Securitization

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Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Security (finance) tradable financial asset

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.

Bond (finance) instrument of indebtedness

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

Collateralized debt obligation financial product

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.

Contents

The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss. [1]

Granularity, the condition of existing in grains or granules, refers to the extent to which a material or system is composed of distinguishable pieces or grains. It can either refer to the extent to which a larger entity is subdivided, or the extent to which groups of smaller indistinguishable entities have joined together to become larger distinguishable entities.

In mathematics and statistics, a stationary process is a stochastic process whose unconditional joint probability distribution does not change when shifted in time. Consequently, parameters such as mean and variance also do not change over time.

Tranche Part of an investment

The word tranche is French for 'slice', 'section', 'series', or 'portion', and is a cognate of the English 'trench' ('ditch'). In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation usually defines the tranches as different "classes" of notes, each identified by letter with different bond credit ratings.

Securitization has evolved from its beginnings in the late 18th century to an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. [2] WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to control the company. [3]

Asset-backed security Security with value derived from a commodity or asset

An asset-backed security (ABS) is a security whose income payments and hence value are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.

United Kingdom Country in Europe

The United Kingdom (UK), officially the United Kingdom of Great Britain and Northern Ireland, and sometimes referred to as Britain, is a sovereign country located off the north-western coast of the European mainland. The United Kingdom includes the island of Great Britain, the north-eastern part of the island of Ireland, and many smaller islands. Northern Ireland is the only part of the United Kingdom that shares a land border with another sovereign state, the Republic of Ireland. Apart from this land border, the United Kingdom is surrounded by the Atlantic Ocean, with the North Sea to the east, the English Channel to the south and the Celtic Sea to the south-west, giving it the 12th-longest coastline in the world. The Irish Sea lies between Great Britain and Ireland. With an area of 242,500 square kilometres (93,600 sq mi), the United Kingdom is the 78th-largest sovereign state in the world. It is also the 22nd-most populous country, with an estimated 66.0 million inhabitants in 2017.

Structure

Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances (but also includes businesses established specifically to generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

Loan transfer of money that must be repaid

In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient incurs a debt, and is usually liable to pay interest on that debt until it is repaid, and also to repay the principal amount borrowed.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks". A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.

A suitably large portfolio of assets is "pooled" and transferred to a " special purpose vehicle " or "SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote", meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities. Many issuers are typically "orphaned". In the case of certain assets, such as credit card debt, where the portfolio is made up of a constantly changing pool of receivables, a trust in favor of the SPV may be declared in place of traditional transfer by assignment (see the outline of the master trust structure below).

Bankruptcy legal status of a person or other entity that cannot repay the debts it owes to creditors

Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor.

Orphan structure or Orphan SPV or orphaning are terms used in structured finance closely associated with creating SPVs for securitisation transactions where the notional equity of the SPV is deliberately handed over to an unconnected 3rd party who themselves have no control over the SPV; thus the SPV becomes an "orphan" whose equity is controlled by no one.

Accounting standards govern when such a transfer is a true sale, a financing, a partial sale, or a part-sale and part-financing. [4] In a true sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator. [5] Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE".

Accounting measurement, processing and communication of financial information about economic entities

Accounting or accountancy is the measurement, processing, and communication of financial information about economic entities such as businesses and corporations. The modern field was established by the Italian mathematician Luca Pacioli in 1494. Accounting, which has been called the "language of business", measures the results of an organization's economic activities and conveys this information to a variety of users, including investors, creditors, management, and regulators. Practitioners of accounting are known as accountants. The terms "accounting" and "financial reporting" are often used as synonyms.

Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.

Issuance

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision.

In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors.

Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.

The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system. Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-amortizing assets in the floating market. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk. [6]

Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities created in a securitization are "credit enhanced", meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive the cash flows to which they are entitled, and thus enables the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).

