Investment Management: Securitization, Subprime Loans and Collateralised Debt Obligations
Investment Management: Securitization, Subprime Loans and Collateralised Debt Obligations
May 17th 2020, Uden/ The Netherlands
Consultant & Trainer: Joris Kersten
Joris (1980) is an independent Corporate Finance consultant through his firm “Kersten Corporate Finance” at Uden (The Netherlands).
He provides consulting and deal making in Mergers & Acquisitions (M&As) of medium sized companies in The Netherlands.
Moreover, he provides training in “Business Valuation” and “Financial Modelling” at leading “bulge bracket” investment banks in New York, London and Hong Kong.
In addition, he provides training in Corporate Finance at Universities and at Corporations all over the world (e.g. Mongolia, Surinam, Kuwait, Peru, Luxembourg, Saudi Arabia, Dubai, The Netherlands, Belgium etc.).
At last, he writes blogs on LinkedIn on Corporate Finance, almost 60 of his (free) blogs can be found at the end of this one (and on his LinkedIn page under “articles”).
NEW: 100% Online training “Certificate Investment Management”
On September 1st 2020 you can start (100% online) with obtaining your “Certificate Investment Management” given out by “Kersten Corporate Finance” in The Netherlands.
In 19 webinars (19 topics) of about 3 hours each, I will teach you the key elements of “investment management”. And this in 6 main themes.
After the webinars you practice with cases and exercises yourself, including questions from past CFA exams (level 1, 2 and 3). In the cases and exercises I will also teach you to actively use “Microsoft Excel” since this is an important tool in Corporate Finance.
The correct answers of the cases and exercises are also presented to you by webinars, worked out in detail. This in order to check your own work.
When you have finished the 19 webinars and have practised with the exercises and cases (all online), then there is an online exam to take (whenever you feel ready).
And when you pass the exam then you will receive the “Certificate Investment Management” of “Kersten Corporate Finance”. (pass = grade above 5.5 on a scale of 10)
Your name, and certificate number, will then be mentioned in the register on www.joriskersten.nl.
So for example your employer can then verify that you obtained the “Certificate Investment Management” of “Kersten Corporate Finance”.
Level training:
Participants get from a "foundation" level to "intermediate" level. This takes about 1 month to 3 months, depending on your own speed.
Foreknowledge needed for the training: A basic understanding of the Profit & Loss statement, cash flow statement and balance sheet. Moreover, a basic understanding of Microsoft excel.
The “course manual” with all info and conditions of the training will be available in the week of June 8th 2020.
And registration & subscription will also start in the week of June 8th 2020.
The 19 topics of the webinars, divided over 6 main themes are:
Theme 1: Key elements of investments
1) Asset classes and financial instruments. 2) Securities markets. 3) Mutual funds and other investment companies.
Theme 2: Portfolio theory
4) Risk, return and the historical record. 5) Efficient diversification. 6) Capital asset pricing model and arbitrage pricing theory. 7) Efficient market hypothesis.
Theme 3: Debt securities
8) Bond prices and yields. 9) Managing bond portfolios.
Theme 4: Security analysis
10) Macroeconomic and industry analysis. 11) Equity valuation. 12) Financial Statement Analysis.
Theme 5: Derivative markets
13) Option markets. 14) Option valuation. 15) Future markets and risk management.
Theme 6: Active investment management.
16) Evaluating investment performance. 17) International diversification. 18) Hedge funds. 19) Taxes, inflation and investment strategy.
The “course manual” with all info and conditions of the training will be available in the week of June 8th 2020.
Open (real life) training programs
The open training programs of Joris Kersten in The Netherlands take place at the dates below.
And for registration just write an email ([email protected]) or look at www.joriskersten.nl.
· 17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;
· 24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;
· 19, 20, 21, 22 and 23 July 2020: 5 days – Training with Certificate in Investment Banking. Location: Dubai/ United Arab Emirates;
· 16, 17, 18, 19 and 20 August 2020: 5 days – Training Master Financial Modelling Specialist. Location: Riyadh/ Saudi Arabia;
· 28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;
· 16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.
Investment Management
This is a sequence of blogs on “Investment Management”. And in this first one I will talk about the “Financial crisis of 2008”.
I have used the brilliant book mentioned below as a source. The book gives a great general overview on investment management, and this with a good level of depth.
