fin 435 claude cards midterm

Write a concise history of the 2008 financial crisis tying together: housing affordability,

financial engineering, skin in the game, AAA collateral, and securitization/sequential pay.

1. Affordability: Home prices outran incomes, so conventional loans priced buyers out.

2. Financial engineering: Teaser/hybrid ARMs, IO, pay-option, high-LTV and no-doc loans made the initial

payment affordable. They only worked if prices kept rising.

3. Skin in the game: Under originate-to-distribute, originators earned fees and sold loans right away. With

no credit risk kept, they chased volume over quality.

4. Securitization/sequential pay: Pools were tranched so senior tranches were paid first and took losses

last, which got them rated AAA even with subprime collateral.

5. AAA collateral: Huge global demand for "safe" AAA paper pulled in ever more loans, a feedback loop

that loosened standards.

6. Collapse: Prices stalled and ARMs reset, so borrowers couldn't refinance. Defaults ate into the "AAA"

tranches. Banks levered 30–40× fire-sold assets, credit froze, and the GSEs went into conservatorship

(2008).

Why do lenders consider both a top-line and a bottom-line debt-to-income ratio on

residential mortgages?

Top-line (PITI ÷ gross income): is this housing payment affordable?

Bottom-line (all debt payments ÷ income): is the borrower overextended overall?

A borrower can pass the top line while car, student-loan and card payments compete for the same

income, which makes mortgage default likely.

Why has DSCR fallen out of favor in commercial underwriting? Address cash flow risk

and exit risk.

DSCR = NOI ÷ debt service, which depends on the rate and amortization. Low rates, IO periods or long

amortization inflate it.

In a low-rate world you can hit a DSCR target on a huge loan. Cash flow risk looks low.

Exit risk: can the balloon be repaid or refinanced at maturity (especially if rates rise)? DSCR is silent on

this, and commercial loans usually balloon.

Lenders now prefer debt yield (NOI ÷ loan). It can't be manipulated with loan terms and equals the

lender's cash-on-cash return if it forecloses.

List two reasons why deficiency judgments are so rarely pursued.

The borrower is often judgment-proof, with no meaningful assets beyond the property.

Costly and slow litigation relative to the likely recovery.

The loan is non-recourse (almost all owner-occupied residential), or state anti-deficiency rules apply

(e.g., after a nonjudicial sale).

Appointing a receiver can cut off the right.

Explain loan bifurcation, how it creates value for lenders, and how it improves outcomes

for borrowers.

A note: sized to current NOI at market terms, so it performs.

B note: the remainder. It accrues with little or no current pay and is repaid from a future sale or

refinance.

Lender value: a non-performing loan becomes a performing A note that can be held or sold. The lender

avoids foreclosure/REO costs and value loss, keeps upside through the B note, and keeps an

experienced owner running the property.

Borrower: gets an affordable payment, avoids foreclosure and credit damage, and keeps ownership

and upside, so they keep investing instead of walking away.

What's evidence a borrower is defaulting strategically, not from crisis conditions? Give at

least 2 examples (WaW case or general).

NOI still covers debt service (DSCR > 1), but payments stopped.

The borrower is current on other loans and properties, or has real liquidity or net worth.

The default is timed for when the property is underwater on a non-recourse loan, a rational "put."

Rents are collected but not used for debt service, escrows or upkeep.

The borrower or an affiliate offers a discounted payoff or tries to buy the note cheaply.

A $100K property backs a defaulted $80K senior loan and a $30K junior loan. Is the

junior lienholder out of luck on full repayment?

At a $100K sale, the senior gets $80K and the junior gets $20K, so it's $10K short.

Pursue the borrower for the shortfall if the loan has recourse.

Cure or buy out the senior loan, then control timing and wait for value to recover.

Holdout leverage in a workout, since the senior needs its cooperation.

Value may rise before resolution.

What was the basic business model of banking in the "olden days," and how has it

changed?

Old: take short-term deposits, make long fixed-rate loans, hold them on the balance sheet, earn the

spread. The bank bore credit and interest rate risk.

Pressure: money market funds and other liquid savings vehicles competed for deposits. Early-1980s

rate volatility (the S&L crisis) showed the danger of funding fixed loans with floating deposits.