The issued securities are often split into tranches , or categorized into varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure: there is generally a senior ("A") class of securities and one or more junior subordinated ("B", "C", etc.) classes that function as protective layers for the "A" class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have been repaid. Because of the cascading effect between classes, this arrangement is often referred to as a cash flow waterfall. [7] If the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities might be AAA or AA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk. [6]

The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid whenever the properties are sold. Since any early repayments are passed on to this class, it means the other investors have a more predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals one cannot categorise the revenue so easily between income and principal repayment. In this case all the revenue is used to pay the cash flows due on the bonds as those cash flows become due.

Credit enhancements affect credit risk by providing more or less protection for promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can make the securities more attractive.

In addition to subordination, credit may be enhanced through: [5]

Servicing

A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle.

The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default. [5]

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors.

Repayment structures

Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralised by fully amortizing assets, such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed to try to define common prepayment activity. The PSA prepayment model is a well-known example. [6] [8]

A controlled amortization structure can give investors a more predictable repayment schedule, even though the underlying assets may be nonamortising. After a predetermined "revolving period", during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early. [6]

On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed to be paid on the scheduled maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the scheduled maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee. [6]

Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth. [6] Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security. [6]

Structural risks and misincentives

Some originators (e.g. of mortgages) have prioritised loan volume over credit quality, disregarding the long-term risk of the assets they have created in their enthusiasm to profit from the fees associated with origination and securitization. Other originators, aware of the reputational harm and added expense if risky loans are subject to repurchase requests or improperly originated loans lead to litigation, have paid more attention to credit quality.[ citation needed ]

Special types of securitization

Master trust

A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards.

There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.

A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors and potential receivables.

A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur. [5]

Issuance trust

In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities. [5]

Grantor trust

Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis. [9]

Owner trust

In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.

Motives for securitization

Advantages to issuer

Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements. [5]

Reduces asset-liability mismatch : "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis." [10] Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.

Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets. [9]

Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.

Off balance sheet: Derivative (finance) of many types have in the past been referred to as "off-balance-sheet." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.

Earnings : Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.

Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.

Liquidity : Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.

Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.

Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.

Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.

Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.

Portfolio diversification : Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. [11] For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings. [6] Almost all mortgages, including reverse mortgages, and student loans, are now insured by the government, meaning that taxpayers are on the hook for any of these loans that go bad even if the asset is massively over-inflated. In other words, there are no limits or curbs on over-spending, or the liabilities to taxpayers.

However, the credit crisis of 2007–2008 has exposed a potential flaw in the securitization process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards.

Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer. [6]

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates. [6]

Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread. [12]

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction. [6]

History

Early developments

Modern practice of securitization has its roots in the 17th-century Dutch Republic. [13] [14]

Examples of securitization can be found at least as far back as the 18th century. [15] Among the early examples of mortgage-backed securities in the United States were the farm railroad mortgage bonds of the mid-19th century which contributed to the panic of 1857. [16]

In February 1970, the U.S. Department of Housing and Urban Development created the first modern residential mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans. [17]

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralised pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence. [18]

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1). [19]

The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows. [18]

Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.

The first public Securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods. [20]

As estimated by the Bond Market Association, in the United States, the total amount outstanding[ clarification needed ] at the end of 2004 was $1.8 trillion. This amount was about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the previous ten years (1995–2004) ABS[ clarification needed ] amount outstanding had grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities was strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion. [21]

At the end of 2004, the larger sectors of this market were credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments were student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases. [21]

Modern securitization took off in the late 1990s or early 2000s, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards), Insurance-backed transaction (such as those implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables).

As the result of the credit crunch precipitated by the subprime mortgage crisis the US market for bonds backed by securitised loans was very weak in 2008 except for bonds guaranteed by a federally backed agency. As a result, interest rates rose for loans that were previously securitised such as home mortgages, student loans, auto loans and commercial mortgages [22]

Recent lawsuits

Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. In July, 2009, the USA’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies. [23]

See also

Related Research Articles

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

Collateralized mortgage obligation

A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor needs.

