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Prospects for Asset-Backed Securitization

National University of SingaporeJuly 23 – 30, 2001

Notes from lecture given by Jay Sa-Aadu at National University of Singapore – July 2001

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Objectives of this session• When we finish this session you will understand the

following:– Concept of Asset Backed Securitization– Primary Impetus/Incentives for Securitization– Potential for Securitization in Singapore– Strategic and Financial Considerations for Securitization– Types of Securitization Structures– Innovations in Asset Securitization– Economics of Asset Securitization

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Introductory Remarks• Asset Backed Securitization (ABS) has emerged as an active

liquid, fixed-income market in a relatively short period• This is because ABS represents a technological advance and

not a complex regulatory arbitrage• Indeed, ABS draws its lifeblood not from exploitation of

regulatory loopholes but from the way it handles risks• It makes risks of lending more transparent and it allocates

them far more precisely to the players best able to handle them

• Far from threatening the well-being of well-managed banks and thrifts, this new technology could enable them to prosper

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What is Asset Securitization?• Asset-backed securitization (ABS) involves

– combining loans of similar characteristics,– creating credit-enhanced claims against the cash flow of

this portfolio, – selling these claims in the form of securities to capital

market investors.• Cash flows from underlying assets support (or secure)

payments to investors• Can be structured as sale of asset or simply as off

balance sheet funding

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Asset Backed Securitization: Factoid

• Securitization started in the U.S. in 1970 • $4.02 trillion residential mortgages outstanding in US• About 57% (or $2.29 trillion) have been securitized • Roughly 80% of securitized mortgages have agency labels

– guaranteed by GNMA or issued by FNMA or FHMC

• Appeared in UK in 1985 with no government guarantee• Wide range of other assets have been securitized since

1984– credit cards, auto loans, trade receivables, equipment leases, student

loans, junk bonds, telephone receivables

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Exhibit 1.1 Traditional Lending System: Bundles operations and risks

Originate& underwrite Guarantee Book Fund Service

Why Does Traditional Lending Foster Bundling of Operation? -- funding advantage !!!!! (1) Interest rate ceiling (2) Underpricing of deposit insurance (3) Entry restrictions (4) Tax rulesChief advantage of traditional credit system: personal relationship between borrower and the lender develop

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Why Traditional Bank Lending System is Costly • Financial institutions tend to concentrate credit risks on their

portfolio – geographically, by industry, demographically• Financial institutions face other noncredit risks in the normal

course of business, which are extremely difficult to eliminate– Interest rate risk– Prepayment risk/Reinvestment Risk– Liquidity and Marketability Risk

• Discretionary lending activities– Lenders can use funds obtained from depositors and other creditors to fund

existing loans as well as future loans

• Since depositors, note holders and other senior creditors absorb these risks, capital markets require excess layer of equity protection from financial institutions

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Primary Impetus for Securitization• Erosion of Funding Benefits

– Removal of interest rate ceiling– Increase in price of deposit insurance– Capital requirements and other regulatory taxes

• Asset-Liability mismatch• Liquidity needs• Advances in information technology

– Reduce information gaps between originators and investors– Investors are able to assess payoff attributes of loans– Information technology is key to originating, servicing and

monitoring provided by financial institutions

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Securitization Unbundles Traditional Lending Operations and Risks

• At the heart of new technology is the structuring process

• Structuring involves the explicit underwriting and absorption of credit risk, through credit enhancement, and the use of special purpose vehicle

• Structuring converts the loans into securities and transforms the quality of their risk and return to the end investors

• In purchasing an asset backed security such as agency MBS, the investor assumes no credit risk but does assume prepayment risk

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Originate Structure CreditEnhance Place Trade Service

Exhibit 1.2 Asset Securitization Unbundles Operations and Risks of Traditional Banking System

•Thrifts•Commercial banks•Finance companies•Mortgage banks

•Investment banks•Retail securities firms

•Insurance company•Government entity•Banks•Internal guarantee

•Pension funds•Thrifts•Insurance companies•Banks•Individuals

•Investment banks•Commercial banks

•Investment banks•Commercial banks•Mortgage banks

Asset securitization unbundles the various operations in connection with traditionallending. So under the new technology several different institutions might be involvedeach playing a different functional role