New: fee-based originate-to-distribute, especially in residential. Earn origination and servicing fees,

sell to the GSEs and securitizers, and prefer floating-rate assets on the books.

Why do banks keep most commercial loans on their balance sheet but sell off residential?

Give 2+ reasons.

Commercial loans are heterogeneous. There's no standardized buyer like Fannie/Freddie.

Often floating-rate or shorter-term, which matches the bank's short, floating liabilities.

Relationship lending: local information, control, and cross-selling deposits and other services.

Covenants and prepayment protection make them attractive to hold.

Residential loans are standardized 30-year fixed (big rate risk) with a liquid GSE market to sell into.

Explain why, when interest rate risk to the lender declines, default risk increases.

With an ARM or floating rate, the lender passes rate risk to the borrower.

When rates rise, the borrower's payment rises.

Higher payments strain the ability to pay, so default becomes more likely.

How does time-to-repayment affect the interest rate risk lenders face?

How does time-to-repayment affect the interest rate risk lenders face?

Between a 5/1 and a 10/1 hybrid ARM, which has the higher average interest rate and

why?

The lender bears rate risk for 10 years instead of 5, so it needs more compensation.

With a normal upward-sloping yield curve, 10-year rates are above 5-year rates.

The borrower pays for the longer stretch of payment certainty.

Why would interest rate risk rise with interest rate caps but not with payment caps?

Rate cap: if market rates exceed the cap, the lender earns below market, so rate risk shifts back to the

lender.

Payment cap: the rate still floats fully. Unpaid interest is added to the balance (negative amortization),

so the lender still earns the market rate.

Rate risk stays with the borrower, though default and exit risk rise as the balance grows.

Why are pension funds involved in real estate capital markets? What loans do they like

and why?

Retirement payouts are long-term and predictable, so they want long-duration, steady-income assets.

Real estate debt offers a yield premium over bonds, plus diversification.

They prefer long-term, fixed-rate commercial loans (and senior CMBS) with strong prepayment

protection (lockouts, yield maintenance, defeasance), which keeps cash flows predictable.

Life insurers follow the same logic.

Why was there an enormous shift in the share of mortgage debt from private loan pools to

government agencies around 2009?

In the chart, pools fall from ~53% to ~22% and agencies jump from ~6% to ~37% around 2010Q1.

After the 2008 conservatorship, FAS 166/167 (effective 2010) made Fannie and Freddie consolidate

their MBS trusts on-balance-sheet. Agency pools were reclassified as "agencies."

Private-label securitization collapsed after the crisis, so the government became essentially the only

buyer.

How is prepayment risk typically dealt with in residential vs. commercial lending? Why

do they differ?

Residential: penalties are rare. Lenders build the risk into the rate and points, or sell the loan so MBS

investors bear it, and CMO tranching redistributes it.

Commercial: explicit deterrents such as lockouts, yield maintenance, defeasance and step-down

penalties.

Why they differ: residential borrowers are consumers who move for life reasons and are protected by

regulation. Commercial borrowers are sophisticated and prepay for financial reasons (refinancing when

rates fall). Commercial loans also sit on bank books or in CMBS, whose investors demand call

protection.

Why don't prepayable mortgages rise in value as much as the valuation math says when

rates fall?

When rates fall below the contract rate, borrowers refinance, so the expected time to repayment

shrinks toward zero.

No investor pays more than par for a loan that's about to repay at par.

So the value bends back toward par instead of rising.

negative convexity

A penalty of 5% of OLB in year 1, 4% in year 2, 3% in year 3, and so on. Why might a

lender be unhappy with this structure? Think about why commercial prepayment happens and

how it hurts lenders.

Why prepay: mainly because rates fell (refinance cheaper) or the property's value rose (sell or cash

out).

Lender's harm: reinvestment. It gets principal back when it can only relend at lower rates, losing the

rate gap over the remaining term.

A flat % may be far smaller than the PV of that lost interest, so the borrower prepays anyway and the

lender is under-compensated.

It shrinks with time regardless of rates, so there's little protection late in the loan. And it's pointless

when rates rise, since no one prepays then.