Mortgage-backed security security

A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. The mortgages of a MBS may be residential or commercial, depending on whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by structures set up by investment banks. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations and collateralized debt obligations (CDOs).

Structured finance

Structured finance is a sector of finance, specifically Financial law that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.

Commercial mortgage-backed security

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.

Commercial mortgage

A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.

A real estate mortgage investment conduit (REMIC) is "an entity that holds a fixed pool of mortgages and issues multiple classes of interests in itself to investors" under U.S. Federal income tax law and is "treated like a partnership for Federal income tax purposes with its income passed through to its interest holders". REMICs are used for the pooling of mortgage loans and issuance of mortgage-backed securities and have been a key contributor to the success of the mortgage-backed securities market over the past several decades.

Credit enhancement

Credit enhancement is the improvement of the credit profile of a structured financial transaction or the methods used to improve the credit profiles of such products or transactions. It is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization.

A Super Jumbo Mortgage is classified in the United States as a residential mortgage or other home-equity secured loan in an amount greater than $650,000, although lenders differ on just what constitutes a super jumbo mortgage subject to their own internal investment criteria. Super Jumbo mortgages are made available to borrowers whose loan requirements exceed the guidelines commonly referred to as Jumbo loan limits, which apply to mortgage loan amounts in excess of the FNMA / FHLMC conforming loan limits of 417,000. Unlike Jumbo loan limits, the super jumbo mortgage category is not directly defined, controlled, or regulated by any of these aforementioned agencies. Instead, mortgage lenders internally and independently define their own parameters and criteria for what defines a Super Jumbo mortgage. The minimum loan amount for some lenders to classify a loan as Super Jumbo ranges from $500,000 to $1,500,000, with maximum super jumbo loan amounts generally running into the $10,000,000 to $20,000,000 range.

Residential mortgage-backed security

Bonds securitizing mortgages are usually treated as a separate class, termed residential mortgage-backed security (RMBS). In that sense, making reference to the general package of financial agreements that typically represents cash yields that are paid to investors and that are supported by cash payments received from homeowners who pay interest and principal according to terms agreed to with their lenders; it is a funding instrument created by the "originator" or "sponsor" of the mortgage loan; without cross-collateralizing individual loans and mortgages, it is a funding instrument that pools the cash flow received from individuals and pays these cash receipts out with waterfall priorities that enable investors to become comfortable with the certainty of receipt of cash at any point in time.

Collateralized loan obligation

Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.

Collateralized fund obligation

A collateralized fund obligation (CFO) is a form of securitization involving private equity fund or hedge fund assets, similar to collateralized debt obligations. CFOs are a structured form of financing for diversified private equity portfolios, layering several tranches of debt ahead of the equity holders.

A synthetic CDO is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments — as in the case of a regular or "cash" CDO — but from premiums paying for credit default swap "insurance" on the possibility that some defined set of "reference" securities — based on cash assets — will default. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

Credit rating agencies (CRAs)—firms which rate debt instruments/securities according to the debtor's ability to pay lenders back—played a significant role at various stages in the American subprime mortgage crisis of 2007–2008 that led to the great recession of 2008–2009. The new, complex securities of "structured finance" used to finance subprime mortgages could not have been sold without ratings by the "Big Three" rating agencies—Moody's Investors Service, Standard & Poor's, and Fitch Ratings. A large section of the debt securities market—many money markets and pension funds—were restricted in their bylaws to holding only the safest securities—i.e. securities the rating agencies designated "triple-A". The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007. Hundreds of billions of dollars' worth of these triple-A securities were downgraded to "junk" status by 2010, and the writedowns and losses came to over half a trillion dollars. This led "to the collapse or disappearance" in 2008–09 of three major investment banks, and the federal governments buying of $700 billion of bad debt from distressed financial institutions.

