Betting on Failure: Profiting from Defaults on Subprime Mortgages


Consider Exhibit 5 (Cash Flows on the CDS).
Principal Repayments (on the mortgages) and Principal Writedowns on the Bonds will both reduce the Outstanding Face Amount of the Bonds.
The Notional Principal on the CDS is 1000 initially. It declines proportionately to the amount of Outstanding Face Amount of the Bonds.
The Fixed Swap Payment is essentially the “insurance premium” and is tied to the Notional Principal on the CDS.
The Floating Swap Payment is what the buyer of the CDS receives as compensation for losses and is tied to the Principal Writedowns on the Bonds.

Replicate the Table in Exhibit 5 under the following set of assumptions:
Principal received is $10/month (rather than $5/month). Principal Writedowns remain the same as in the base case.
Principal received remains at $5/month, but writedowns associated with earlier defaults rise to $10/month in Month 8 and $20/month in Months 9 through 12.

Calculate the (annualized) IRR for the base case and (2a) and (2b).

In this case, Keating picked an MBS that he expected would contain a high rate of mortgage defaults. Based on the data in the case, does his choice seem reasonable?

Given the information in the case, what investment strategies are available to an investment manager to make money when homeowners with mortgages in this particular deal default? What of these strategies seems most appealing? {Note: it is ok to say that the whole mess is pretty disgusting}