Summary

The failure of regulators to recognize changes in credit risk on structured products contributed to and exacerbated the economic impact of the housing bubble meltdown, beginning in the third quarter of 2006. I began this chapter with some background on how securitization works in general and the role that the federal government has historically had in this process. Securitization originally pooled mortgages whose cash flows were used to back pass-through securities issued by the GSEs. Private label issuance led to the pooling of cash flows from credit card debt, student loans, car loans, and personal loans, as well as mortgages that were structured to provide credit enhancement. The concept of credit enhancement worked as long as credit defaults were truly independent and identically distributed. This turned out not to be the case. Rating agencies grossly underestimated risk on these securities, which by 2008 had grown in such proportion to the size of the economy that defaults effectively cascaded, destroying bank balance sheets and drying up the credit channel, which, in turn, choked off growth throwing the global economy into a recession not experienced since the Great Depression.

This chapter develops models that show how the securitization process works, how credit enhancement led to unanticipated risks and how the securities created in the form of collateralized obligations are priced. In the process, we developed the theory underlying interest rate derivatives and use it to derive our pricing models. Abundant examples can be generated from the chapter spreadsheet.