Question

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 wil 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. We will publisha solution guide after the due date. a. The risk weighted assets of BIG Bank are $ 90.5 no rounding!). Therefore its capital ratio is less (more/less) than 10% If 15 percent of Subprime Quick Money loan pool is written off, the value of BIG Bank AAA tranche holding will be S and its Ba1 tranche holding will be valued at $ still 10% of its RWA? b. Big Bank's Equity will change to $ Is this 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 S better/worse) than the investment in the tranches. 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 $ This would have been worse d. (no rounding). Check if Big Bank is now achieving its minimum CAR of 10% again. If Clever Bank keeps all its loans on its balance sheet, its RWA would be exactly $ with Quick Money its RWA would be $ management point of view. Did the actual riskiness of the assets change? e. m. However, if it does the deal m. This is an

Answer 1

Sol (b) Assumptions before answering the question is loss of 15% on $20mn is $3mn but it will from lowered rated bond only i.e. Ba1 thus Aaa tranche holding will be $15mn and $2mn for Ba1 tranche. Equity will be $7mn which will be =$7mn/$80mn (RWAs) which will be less than 10% it is only 8.75%.

Sol (c) Loss of Big Bank given the default of 15% loans in MBS is as given:- Total underlying loans in MBS $100 mn out of which $ 15 mn defaulted but in this default we are assuming the defaults taking place in lower rated bonds thus RWA for CAR will be $17.5 mn only for Ba1 rated bond of $ 5 mn, then loss totalling $ 10 mn for both Baa2 and Baa3 bonds. Thus, total loss is $27.5mn - $20.00 mn i.e. $7.5mn which is worse than investment in the tranche.

Sol (d) If all quick money loan will change to Aaa tranche then total loan in Aaa tranche will be $17mn and RWA revised on the total loan portfolio will be $70.0mn + $3.4mn (i.e. 20% of 17mn)= $73.4mn. The CAR is still less than 10% it is 9.54%.

Sol (e) Clever bank keeping all its loan on its balance sheet i.e. $70mn its RWAs will also be $70mn. The deal with quick money results in RWA of $90.5mn. This is a disadvantage from Capital Management point of view. Yes the riskiness of the assets changed due to highly risky investment of $5mn in Ba1 tranche.