Transcript Loan Securitization Basics

Class #20; Chap. 26
Purpose: Gain a basic understanding of what securitization is,
why it exists and who the big players are.

Introduction

How assets are securitized (SPV or SIV)

Pass-through security

Who are the main players in securitization

What can be securitized

Costs and benefits of securitization
2
3

Securitization:
◦ Package loans or other assets into a pool of assets
◦ Sell securities backed by the pool of assets

Basics
1. Package assets – Almost any type of asset can be
securitized (mortgages, credit card loans, student loans …)
2. Create a conduit, a subsidiary, sell the packaged assets to
the subsidiary (SPV, SIV) – assets go off balance sheet
3. The subsidiary finances the purchase of assets by issuing
debt or assets backed by the pool.
4
How Are Assets Securitized?
5
1. Through a Special Purpose Vehicle (SPV)- Bank
creates a SPV and sells it a bundle of assets, which
removes them from its balance sheet
2. Through a Structured Investment Vehicle (SIV) -
Bank creates a SIV and sells it a bundle of assets,
which removes them from its balance sheet
6
Securitization through a Special
Purpose Vehicle (SPV)
7
New Assets
SPV
Bank
Creates
SPV
repackages
assets
New asset
(bonds) sold
to investors
Investors
SPV
SPV pays bank
for mortgages
Investors purchase securities
and pay SPV an initial sum
Why does the bank go through all that trouble?
To remove assets from its balance sheet
 Allows them to free-up regulatory capital (tax)
Pension Funds and
Insurance Companies
8
The SPV create securities based on the pool of assets
 The pass-through is one type of securitization
Loan pool
SPV
Principal
$$$
Interest
Asset Backed
Securities
CDO
CMO
CLO
RMBS
Pass Through
SPV:
1.
Collects fees for creating and servicing the Asset Backed Security (ABS)
2.
The SPV exists until cash flows from the assets are fully distributed
9
1.
2.
3.
4.
Bank Creates SPV
Bank sells SPV loans – removing them from the
Balance-sheet
SPV repackages loans into pass-through securities
Pass-through securities are sold to investors – pension
funds and insurance companies
5.
SPV pays bank for loans
6.
SPV collects origination and servicing fees for the
asset-backed security
10
Securitization through a Structured
Investment Vehicle (SIV)
11
SIV
Bank
Creates SIV
Payment for mortgages
Asset Backed Commercial
Paper (ABCP)
Commercial paper
is secured by loans
Receive Payment $$
Profits =
Rate on –
Mortgages
+ Fee income
Rate on
ABCP
Commercial
Paper Market
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1.
2.
Bank creates SIV
Bank Sells SIV assets (loans) – removes assets (loans)
from its balance-sheet
3.
SIV offers an issue of commercial paper to finance the
purchase of assets
4.
Commercial paper is backed by the purchased assets
making it asset backed commercial paper (ABCP)
5.
SIV pays bank using the proceeds from commercial
paper
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
Interest rate risk:
◦ SPV issues pass-through securities – payments to investors are based on
cash flows from the pool so SPV is not subject to interest rate risk
◦ SIV issues commercial paper so their profits depend on the difference
between the commercial paper rate and the mortgage rate (interest rate risk)

Profits:
◦ SPV earns profits from fees on originating and servicing the ABS
◦ SIV earns fees as well as the spread between CP and mortgage rates

Financing:
◦ SPV issues pass-through or asset backed securities
◦ SIV issues commercial paper (ABCP)
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Pass-Through Securities
15
Pass-Through
Asset Backed
Security
The SPV create securities based on the pool of assets
 The pass-through is one type of securitization
Investors
Loan pool
SPV
25% Share
Principal
$$$
Interest
75% Share
Question – who owns the loans?
16

FI builds a pool of mortgages and sells interest in the pool as
pass-through securities

Pass-through securities represent a fraction of ownership in
the pool
◦ e.g. a 1% share in the principal and interest payments of the pool

The originator of the pass-through collects payments from the
pool and passes them through to the bond holders

Investors have direct ownership in this portfolio of mortgage
loans or other securitized assets.