The book is so good that I have decided to make in the handbook in my new 100% online training “Investment Management” to obtain your “Certificate Investment Management” given out by “Kersten Corporate Finance”.
Registered participants receive an original copy of the book!
· Source: Essentials of Investments: 11th edition (2019). Authors: Bodie, Kane and Marcus. McGraw-Hill Education New York.
The financial crisis of 2008: The antecedents
In 2007 most people thought it was highly unlikely that within two years the world’s financial system would be facing its worst crisis since the great depression in the 1930s.
Of course there was the collapse of the still quite recent high tech bubble (2000-2002). But the “Federal Reserve” responded to an emerging recession after the tech bubble by aggressively reducing interest rates.
The “treasury bill” (short term government debt) rates dropped significantly between 2001-2004.
Also the LIBOR rate dropped significantly. And the LIBOR rate (London Inter Bank Offered Rate) is the interest rate at which major banks lend to each other.
This worked well and the recession after 2001 was mild. And the stock exchange (e.g. S&P 500 index) was fully recovered again in about 2006 compared to before the tech bubble collapsed.
(Source used: Bodie, Kane and Marcus, 2019)
Banking sector & TED Spread
As well the banking sector “seemed” healthy after the tech bubble, this when taken a look at the “TED Spread”.
The “Ted Spread” is the “spread” (delta) between the 3-month LIBOR and 3-month treasury bill rate.
So these are 1) the rate at which banks borrow from each other, and 2) the rate at which the US government borrows.
And a common measure of “credit risk” in the banking sector is measured with this TED Spread.
And this TED spread was only around 0.25% in 2007, which suggests that the fears of default or “counterparty” risk in the banking sector was very low.
(Source used: Bodie, Kane and Marcus, 2019)
Housing prices and financing houses
But the low interest rates, and an apparent stable economy, after the tech bubble contributed to a big increase in the housing prices from around 2000 to 2007.
Housing prices more than doubled in this period.
Actually when you look at housing prices in the US from 1997 to 2007, so 10 years, then housing prices even tripled.
And also the way houses where financed changed.
From the 1970s “Fannie Mae” (FNMA = Federal National Mortgage Association) and “Freddie Mac” (FHLMC = Federal Home Loan Mortgage Corporation) began buying large quantities of mortgage loans.
They bought them from “originators” (parties who in first instance issued the mortgage loan) and bundled them into pools that could be traded like a “financial asset”.
These pools of loans were actually just claims on the underlying mortgages, so they started to be called “mortgage backed securities”. And this process of bundling was called “securitization”.
Fannie Mae and Freddie Mac became very big in this area, and together they bought more than half of the “mortgage backed loans” that originated from the “private sector”.
(Source used: Bodie, Kane and Marcus, 2019)
Securitization
With “securitization” the loan originator gives a loan to a “home owner”. The originator then sells the loan to for example Fannie Mae or Freddie Mac and recovers the cost of the loan.
In turn, Fannie Mae or Freddie Mac would pool the loans into “mortgage backed securities” and sell them again to investors such as “pension funds” and “mutual funds”.
Typically, Fannie Mae or Freddie Mac would “guarantee” the credit or default risk of the loans included in each pool.
And because the mortgage cash flows were passed along from the homeowner to the lender, then to Fannie Mae or Freddie Mac, and then finally to the investor (e.g. pension fund or mutual fund), these “mortgage backed securities” were called “pass-throughs”.
(Source used: Bodie, Kane and Marcus, 2019)
“Subprime” loans
In essence, mortgages that had been securitised into pass-throughs, and guaranteed by Freddie Mac or Fannie Mae, they were low risk mortgages.
The loans could not be too big, and homeowners had to meet the underwriting criteria, in order to establish their ability to pay back the loan.
For example the ratio “loan amount to house value” could not be more than 80%.
But then the “private label pass-throughs” (subprime loans) followed after the “government-agency pass-throughs” (of Fannie Mae and Freddie Mac).
With the private label pass-throughs (subprime loans) the investor, so the last in line, would bear the risk that homeowners might default on their loans.
And this was not the case with the “pass-throughs” of Fannie Mae and Freddie Mac (government agencies), since they “guaranteed” the mortgages.