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Figure 1.3: How Securitization Unbundles and Diversifies Risk

Other CreditEnhancers

RatingAgency

Originator Credit Enhancer Investor

•Takes Catastrophe credit risk

•Takes first-lossrisk

•Syndicate

•Takes market riskbut little credit risk

•Takes prepaymentrisk

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ABS Manages Risks Better• ABS isolates the loans to be securitized from the originators

balance sheet– The risks of ABS is separate from general risk of the originator

• Pooling and sale of assets create transparency and reduce uncertainty for capital market investors– Investors are funding clearly delineated existing pool of loans– Not funding future discretionary lending or risk-taking the original

lender may undertake• ABS typically splits credit risk into several levels and places it

with institutions in the best position to absorb it (see exhibit 1-3)

• ABS also segment interest rate risk and prepayment risk so they can be tailored and placed among appropriate investors

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Benefits of Securitization • Securitization isolates credit of assets backing an issue

from credit of the originator -- risk transparency • Means of channeling different sources of capital into

consumer lending -- institutional and geographic• Provides link between primary market for consumer

credit and capital markets -- market integration• Provides a means of transforming illiquid assets into

liquid tradable securities -- lower cost of capital• Means to participate in traditional lending without

having to originate or service -- economies of scope

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Incentives to Securitize Assets • Capital Requirement

– Banks are required to maintain adequate capital to cover risks assumed in making loans

• Reserve Requirements– Central Banks or Monetary Authorities also imposed

noninterest-bearing reserve requirement on the liabilities of banks

• Deposit Insurance– Banks must annual deposit premium if such a program

exists

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Effects of Securitization on Balance Sheet of Financial Institution seeking to Securitize Mortgages

• Suppose a bank has just originated 1,000 new residential mortgages in its local market. Each mortgage is worth $100,000.

• The total size of mortgage pool = 1,000x$100,000 = $100 million.• Suppose the bank relies mostly on liabilities eg. demand deposit

and its own capital to finance these mortgages.• Assume risk-based capital requirement is 12%.• Assume each $1 of mortgage must be backed by some capital, and

the risk-adjusted value of residential mortgages is 50% of face value.

• Also assume reserve requirement is 10% and there is deposit insurance of 27 basis points.

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Incentive to Securitize Mortgages• Bank faces three levels of regulatory costs:

– Capital requirement ( 12%)– Reserve requirement (10%)– Deposit insurance (27 bsp)

• Two risk exposures:– Gap exposure

• bank funds 30-year mortgages with short term liabilities and demand deposits

– Illiquidity exposure• Risk of conducting mortgage asset sale at short notice to meet

unexpected demand deposit withdrawal

• Issue: How to mitigate these problems

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Decision Analysis• Bank capital (equity) needed to back $100 million of mortgage

portfolio would be: – $100 M x.5x.12 = $6 million

• The difference between $100M and $6M is $94, but liabilities to be issued by the bank must be– $94/(1-.10) = $104.44M

• Reserve requirement (noninterest-bearing)– ($104.4)x(.1) = $10.44– Bank really has only $94M of the $104.4 to fund the mortgages

• With deposit insurance premium of 27 basis points, the insurance premium is– $104.4Mx.0027 = $281,880

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Exhibit 1-6: Bank’s Balance Sheet Before Securitization

Assets Liabilities

Cash Reserves $10.44Mortgage Loans 100.00 $110.44

Demand deposits $104.44Capital 6.00 $110.44

Assets LiabilitiesCash reserves $10.44Cash proceed from assetsecuritisation 100.00 $110.44

Demand deposits $104.44Capital 6.00 ______ $110.44

Exhibit 1-7: Banks’ Balance Sheet After Securitization

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Bank’s Situation after Securitization

• Illiquid mortgages replaced by liquid cash• Asset liability mismatch is reduced• Bank has enhanced ability to deal with regulatory costs or

taxes• Capital requirement is reduced since risk-adjusted asset value

of cash is zero• Reserve requirement and deposit insurance are reduced if part

of cash are used to retire demand deposits• Note: The real logic of asset securitization is that cash

proceeds from the mortgage sale can be reused to create more mortgages and book the fees

