Securitization - Week 8

Securitization Process

  • Transfers ownership of assets like loans to a legal entity.

  • This entity issues securities asset-based securities (ABS) that use asset cash flows to pay investors.

  • The pool of assets generating cash flows is known as collateral or securitised assets.

Securitized Assets

  • Assets typically used for asset-backed bonds include:

    • Residential mortgage loans.

    • Commercial mortgage loans.

    • Automobile loans.

    • Student loans.

    • Bank loans.

    • Credit card debt.

  • Mortgage-backed securities (MBS) are a specific type of asset-backed security (ABS).

Benefits of Securitization

  • Direct legal claims on loan portfolios tailored for investor’s risk.

  • Direct exposure to portfolios without needing a bank intermediary.

  • Creation of securities matching investors' risk, return, and maturity preferences.

  • Banks can separate origination from financing, increasing profitability and reducing capital requirements.

  • Expansion of lending origins beyond banks' balance sheets.

  • Creation of tradable securities with improved liquidity.

Historical Context

  • Banks historically funded loans via deposits.

  • 1960s saw mortgage demand outpacing deposits.

  • Emergence of the MBS market with key players:

    • Government National Mortgage Association (Ginnie Mae).

    • Federal National Mortgage Association (Fannie Mae).

    • Federal Home Loan Mortgage Corporation (Freddie Mac).

  • These entities purchased mortgages, packaging them as securities and guaranteeing payments for a fee.

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Example: Mediquip's Securitization

  • Mediquip manufactures medical equipment, financing sales through customer loans.

  • Loans have five-year maturities and fixed interest rates, representing assets.

  • The credit department manages credit decisions and servicing of loans.

Securitization Process Overview

  1. Sale of medical equipment financed by loans.

  2. Cash payment for loans.

  3. Customers pay Mediquip.

  4. Investors buy asset-backed securities (ABS).

  5. Mediquip receives payment for ABS.

  6. Periodic cash payments made to investors.

Parties Involved in Securitization

  • Originator: Original owner of the assets, sells to the issuer (SPE).

  • Special Purpose Entity (SPE): Buys collateral to issue ABS to investors.

  • Servicer: Manages the collateral, can be the originator or another party.

Asset-Backed Security Tranches

  • Breakdown of asset classes based on principal and returns, including:

    • Senior Tranche.

    • Mezzanine Tranche.

    • Equity Tranche.

Mortgage Loan

  • a mortgage loan is a loan secured by real estate.

  • Obligates borrower to make predetermined payments, allowing foreclosure if defaulted.

  • Loan-to-value ratio usually less than 100%.

Mortgage Design Variations

  • Global differences in:

    1. Maturity of loans.

    2. Interest rate determination.

    3. Repayment principal structure (amortization schedule).

    4. Prepayment options and penalties.

    5. Lender's rights in foreclosure.

Residential Mortgage-Backed Securities (RMBS)

  • RMBS sectors in the U.S.:

    • Securities guaranteed by federal agencies.

    • Securities guaranteed by government-sponsored enterprise (GSEs).

    • Private entity issued and non-guaranteed securities (non-agency RMBS).

Mortgage Pass-through Securities

  • Created when mortgage holders pool mortgages and sell shares/participation certificates.

  • Cash flows depend on the pool's mortgage cash flows.

Collateralized Mortgage Obligations (CMOs)

  • CMOs redirect interest and principal from pooled assets (e.g., pass-throughs) to different classes called tranches.

Tranche Structure of CMOs

  • Payments are made sequentially among tranches, with the focus on retiring lower classes first.

Commercial Mortgage-Backed Securities (CMBS)

  • CMBS backed by commercial mortgage loans from income-producing properties.

  • Loans are non-recourse, relying only on collateral property for debts.

Non-Mortgage Asset-Backed Securities

  • Collateral can be:

    • Amortizing loans (e.g., auto loans,commercial loans).

    • Non-amortizing loans (e.g., credit card receivables).

Auto Loan ABS

  • Cash flow consists of monthly payments and prepayments.

  • Usually includes credit enhancement, especially for senior tranches.

Credit Card Receivable ABS

  • Cash flows from finance charges, fees, and principal repayments.

  • Fixed or floating interest is periodically paid to holders.

Collateralized Debt Obligations (CDOs)

  • CDOs backed by a diversified pool of:

    • Corporate bonds.

    • Structured financial products like mortgage-backed securities.

    • Bank loans.

    • Credit default swaps.

CDO Management

  • CDOs managed by a collateral manager, responsible for portfolio asset management.

GFC Triggers

  • Since 2000, subprime mortgage origination relaxed, leading to increased real estate demand.

  • Further relaxation and packaging of mortgages into financial products.

Features of the Mortgage Market

  • Rise of 100% mortgages

  • ARMs

  • teaser rates

  • NINJAs

  • liar loans

  • non-recourse borrowing leading to GFC.

Understanding Default Risks

  • Default risk correlations increase under stress; recovery rates diminish.

  • Importance of differentiating ratings and loss distributions.

Regulatory Arbitrage

  • Banks securitized mortgages to lower capital requirements.

Agency Costs and Incentives

  • – Mortgage originators (Their prime interest was in originating
    mortgages that could be securitized.)

  • – Valuers (They were under pressure to provide high valuations so that
    the loan-to-value ratios looked good.)

  • – Traders (They were focused on the next end-of-year bonus and not
    worried about any longer-term problems in the market.)
    Incentives