Then even worse a strong trend of “low documentation” loans, and then “no documentation loans” emerged within the subprime loans (private label pass-throughs).
And also other underwriting standards deteriorated with the subprime loans.
For example, by 2006 the majority of the subprime borrowers purchased houses by borrowing the entire purchase price.
So loans were given out with a ratio “loan amount to house value” of 100%.
And when housing prices started to fall the highly leveraged loans were quickly “under water” (more debt than house value).
(Source used: Bodie, Kane and Marcus, 2019)
Mortgage derivatives
Then from 2004 higher interest rates put payment pressure on homeowners since the initial low interest payment period was over.
(low interest beginning, “normal” interest rate later, and this was the common deal in “adjustable rate mortgages”).
Also the housing prices peaked in 2006, so home owner’s ability to re-finance when they were in trouble became problematic after that.
This since their level of “equity” (value of the house minus loan on the house) decreased due to decreasing housing prices. And less equity = less possibility to re-finance.
So mortgage defaults started to grow in 2007, and consequently losses on mortgage backed securities as well, with the credit crunch as a result.
So the question is: Why would investors be willing to buy all of these very risky (subprime) mortgages?
Well the answer is, due to:
- Securitisation;
- Restructuring;
- Credit enhancement.
Due to new “risk shifting tools” investment banks could carve out “AAA-rated securities” (triple A = very good) from original issued “junk loans” (very bad).
And this is done through so called “Collateralised debt obligations” (CDOs).
CDOs were designed to concentrate the credit risk of a bundle of loans on one class of investors.
So the bundle of loans was divided in tranches.
For example 70% of the bundle was allocated to a “senior tranche” (low risk) and for example 30% was allocated to a “junior tranche” (high risk).
Simply said, now even bundles of risky subprime loans could be rated “triple A” (AAA by Moody’s, Standard & Poor’s and Fitch).
This because default rates of above (for example) 30% seemed very unlikely.
(Source used: Bodie, Kane and Marcus, 2019)
Rating agencies
Rating agencies could (because of the CDO structure) carve out large amounts of AAA-rated securities out of actually “low rated mortgages”.
Now we know that these rating were wrong, but how could this happen?
First: Default probabilities on the loans had been estimated using historical data, and this turned out to be not representative for the CDOs.
And Second: The rating agencies extrapolated historical default numbers to a new sort of borrower pool (CDOs) which was also not a good fit either.
(Source used: Bodie, Kane and Marcus, 2019)
In the next blog in this sequence I will finish this discussion on the “2008 financial crisis”.
Topics that will then come back are: Credit Default Swaps, new systemic risk and the Dodd-Frank Reform Act.
Source
I have used the brilliant book mentioned below as a source. The book gives a great general overview on investment management, and this with a good level of depth.
The book is so good that I have decided to make in the handbook in my new 100% online training “Investment Management” to obtain your “Certificate Investment Management” given out by “Kersten Corporate Finance”.
Registered participants receive an original copy of the book!
- Source: Essentials of Investments: 11th edition (2019). Authors: Bodie, Kane and Marcus. McGraw-Hill Education New York.
Under here you can find the links to my previous free articles (almost 60) on business valuation.