Better: yield maintenance or defeasance, which tie the penalty to the actual rate decline.

The penalty doesn't scale with the lender's actual loss, which is the rate drop.

Why do banks show more forbearance to delinquent commercial borrowers than

residential ones? Give 2 answers.

Commercial loans sit on the bank's own balance sheet. The loss is the bank's, the loans are big, and recognizing it hits capital. (Residential loans are mostly sold, and servicers follow rules.)

Commercial property needs active management. The borrower has the expertise, and foreclosure risks tenant flight and value collapse.

Relationship lending: other business is at stake.

Distress is often temporary (lease-up, a market dip).

The bank owns the loss, and the borrower is the better operator.

List THREE distinct reasons why foreclosure is seen as a resolution option of last resort.

1. Cost and time: legal fees and months-to-years timelines with no payments coming in.

2. Value destruction: deferred maintenance, tenant flight and the REO stigma lead to a fire-sale price in a

weak market.

3. Ownership burden: a non-earning REO asset to manage, insure, pay taxes on and hold capital against,

with possible environmental or lender liability.

Expensive, destroys value, and the bank ends up owning a building.

What is the job of a receiver? Why does having one typically cut off access to a

deficiency judgment?

Job: takes control during default and foreclosure. Collects rents, pays expenses, maintains and leases, preserves value, and stops rent diversion.

Deficiency cut off: the borrower no longer controls the property's value or income, so holding them liable for a shortfall that arose under someone else's control is treated as unfair.

Under statutes like Washington's, choosing a receivership or the nonjudicial route trades away the deficiency claim. The lender gets speed and control instead of recourse. Check this against your notes.

A court-appointed neutral party runs the property. Once the borrower loses control, they can't be blamed for the shortfall.

List two circumstances where foreclosure might be the best course of action for a lender.

The borrower is fraudulent, uncooperative or diverting rents.

The property is worth more than the loan, so the lender recovers in full.

The borrower has no ability or will to pay and the asset is deteriorating fast, so the lender needs control now.

The lender has a ready buyer or a clear repositioning plan.

No workout is possible, or foreclosure makes the lender whole.

What is a pay-option ARM, and why was it doomed to fail before the 2007–08 crisis? Be

specific about structure and underwriting.

Structure: each month the borrower picks a fully amortizing, interest-only or minimum payment. Unpaid interest is added to the balance.

When the balance hits a cap (~110–125% of the original) or after ~5 years, it recasts to fully amortizing, and the payment can double.

Underwriting: borrowers qualified on the teaser or minimum payment, often with no-doc and high LTV.

Adverse selection: the most constrained borrowers chose the minimum, so LTV kept rising.

It only worked if prices kept rising. When prices fell, borrowers were underwater just as payment shock hit.

A minimum payment below the interest due → negative amortization → recast → payment shock.

Why do ARMs typically have lower rates over the life of the loan than fixed-rate

mortgages? Link interest rate risk, default risk, and the yield curve.

Interest rate risk shifts to the borrower, so the lender doesn't need a premium for bearing it.

Yield curve: ARMs are priced off short rates, which are normally below the long rates fixed loans are priced off.

Default risk rises because payments can increase. Lenders add some margin for that.

On net, the first two effects dominate, so ARM rates are lower.

Shedding rate risk plus pricing off short rates outweighs the added default risk.

Outline a bank's broad thought process in evaluating a commercial loan at three levels:

asset, borrower, and the bank's portfolio.

Asset: quality and stability of NOI (tenant credit, lease rollover, vacancy, market rents). Size the loan with DSCR, LTV and debt yield. Check condition, location and market trends, and above all the exit: can he balloon be refinanced or the property sold?

Borrower: experience with this property type, net worth and liquidity (to cover shortfalls and give recourse real teeth), credit history, other obligations, and any signs they'd strategically walk.

Portfolio: concentration (property type, geography, single borrower), regulatory capital and CRE limits,

how the loan's rate and term match the bank's short, floating liabilities, and relationship value. Pricing must compensate for the risk added.

Besides lower LTVs or higher DSCR/lower DTI, name two ways banks can mitigate

default risk.

Recourse or personal guarantees: the borrower has more to lose.