Ownership of loans rests with certificate holders (investors)
and pass-throughs don’t appear on the originating bank’s B/S.
17
Who Securitizes Assets
&
Which Assets?
18
1.
Financial Institutions – Banks
◦ Usually securitize riskier assets
◦ Securitizations are usually more complicated: RMBS CDO
CMO …
2.
Government Sponsored Enterprise (GSEs)
◦ Securitize less risky home mortgages
◦ Usually more simple assets: Pass-through
Why do we have the GSEs?
19
Created to increase mortgage lending by facilitating
securitization

FNMA – Fannie Mae (Federal National Mortgage Agency)

FHLMC – Freddie Mac (Federal Home Loan Mortgage Corp)

GNMA – Ginnie Mae (Government National Mortgage
Association)
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
Founded 1938, oldest of the three Mortgage Backed Securities
(MBS) sponsors – publicly traded (owned by share holders)

Main Functions
◦ Purchases loans and creates pass-through securities
◦ Sells MBS to outside investors

Swaps – engages in swap transactions swapping mortgages for
MBS with the mortgage originator

Securitizes conventional loans as well as government insured
loans
◦ Conventional loans must have the proper loan-to-value ratio normally
not to exceed 80%
◦ Charter
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
Public (stock holder owned) corporation founded in 1970

Performs similar tasks as FNMA
◦ Purchases loans from FIs
◦ Sells MBS
◦ Swaps MBS for loans

Charter
22

Main Difference between FHLMC and FNMA
◦ Originally FHLMC dealt mainly with savings banks
◦ Originally FNMA dealt mainly with mortgage bankers
◦ Now they are pretty much the same – competition promotes
capitalism


Where are they now?
http://www.foxbusiness.com/economypolicy/2014/10/20/frannie-freddie-to-ease-creditrequirements/
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
Founded in 1968 after splitting from FNMA

Ginnie Mae does not buy or sell loans or issue mortgage-backed
securities (MBS)

Main Functions
◦ Sponsoring mortgage backed securities programs by FIs – banks, thrifts,
& Mortgages Banks
◦ Provides guarantees to investors in Mortgage backed securities for
timely payments

Has strict requirements for mortgages in the pool◦ Each mortgage must be, and must remain, insured or guaranteed by a
federal agency FHA, VA, RHS or PIH.
◦ Mortgage insurance makes the lender whole if the borrower defaults
24
25

Home Mortgages: MBSs (Mortgage Backed Securities)
◦ Sub prime
◦ Conventional

Credit Cards: CARDs (certificates for amortizing revolving debts)

Auto Loans: CARs (certificates for automobile receivables)

Small Business Loans guaranteed by the Small Business
Administration

Commercial and Industrial Loans: CLOs (Collateralized Loan
Obligations)

Can all assets be securitized?
26
Costs and Benefits of
Securitization for Banks
&
Risks Faced by Investors
27

Main Coast: Increase off-balance sheet risk exposure

SIV: – Issues
How
commercial
does an SIV
paper
raise
(high
funding?
or low quality?)
◦ The sponsoring bank guarantees the issue. How?
can
the SIV
issue
high-quality
1. BankHow
can issue
a Standby
letter
of credit
2. Bank can sell the loans with recourse
CP?
◦ In either case, the guarantee increases the banks’ off-balance sheet risk
◦ If the SIV defaults, the bank assumes responsibility for the issue or takes
possession of the bad loans
How would this affect a bank’s
capital adequacy?