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Necessary Conditions for Asset Securitization

• Predictable risk characteristics• history of payoffs, delinquencies, and write off that can

be used to guide future prepayment and default behavior

• Diversifiable risk characteristics• sizable number of loans allows for diversification of risk

necessary for securing credit enhancement

• Predictable duration• investors (pension funds, insurance companies etc) want

to have good idea about prepayment behavior

• Homogeneity and standardization and relative ease of valuation of assets

• 30-year mortgages were first to be secuiritized in US

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Do Financial Institutions have the Size and Ability to Generate and Support ABS?

Financial institutions must attain certain economies of scale in origination, packaging, and servicing for securitization to make economic sense

• In US markets economics of ABS are such that issues must be in the range of $200 to $300 million

• The financial institution must be large enough with proper system and procedures to support and service assets

• Sophisticated system for tracking the cash flows (principal, interests, prepayment) from collateral.

• Securitization is computer, legal, and accounting intensive.

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Types of Asset Securitization Contracts

• There are three basic structures of asset-backed securities– Pass-Through Security

• Pass-throughs guaranteed by GNMA, Ginnie Mae• Pass-through guaranteed by FHLMC, or Participation Certificates

(PC)• Pass-Throughs guaranteed by FNMA, or Mortgage-Backed Securities

(MBS)– Pay-Through Security

• Collateralized Mortgage Obligations (CMOs)– Asset Backed Bonds (ABB)

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The Pass-through Security• The creation of Pass-through security starts with the

pooling of assets (mortgages) with similar characteristic by originator.

• The pool of mortgage assets are sold to a grantor trust who issues certificates.

• The certificates (equity interests) are in turn sold to investors which entitles them to receive pro rata cash flows from pool of mortgages.

• Assets are removed from originators balance sheet• The Pass-throughs provide only one prepayment risk

profile

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Originator/Seller Special Purpose Vehicle

Credit Enhancer

TrusteeIssues Certificates

Investment Banker

Investors

Sellsloans

Purchases Credit Enhancement

Transferrights underloan contracts

Rating Agency

Distributes certificates

Ratesissue

Proceeds( $) go to seller

Asset Securitization Issue Structured as a Pass-through

Creditenhancement

Cover Loss $

Exhibit 1-8

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Asset-Backed Bond Structure• The second type of ABS is asset-backed bonds (See Exhibit 1.9)• Like the PTS, the ABB is collateralized by a portfolio of loans or receivables• The originator in ABB segregates a group of assets and transfers the assets to a

wholly owned subsidiary, e.g captive finance company• The subsidiary issues notes secured solely by its assets and any credit

enhancement obtained for the purpose and sells them to investors• However, unlike PTS, there is no direct link between the cash flow on the

underlying loans backing the bonds and the interest and principal payments on the bonds -- the bonds are in effect general obligation of the issuer

• However, if the issuer were to fail the bond holders have first claim to a segment of the financial institutions assets --- ie the ABB is in effect a senior debt

• Unlike PTS the assets remain on the originator’s (consolidated) balance sheet.

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Originator/Servicer

RatingAgency

Trustee

Investment Banker

Investors

Exhibit 1.9: Asset Backed-Bond Structure

Finance Company(subsidiary of originator)

Transfers loans

Issues notes

Proceeds from saleof notes

Distributesnotes

Pays insurancefees for creditenhancement

Provides creditenhancement

Disburses cash flow toinvestors

Principal & interest

Note: (1) typically the pool will beovercollateralized to minimize the impact of prepayment.

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Asset Backed Bond Has Lower Funding Costs

• First, the issuer is required to overcollateralize, that is set aside more assets or loans than there are bonds.

• Second, the assets are typically marked-to- market to ensure maximum coverage

• Third, the trustee periodically monitors the segregation of assets to ensure that the market value of the collateral does not fall below that of the bonds.

• Fourth, ABB bondholders have first claim to a segment of the issuer’s assets in case of insolvency or failure of the issuer.