Earlier blogs on “net debt” (cash & debt free)
Article 1: Valuation: Introduction to "net debt" (cash & debt free)
https://www.dhirubhai.net/pulse/valuation-introduction-net-debt-cash-free-joris-kersten-msc-bsc-rab/
Article 2: Valuation: Net debt (cash & debt free)
https://www.dhirubhai.net/pulse/valuation-net-debt-cash-free-joris-kersten-msc-bsc-rab/
Article 3: Valuation: Adjusted net debt – Cash like items
https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-cash-like-items-kersten-msc-bsc-rab/
Article 4: Valuation: Adjusted net debt – Debt like items
https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-like-items-joris-kersten-msc-bsc-rab/
Earlier blogs on “valuation of banks”
Article 1: Valuation of Banks: Business models of Banks
https://www.dhirubhai.net/pulse/valuation-banks-business-models-joris-kersten-msc-bsc-rab/
Article 2: Bank Valuation: Financial Statements of Banks (part 1)
https://www.dhirubhai.net/pulse/bank-valuation-financial-statements-banks-part-1-joris/
Earlier blog on “Valuation of Oil & Gas Companies”
Article 1: Valuating Oil & Gas Companies: The Oil Industry
https://www.dhirubhai.net/pulse/valuating-oil-gas-companies-industry-joris-kersten-msc-bsc-rab/
Article 2: Valuating Oil & Gas Companies: The Oil Industry – Part 2
https://www.dhirubhai.net/pulse/valuating-oil-gas-companies-industry-part-2-kersten-msc-bsc-rab/
Earlier blogs on “Debt & Leverage”
Article 1: Debt: Ratio “debt/ GDP” in the US, The Netherlands, Germany and Japan
https://www.dhirubhai.net/pulse/debt-ratio-gdp-us-netherlands-germany-japan-kersten-msc-bsc-rab/
Article 2: Debt: Why global debt increased over the last 100 years
https://www.dhirubhai.net/pulse/debt-why-global-increased-over-last-100-years-kersten-msc-bsc-rab/
Article 3: Debt of companies: Leverage, Private Equity, Solvency and Bankruptcy
https://www.dhirubhai.net/pulse/debt-companies-leverage-private-equity-solvency-kersten-msc-bsc-rab/
Earlier blogs on “Weighted Average Cost of Capital (WACC) – step by step”
Article 1: Capital Market History Lessons – Corporate Finance (part 1)
https://www.dhirubhai.net/pulse/capital-market-history-lessons-corporate-finance-part-joris/
Earlier blogs on Financial Modelling
Article 1: Financial Modelling in Excel: Circular references, interest calculations and iterations
https://www.dhirubhai.net/pulse/financial-modelling-excel-circular-references-kersten-msc-bsc-rab/
Article 2: Excel basics for Finance: SUM, MAX, MIN, AVERAGE, IF, cell referencing, named ranges
https://www.dhirubhai.net/pulse/excel-basics-finance-sum-max-min-average-cell-named-joris/
Article 3: Excel for Valuation: COUNTIF, VLOOKUP, INDEX and MATCH
https://www.dhirubhai.net/pulse/excel-valuation-countif-vlookup-index-match-kersten-msc-bsc-rab/
Article 4: Excel for Business Valuation: OFFSET, FORECAST and CHOOSE
https://www.dhirubhai.net/pulse/excel-business-valuation-offset-forecast-choose/
Article 5: Excel for Business Valuation: NPV, IRR, PMT and EOMONTH
https://www.dhirubhai.net/pulse/excel-business-valuation-npv-irr-pmt-eomonth-kersten-msc-bsc-rab/
Article 6: Excel for Business Valuation: Custom Formatting, Conditional Formatting and Sparklines
https://www.dhirubhai.net/pulse/excel-business-valuation-custom-formatting-sparklines-joris/
Earlier blogs on “various topics”
Article 1: Financing a M&A transaction: An introduction
https://www.dhirubhai.net/pulse/financing-ma-transaction-introduction-joris-kersten-msc-bsc-rab/
Article 2: Valuation: How to adjust for “Operating Lease” (under Dutch GAAP)
https://www.dhirubhai.net/pulse/valuation-how-adjust-operating-lease-under-dutch-gaap-joris/
Article 3: M&A closing mechanisms: Locked Box & Completion Accounts
https://www.dhirubhai.net/pulse/ma-closing-mechanisms-locked-box-completion-accounts-joris/
Article 4: Scoping a financial model built primarily for business valuation:
https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/
Article 5: Consolidation of M&A targets and Purchase Price Allocation (PPA)
https://www.dhirubhai.net/pulse/consolidation-ma-targets-purchase-price-allocation-joris/
Article 6: Economics: Do economies have to grow to maintain the same level of prosperity ???