SPV: There is really no risk to the bank with an SPV
◦ Pass-through payments are based on the cash flows of the pool
◦ If mortgages go bad the investors receive lower payments. The SPV is not
in danger of defaulting on its obligated payments
SIV seems more risky why not
just use the SPV?
28
1.
Reduces Regulatory tax
◦ Banks face substantial regulatory costs for holding risky assets on their
balance sheet
◦ Banks can avoid these regulatory costs by securitizing risky assets
2.
Reduces Gap exposure (refinancing risk)
◦ Mortgages are financing using short-term debt which must be refinanced.
That rate will change but the mortgage interest rate will remain constant
3.
Illiquidity Risk
◦ Mortgages are illiquid and will likely need to be sold at a large discount
◦ Securitizations are more liquid so they can usually be sold at less of a
discount.
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Default Risk
1.
◦
◦
◦
If the mortgage pool is not insured, bond holders will loose principal and
interest if mortgagees default on their loans.
If the SPV/SIV payments are not insured, then bond holders may loose
principal and interest if the SPV defaults.
GNMA bonds are not exposed to default risk !
Prepayment risk (discussed in next section)
2.
◦ Bond holders will likely lose interest income on prepaid principal
Interest rate risk
3.
◦
Just like a treasury bond, the price of bonds generated through
securitization are sensitive to changes in interest rates.
30
1. Bank Creates SPV/SIV
2. Bank Sells Assets to SPV/SIV
3. SPV/SIV creates securities and sells them to investors
Bank
SPV/SIV
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Example
Benefits of Securitization
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Bank
Bank issues 1,000 loans with $100,000 principal



100 Mill
Size of mortgages are small so they need insurance
The average maturity is 30 years
The aggregate mortgage coupon is 12%
Capital Requirements:

Why capital requirements? What do they have to do with regulatory tax?
If we add risky mortgages to the balance sheet, then we need to hold
capital against these mortgages
The question is: how much capital do we need to raise so your cap ratio does not change?


↑ mortgages = ↑ risk adjusted asset value = ↓ risk-based capital ratio
raise capital to restore risk-based capital ratio
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Bank
Bank issues 1,000 loans with $100,000 principal



100 Mill
Size of mortgages are small so they need insurance
The average maturity is 30 years
The aggregate mortgage coupon is 12%
Capital Requirements:
 50% risk weight in risk-based capital
 Current capital ratio is 8%
RBC Ratio 
Capital
 0.08
Risk  Adjusted Asset Value
If we increase RAAV by
$100, then we need to
increase capital by
(0.08)($100) = $8 to
maintain the RBC ratio
Capital  0.08Risk  Adjusted Asset Value
Capital  1,000100,000  0.5  0.08  4,000,000
$100M in mortgages
50% risk weight
8% capital requirement
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Assume the remaining $96M needs to be funded by
raising demand deposits
Reserve Requirements:
 For every $1 of demand deposits $0.10 needs to be held in
reserves
$96 M
$X 
 $106 .67 M
$ X (1  .1)  $96M
.9
$96M to fund mortgages
$10.67M to meet reserve requirements
Excess Reserves
FDIC: bank needs to pay a 40 basis point insurance premium
Insurance ($106.67mill)  .0040 $426,680
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
Cost of holding mortgages on balance sheet:
Capital Adequacy Requirements
Excess Reserve Requirements
FDIC Insurance Premium
Total Regulatory Tax

= $4,000,000
= $10,670,000
=
$426,680
= $15,096,680
Securitizing mortgages removes them from the
balance sheet and frees up all the regulatory capital
associated with holding mortgages
Why do banks want to
securitize mortgages?
36
Example: Atlantic National Bank purchased a pool of 300 mortgages with an average principal of 250,000
each. They finance the purchase with deposits and equity. Currently, their total risk-based capital ratio of
9.3%. The FDIC charges 0.24% of deposits for insurance and the Fed requires 10% of deposits to be held in
reserves. Calculate the total regulatory tax that Atlantic Nation is exposed to from holding mortgage on its
balance sheet. Assume mortgages have a 50% risk weight
37

Securitization through and SPV or SIV

Pass-through security

Who securitizes assets – which assets

Costs, Benefits and risks associated with Securitization
◦ Regulatory tax
38