A renewable energy derivative is based on a new method of securitization, which is a structured finance process that pools and repackages cash-flow-producing financial assets into securities which are then sold to investors. The term "securitization" is derived from the fact that securities are used to obtain funds from investors.

References

  1. Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford U Press, 2003, p. 103. ISBN   978-0-19-515273-9
  2. "ESF Securitization Data Report Q2:business
  3. Claire A. Hill, Whole Business Securitization in Emerging Markets, Duke Journal of Comparative and International Law 12:2 (2002).
  4. Financial Accounting Standards Board (FASB) Statement No. 140 "Accounting for transfers and servicing of financial assets and extinguishments of liabilities—a replacement of FASB Statement No. 125" September 2000
  5. 1 2 3 4 5 6 T Sabarwal "Common Structures of Asset Backed Securities and Their Risks, December 29, 2005
  6. 1 2 3 4 5 6 7 8 9 10 11 Fixed Income Sectors: Asset-Backed Securities – A primer on asset-backed securities, Dwight Asset Management Company (2005).
  7. Kim, M. ; Hessami, A. ; Sombolestani, E. (2010, March 24) CVEN 640 - Cash Flow Waterfall [Video file]. URL: https://www.youtube.com/watch?v=Dw_z56HmLYs
  8. The Committee on the Global Financial System defined Structured Finance, "The role of ratings in structured finance: issues and implications", January 2005
  9. 1 2 Reis-Roy, Calvin (1998). "Rating Securitisation Structures". Journal of International Banking Law. 13 (9): 298–304.
  10. "The Handbook of Asset-Backed Securities", Jess Lederman, 1990.
  11. Reis-Roy, Calvin (2003). An Analysis of the Law and Practice of Securitisation.
  12. Tavakoli, Janet. "CDOs: Caveat Emptor" GARP Risk Review (Journal of the Global Association of Risk Professionals), September/October 2005 Issue 26.
  13. Goetzmann, William N.; Rouwenhorst, K. Geert (2008). The History of Financial Innovation, in Carbon Finance, Environmental Market Solutions to Climate Change. (Yale School of Forestry and Environmental Studies, chapter 1, pp. 18–43). As Goetzmann & Rouwenhorst (2008) noted, "The 17th and 18th centuries in the Netherlands were a remarkable time for finance. Many of the financial products or instruments that we see today emerged during a relatively short period. In particular, merchants and bankers developed what we would today call securitization. Mutual funds and various other forms of structured finance that still exist today emerged in the 17th and 18th centuries in Holland."
  14. Markham, Jerry W.: A Financial History of the United States from Enron-Era Scandals to the Great Recession (2004–2009). (Routledge, 1st edition, 2011, ISBN   0765624311), p. 355. "An early example of securitization was found in Amsterdam in the seventeenth century."
  15. "Dutch Securities for American Land Speculation in the Late-Eighteenth Century", Rik Frehen, K. Geert Rouwenhorst, and William N. Goetzmann, 2012.
  16. "Déjà Vu All Over Again: Agency, Uncertainty, Leverage and the Panic of 1857", Timothy J. Riddiough and Howard E. Thompson, 2012.
  17. "Asset-Backed securities in Germany: the sale and Securitization of loans by German credit institutions", Deutsche Bundesbank Monthly Report July, 1997.
  18. 1 2 "Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of National Banks, 1997.
  19. "Hearing before the U.S. House subcommittee on Policy Research and Insurance in "Asset Securitization and Secondary Markets" (July 31, 1991), page 13
  20. Wachovia Press Releases Archived 2009-02-11 at the Wayback Machine
  21. 1 2 "Common Structures of Asset-Backed Securities and Their Risks", Tarun Sabarwal, December 29, 2005
  22. "Mechanism for Credit Is Still Stuck" article by Vikas Bajaj in The New York Times August 12, 2008
  23. Leslie Wayne (July 15, 2009). "Caper Sues over Ratings of Securities". New York Times .