https://www.dhirubhai.net/pulse/economics-do-economies-have-grow-maintain-same-level-joris/
Earlier blogs on “bonds”
Article 1: Bonds - An introduction
https://www.dhirubhai.net/pulse/corporate-finance-bonds-introduction-joris-kersten-msc-bsc-rab/
Article 2: Bonds & Bond Markets
https://www.dhirubhai.net/pulse/bonds-bond-markets-corporate-finance-joris-kersten-msc-bsc-rab/
Article 3: Bonds, Rating Agencies and Credit Ratings
https://www.dhirubhai.net/pulse/bonds-rating-agencies-credit-ratings-joris-kersten-msc-bsc-rab/
Earlier blogs on “Valuation & funding of start-ups”
Article 1: Valuation & funding of start-ups - Funding rounds
https://www.dhirubhai.net/pulse/valuation-funding-startups-rounds-joris-kersten-msc-bsc-rab/
Article 2: Startup valuation: Pre-money and post-money valuation
https://www.dhirubhai.net/pulse/startup-valuation-pre-money-post-money-joris-kersten-msc-bsc-rab/
Article 3: Valuation methods for Startups (early stage) – Part 1
https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-1-kersten-msc-bsc-rab/
Article 4: Valuation methods for Startups (early stage) – Part 2
https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-2-kersten-msc-bsc-rab/
Article 5: Startups in Silicon Valley: The beginning – Part 1
https://www.dhirubhai.net/pulse/startups-silicon-valley-beginning-part-1-joris-kersten-msc-bsc-rab/
Article 6: Startup Funding & Convertible Debt (part 1)
https://www.dhirubhai.net/pulse/startup-funding-convertible-debt-part-1-joris-kersten-msc-bsc-rab/
Earlier blogs on “Mergers & Acquisitions (M&As)” and “M&A transactions”
Article 1: M&A Transactions: Share Deals, Asset Deals and Legal Mergers and Divisions
https://www.dhirubhai.net/pulse/ma-transactions-share-deals-asset-legal-mergers-kersten-msc-bsc-rab/
Earlier blogs on “Business valuation to Enterprise Value”
From June until August I have written the following blogs on valuation:
1) Leveraged Buyout (LBO) Analysis:
https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/
2) M&A Analysis – Accretion/ Dilution:
https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/
3) Discounted Cash Flow Valuation:
https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/
4) Valuation Multiples 1 – Comparable Companies Analysis:
https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris
5) Excel Shortcuts & Business Valuation:
https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab
6) Valuation Multiples 2 – Precedent Transaction Analysis:
https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab
Earlier blogs on “Energy Transition”
Article 1: Energy transition: Introduction to Sustainable/ Renewable Energy
Article 2: Energy transition: Energy mix of The Netherlands & Goals for co2 reduction
https://www.dhirubhai.net/pulse/energy-transition-mix-netherlands-goals-co2-reduction-joris/
Earlier blogs on Wall Street
Article 1: Wall Street – A general introduction
https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/
Article 2: Wall Street – The Federal Reserve banking system
https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/
Earlier blogs on the “cost of capital”
Article 1: Valuation & Betas (CAPM)
https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/
Article 2: Valuation & Equity Market Risk Premium (CAPM)
https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/
Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)
https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/
Article 4: Valuation & the cost of debt (WACC)
https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/
Article 5: Valuation & Capital Structure (WACC)
https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/
Article 6: International WACC & Country Risk – Part 1
https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/
Article 7: International WACC – Part 2
https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/
Article 8: Present Values, Real Options, the Dot.com Bubble
https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/
Article 9: Valuation: Different DCF & WACC techniques
https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/
Article 10: Valuation of a company abroad
https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/
Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts
https://www.dhirubhai.net/pulse/valuation-illiquidity-discounts-control-premiums-joris/
Article 12: Valuation: Small firm premiums
https://www.dhirubhai.net/pulse/valuation-small-firm-premiums-joris-kersten-msc-bsc-rab/
Earlier blogs on Financial Due Diligence
Blogs on this topic coming soon
Earlier blogs on Derivatives
Blogs on this topic coming soon
Earlier blogs on Distressed M&A and distressed Valuation
Blogs on this topic coming soon
Earlier blogs on Debt crises
Blogs on this topic coming soon
Earlier blogs on How inflation works
Blogs on this topic coming soon
Earlier blogs on Tax and tax evasion
Blogs on this topic coming soon
Earlier blogs on Financial modelling in excel: step by step model building
Blogs on this topic coming soon
Earlier blogs on Hedge funds
Blogs on this topic coming soon
Earlier blogs on Central banking and the supply of money (quantitative easing)
Blogs on this topic coming soon
Earlier blogs on Advanced Valuation
Blogs on this topic coming soon
Earlier blogs on Finance for Non Financials
Blogs on this topic coming soon
In case you like to see back certain topics within my blogs, please email your suggestions and I will take them into account: [email protected]