Question

**IMPORTANT NOTE: I have uploaded the necessary Securitization Tutorial 10 PDF required for this Question as an image file for your use. Thank you so much for all your prompt assistance! :)

Q.20. This is another exam type question. The risk inherent in tranches is different to normal assets. During the GFC it costs many investors a lot of money and during past exams some students lost a lot of marks. Please make sure that you really understand the underlying mechanics. Please do NOT RELY on memorization and shallow knowledge! Understanding will enable you to get 90% - 100% with ease.

To enable automatic feedback/marking the answers to the attached questions should be provided by filling in the blanks. However, for your own practice, I recommend taking notes on paper / pdf, including detailed calculations, balance sheets and short explanations.

Tutorial 10 Securitization.pdf

a. The risk weighted assets of BIG Bank are $___________ (no rounding!). Therefore its capital ratio is___________ (more/less) than 10%.

b. If 15 percent of Subprime Quick Money loan pool is written off, the value of BIG Bank AAA tranche holding will be $___________ and its Ba1 tranche holding will be valued at $___________. Big Bank's Equity will change to $__________. Is this still 10% of its RWA?

c. If Big Bank would have invested $20 directly into MBS (the same type of loans as Quick Money) and 15% of the underlying loans would have defaulted, the loss for Big Bank would have been exactly $___________. This would have been___________ (better / worse) than the investment in the tranches.

d. Continue with your balance sheet from b) after the losses. If Big Bank would swap all its loans against Quick Money A3 tranches, its RWA would change to $___________ (no rounding!). Check if Big Bank is now achieving its minimum CAR of 10% again.

ECONZ200 TUTORIAL e) Recall that loans have a regulatory risk weight of 100%. Imagine the "Clever Bank" has $100m loans, which it could sell to its own SPV Quick Money. Quick Money can structure the cash flows from the $100m loans to create the following tranches: SECURITIZATION QUESTION: TRANCHES RWA in $m for the Risk weights for CAR (APRA APS 120) 20% Amount in million Bond Rating bank buying the whole tranche Assume that $100 million face value of MBS were used to create the following tranches issued by "Quick Money" SPV: $ 30 $ 20 $ 10 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 Aaa Bond Rating Allocation in % Risk weights for CAR (APRA APS 120) 20% Amount in million Aa1 20% 20% Aa2 $ 30 $ 20 $ 10 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 Aaa Aa1 Aa3 A1 20% 50% 50% 50% 100% 100% 100% 350% 20% Aa2 20% 20% 50% 50% A2 Aa3 АЗ A1 Baa1 A2 Baa2 50% АЗ Baa3 Baa1 Baa2 Baa3 100% 100% 100% 350% Ba1 Total Comment if it is worth for Clever Bank to sell its loans to Quick Money and then buy all tranches that Quick Money created. Ba1 a) BIG Bank invested in the Quick Money Aaa and Ba1 tranch (see balance sheet. Calculate its risk weighted assets and evaluate if its capital buffer was consistent with a 10 percent minimum capital adequacy ratio at the time of the initial purchase. Liabilities and equity $90 Assets Cash $10 Demand deposits Quick Money Aaa tranche Quick Money Ba1 tranche Loans (risk weight 100%) $15 Equity $5 $70 $10 b) Show the changes in Small Banks' balance sheet once 15 percent of the Quick Money loan pool is written off. Check the impact upon the tranches and explain what problem Small Bank faces. c) Assume Big Bank would have invested $20 directly in subprime mortgage instead of the tranches. Explain if this would have been better or worse for Big Bank. d) Big Bank gets an offer to swap all its loans against Quick Money A3 tranches one dollar for one dollar. Explain why this might be an attractive offer from a Capital Management point of view.

e. If Clever Bank keeps all its loans on its balance sheet, its RWA would be exactly $___________m. However, if it does the deal with Quick Money its RWA would be $___________m. This is an___________ (advantage/disadvantage) for a capital management point of view. Did the actual riskiness of the assets change?

Answer 1

Ans (a).

Calculation of Risk Weighted Assets

Asset	%	Workings	Risk Weighted Asset
Cash	0	NA	$0
Quick Money Aaa tranche	20	=$15 x 20%	$3
Quick Money Ba1 tranche	350	=$5 x 350%	$17.50
Loans	100	=$70 x 100%	$70
Total			$90.50

Capital Adequacy Ratio (CAR) = $90.50 / $10 = 9.05 Therefore, the capital ratio is less than 10%

Ans (b). If 15 percent of Subprime Quick Money loan pool is written off, the value of BIG Bank AAA tranche holding will be   $12.75 and its Ba1 tranche holding will be valued at $4.25. Big Bank's Equity will change to $10. Capital Ratio is still less than 10% of its RWA.

Ans (c). If Big Bank would have invested $20 directly into MBS (the same type of loans as Quick Money) and 15% of the underlying loans would have defaulted, the loss for Big Bank would have been exactly $3. This would have been   better than the investment in the tranches.

Ans (d). Continue with your balance sheet from b) after the losses. If Big Bank would swap all its loans against Quick Money A3 tranches, its RWA would change to $52. Check if Big Bank is not achieving its minimum CAR of 10% again.

Ans (e). If Clever Bank keeps all its loans on its balance sheet, its RWA would be exactly $100. However, if it does the deal with Quick Money its RWA would be $53. This is an advantage for a capital management point of view. The actual   riskiness of the assets changed.