuses spread over several years
Proprietary trading restricted
Options, Futures, and Other Derivatives 10th Edition,
Copyright © John C. Hull 2017
13
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