• The combination of these factors results in higher rating for the ABB than the rating of the financial institution issuing them.

• This results in lower cost of funding especially for an originator with lower credit rating, and a better matching of assets and liabilities

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Problem with Pass-through Securities

• Investors in pass-through security grantor trust cannot be sure what the Weighted Average Life (WAL) of their certificates will be – single prepayment risk profile

• Contraction risk– lower interest rates increase prepayment rate

• Extension risk– higher interest rate decrease prepayment risk

Is there a way to manage prepayment risk?

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Pay-through structure: Collateralized Mortgage Obligations (CMOs)

• Designed to take advantage of yield curve by assigning cash flows to classes of bonds (tranches) designed to better meet investor needs.

• Pay-through structure permit the restructuring of cash flows to offer bonds of varying maturities to investors.

• Sequential distribution of cash flows so that each bond varies in the amount of prepayment risk it absorbs

• Quarterly or semi-annual payment rather monthly• Can qualify as sale of asset with trust (REMIC) or as

debt obligation

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Exhibit 1-10: Pay-Through Security Structure

}Sales ProceedsSales Proceeds

$

Servicing fee

$

Sells MortgagesOr Pass-through

Limited PurposeCorporation B

InvestmentBank D

Originator AClass A

Class B

Class C

Class Z

ResidualClass

Sells mortgagebacked notes

$

$$

Trust(REMIC)

3 yr

5 yr

10 yr

15 yr

Bond Investors

Note:(1) Issuer owns mortgages or collateral(2) Issuer simply sells bonds backed by the assets or collateral(3) Interest income from assets is taxable to issuer(4) Issuer may deduct interest payable to bondholders(5) Deduction of interest depends on whether transaction is “true sale” or debt

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Residual Class• CMOs vary somewhat according to the issue, but they share a

common feature: overcollateralization– At every point in time, the amount of outstanding bonds must be small to

assure that the cash inflows from the remaining collateral will be sufficient to pay the promised obligations to bondholders

• The overcollateralization is the residual class, which is in effect the equity supplied by issuer to support the bonds

• The value of the residual class increases as interest rate increases, while normal bond values fall with interest rate increase – exhibit negative duration

• Banks take advantage of this negative duration to hedge their regular bonds and fixed income portfolios

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Innovations in the CMO• This instrument first appeared in the US in 1984• Its extraordinary success suggests that it represents a

significant innovation and it satisfies previously unfilled niche– CMO’s provide return and risk combination that is impossible to obtain

by direct investment in MBS or mortgages– For investors, CMOs provide risk reduction across a spectrum of

holding periods– Some securities created as part of CMO offer an enhanced ability to

hedge interest rate risk exposure or bet on direction of interest rate• CMOs are an excellent example of financial innovation that

makes the market “more complete”• Thus CMOs create value; mortgages are now selling for lower

yields (an thus higher prices) than before the appearance of the CMO

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Arbitrage Opportunities in the CMO• It is said that the repackaging of cash flows in the

CMO results in the sum of the parts (class of bonds) being greater than the value whole (collateral)

• How can this be possible?– pricing at various interest rates that more closely

tracks the yield curve results in lower blended yield (and thus higher price) to investors and lower blended cost to issuer

• This is the value additivity of CMOs

4

1,

iMBSCMOi PP

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Exhibit 1-11: MORTGAGE SECURITIZATION

WAREHOUSING

ORIGINATION UNDERWRITING

RATING

DISTRIBUTIONCLOSINGSTRUCTURING

TASK SEQUENCE

BORROWERSSECURITIES

MORTGAGE(S)

CREDITENHANCEMENT

DUEDILIGENCE

SERVICING MASTERSERVICING

INVESTORS

ADMINISTRATIONTRANSFILE

TRADING

Mortgages

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Players in Mortgage Securitization

Issuer Investment Bank Rating Agency Credit Enhancer Master Servicer

Bond Trustee Owner Trustee

Initiates transaction Underwrites and structures transaction Rates the bonds and structure Improves the bond rating Collects collateral payment and takes

care of delinquencies and defaults Pays bondholders and trust expenses Supervises owner’s interest in trust’s

excess cash flow

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Players in Mortgage Securitization