Reserves and escrows for taxes, insurance, repairs and TI/LC.

Covenants: DSCR-triggered cash sweeps or lockboxes, and reporting requirements.

Mortgage insurance (PMI/FHA) on residential loans.

Cross-collateralization, or stricter credit and sponsor standards.

All else equal, which has the higher interest rate: a loan with a recourse clause or one

without? Explain.

The lender can recover only from the collateral, so the loss given default is bigger.

The borrower holds a free put: hand back the property when it's worth less than the loan, so strategic default is more likely.

The lender charges a higher rate for both.

Why would short-hold borrowers prefer fewer points plus a higher rate over more points

plus a lower rate (same IRR to the bank)?

If you repay early, the points' cost is spread over few months, which pushes the all-in cost (IRR) up sharply.

A higher rate costs extra only for the months you actually hold the loan.

So for short holds, fewer points means a lower all-in cost and less cash at closing.

List two typical commercial loan covenants and explain why covenants are so important.

Examples: maintain a minimum DSCR (a cash sweep or default if breached); reporting requirements (quarterly financials, rent rolls, notice of major lease signings or departures). Others: limits on additional debt or transfer, reserve requirements, MAC clauses.

Why: commercial loans are large and long-lived, and conditions change after closing. Covenants give early warning, triggers to act before default, protection for collateral value, and limits on moral hazard (adding debt, stripping cash). This matters because banks hold these loans on their own books.

Why are pay-option ARMs a particularly risky loan structure?

Negative amortization pushes LTV up over time, which raises exit risk.

Recast causes payment shock, which raises cash flow risk.

Adverse selection: constrained borrowers choose the minimum payment.

Borrowers qualified on the teaser payment, and the loan depended on rising prices to refinance.

Explain why cash flow risk is generally less of a concern to banks than exit risk.

A cash-flow gap can be covered from reserves or other borrower funds, or handled by forbearance or restructuring. The property still has value.

At maturity the entire balance comes due. If value or refinance proceeds fall short, the loss is large and permanent.

Commercial loans usually balloon, so exit risk dominates.

Why were the California strawberry pickers poor candidates for loans of almost any size,

despite high FICO scores?

FICO can be misleadingly high for someone who has credit lines but barely uses them.

Their income was low, seasonal and hard to document, with no stable 2-year employment history.

Any meaningful loan fails DTI, so default risk was huge despite the scores.

Why do falling interest rates produce larger loans under a fixed DSCR target? (Explain,

don't just show math.)

Max annual debt service = NOI ÷ DSCR, whatever the rate.

At a lower rate, less of each payment goes to interest and more retires principal.

So the same payment supports a larger PV (a bigger loan).

That's why low-rate eras produce huge DSCR-based loans, and why exit risk rises when rates later go up at refinance.

DSCR caps the payment, not the loan. A cheaper rate lets the same payment carry more principal.

Why is mortgage servicing theoretically more profitable when interest rates are high?

Servicers earn a fee as a % of the outstanding balance (e.g., ~25 bp a year).

High rates mean few refinances, so loans live longer and the fee stream lasts longer.

Float: payments and escrows held before remittance earn more interest.

Low rates trigger refinance waves that cut servicing streams short.

Why was selling Burton's delinquent note for a quick profit/exit potentially undesirable

for Drive (WaW case)?

Selling fast in a distressed market means a steep discount to the few buyers willing to take the risk, so recovery is locked in low.

Drive's edge is workout expertise. It had just started partnering with equity investors to buy notes outright. A flip forgoes the value a workout could capture if the property's income supports a restructured loan.

Repeat FDIC pool business depends on showing it can actually resolve distress.

Define two of: Float · Secured debt · REO · Loan covenant.

Float: money a servicer holds between collecting borrower payments (P&I, escrows) and remitting them to investors and payees. The servicer earns interest on it meanwhile.

Secured debt: debt backed by a pledge of specific collateral (here, the property) that the lender can seize and sell on default.

REO (real estate owned): property a lender has taken title to through foreclosure or deed-in-lieu and holds on its books.

Loan covenant: a contractual promise to do something (report financials, keep a minimum DSCR, fund reserves) or not do something (add debt, transfer the property). A breach can trigger default.