Owner Lawyer

Accountant

Investor

Owns residual interest in trust Provides legal opinion of trust

structure Provides due diligence and post-

closing services Purchases bonds for investments

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Exhibit 1-12: Necessary Transaction Support Functions for a Standard Mortgage Backed Security (MBS)

DAILY PROCESSING MONTH END PROCESSING

ObligorsRemit

Payments

ProcessPayments

Transfer Deposit

Deposit

ApplyFunds

Total $ Deposit

CreateFile

Invest Funds

SERVICER

Collection Account

ProduceReports

ProduceSettlementStatements

DistributeStatements

Reports

Rating TrusteeAgency

Investment CreditBanking Firm Enhancement

InvestorsPrice/Yield Tables

Excess

Collection/Disbursement

Account

DisbursementInstructions

Statements

SERVICER

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Innovations in Asset Backed Securitization

• There are four innovations that investment bankers use to add value to asset back securities

• Special Purpose Vehicle– This is the trust or corporation that is established for the

sole purpose of owning the loans– Its exact form depends on specific nature and risk of assets,

legal, regulatory, tax issues and objective of issuer/fund raiser

– In every case it sole purpose is to isolate the risk inherent in the loans from all other risk of the issuer

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Innovations in Asset Back Securities

• Pooling of loans– Diversifies credit risk

• Credit structuring and enhancement– Credit enhancement raises credit risk of the pool to

investment grade levels– Attractive to investors such as pension funds, insurance

companies and individuals• Repacking of cash flows into tranches

– Tailor cash flows to specific investors• Short tranch for thrifts and longer term for pension funds

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Economics of Asset SecuritizationIssuers Prospective Benefits

• Management of interest rate risk– Pass-through structure and CMOs can mitigate

asset/liability maturity gap for thrifts with fixed rate loans

– Replacing mortgages in portfolio with pass-throughs and CMOs helps thrifts to diversify prepayment risk

– Mortgage backed bonds could also be used to lengthen the average maturity of liabilities

– While other products can be used to hedge interest rate risk, securitization may be superior in terms of transaction cost and overall effectiveness

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Economics of SecuritizationIssuers Prospective Benefits

• Increased Liquidity– Securitization achieves initial measure of liquidity

before trading in two ways• Third party credit enhancement reduces informational

asymmetries between issuer and investors• Pooling of large number of assets and the subsequent

partitioning of cash flows --- CMOs– The importance of the issuer’s private information about future

portfolio returns diminishes as one moves up the priority ladder

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Economics of SecuritizationIssuer’s Prospective Benefits

• Enables banks to focus on key economic functions of intermediation– Origination, servicing and monitoring are three

activities that banks generally perform more efficiently than others

– Absent regulatory help it is not clear banks and thrifts have any special advantage in funding

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Economics of SecuritizationIssuer’s Prospective Benefits

• Facilitates the avoidance of “adverse selection costs”– Investors who provide funding through deposits

and equity to the bank are in effect purchasing claims against the bank’s entire asset portfolio

– Investors in securitized loans are purchasing claims only against the assets

• With little informational asymmetry there is virtually no adverse selection cost – lower funding cots

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Economics of SecuritizationIssuer’s Perspective

• Avoidance of regulatory taxes– Banks avoid regulatory taxes such as reserve

and capital requirements and deposit insurance premiums

– Because regulatory taxes are flat taxes securitization avoids “subsidization” of low quality assets by high quality assets

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Economics of Securitization:Investors Perspective

• Provides investors with access to higher credit quality claims than otherwise– Typically claims offered via securitization are often of

higher quality than the institution itself• Provides investors with greater variety of cash flow

streams than the underlying asset -- CMOs• Liquidity

– Asset backed securities market is big and trading is very active

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Potential Costs

• Costs of public/private credit risk insurance and guarantee

• Cost of overcollateralization• Cost of pooling/packing/underwriting• Valuation and packaging costs • Other costs: legal fees, accounting fees,

reporting fees, registration fee, etc