ASSET SECURITIZATION

Introduction The purpose of this lecture is to introduce - the asset-backed securities market; - the evolution of asset securitization; - asset-backed securities deal structures; - the role of players; - briefly presents pricing models; and - real estate securitization

Financial Intermediation Traditionally, banks 1) originate a loan; 2) retain the loan in their portfolio of assets, thereby accepting the credit risk associated with the loan; 3) service the loan (collect payments and take legal action if payments were not made; and 4) obtain funds from the public with which to finance their assets.

Problems 1. Asset/liability mismatching 2. liquidity mismatching 3. institutional mismatching

Asset Securitization Recently, banks 1) originate a loan; 2) sell the loan to an investment banking firm that creates a security backed by the pool of loans; 3) the investment bankers obtain credit risk insurance for the pool of loans from an insurance company; 4) the investment banker can sell the right to serve the loan to another bank or a company specializing in servicing loans; and 5) the investment banking firm can sell the securities to individual and institutional investors.

Asset Securitization

Defining Asset Securitization What is Securitization? - the sale of securities backed by the cash flows from a pool of financial assets, such as loans or leases Three basic requirements for any securitization: - a pool of self-liquidating assets that will serve as the source of payments on the asset-backed securities. - the payment performance of the assets (including the likelihood of delays and defaults) must be susceptible to evaluation, and - the cash flow from the assets and the payments made on the securities must be isolated from the risks of a bankruptcy or insolvency of the originator. Securitization involves the sale of assets which generate a cash flow such as residential mortgage loans, commercial mortgage loans, credit card receivables, motor vehicle receivables owed by dealers or retail consumers, equipment and vehicle lease receivables, installment sale contracts, franchise loans, insurance loans, student loans and high yield bonds. The money raised by the entity is borrowed on the security of the assets it has purchased and the debt is repaid from the cash flow generated by those assets.

What sorts of assets are securitized? *residential mortgage loans *commercial mortgage loans *credit card receivables *motor vehicle receivables *equipment and vehicle lease receivables *installment sale contracts *franchise loans * insurance loans *student loans *high yield bonds.

The evolution of asset securitization late 1970s and early 1980s 1982 1983, SEC 1984, Secondary Mortgage Market Enhancement Act 1986, Real Estate Mortgage Investment Conduits 1992 1993, Financial Asset Securitization Investment Trust

Real Estate Mortgage Investment Conduits An alternative for pool owners who want to issue a multi-class security, but can't take on debt or need to sell the mortgages - Created in 1986 by Tax Reform Act - Separate legal entity for tax purposes - Tax-favored entity for issuing CMOs - Pool owners sell mortgages to the REMIC - Can take many forms - trust, corporation, partnership - Can use any type of security - pass-through, debt - Investors only pay tax on interest income

The asset-backed securities market

The Secondary Mortgage Market Debt markets in U.S.A. in 1990 mortgages government securities corporate bond $3.5 $1.9 $1.4 trillion Government National Mortgage Association (GNMA, Ginnie Mae) Federal National Mortgage Association (FNMA, Fannie Mae) Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac)

The Secondary Mortgage Market

Holdings of Mortgage-Backed Securities

Asset-Backed Securities Issuance

Benefits to lenders 1) Obtaining a lower cost of funds 2) More efficient use of capital 3) Better asset/liability management 4) Enhancing financial performance 5) Diversification of sources

Benefits to investors and borrowers reduced credit risk. a) it is backed by a diversified pools of loans, and b) there is credit enhancement. returns are also improved. To borrowers: reduce the lending rates.

Mortgage-backed securities - Mortgage passthrough securities, or simply, passthrough - Collateralized mortgage obligations (CMOs) - Stripped mortgage-backed securities

Mortgage Passthrough Securities - Most popular form of mortgage-backed security - Represents sale of mortgages - Taxed only at investor level - Commits to pay P,I, and prepayments each month as received - "Modified" pass through guarantees timely payment - Greatest volume issued by FNMA, FHLMC and GNMA surrogates - Private entities also issue - Swap program provided more options to originators

Collateralized Mortgage Obligations - Debt instrument secured by pool of mortgages - Appeals to investors who can't tolerate prepayment - A Derivative: different from the underlying mortgages even though CMO distributions are derived from the mortgages - Issued in multiple maturities or tranches - Cash flow is distributed in sequential order (A,B,C,Z tranches) - A method for issue debt, reduce prepayment risk and shift remaining prepayment risk to the investor - Quoted with a stated maturity within a range - Overcollateralized

Stripped mortgage-backed securities - Issuer retains ownership - I is paid based on a coupon rate of interest (IO), P is passed through as it is received from normal amortization and prepayments (PO) - Some overcollateralization is required - Prepayment potential important to investor

Features of passthroughs 1) Type of guarantee: fully modified, modified 2) Number of lenders permitted in the pool. 3) Mortgage design of the loans 4) Characteristics of the mortgage loans in the pool 5) Payment procedure 6) Minimum pool size

Cash flows of mortgage-backed securities 1) interest 2) scheduled principal repayment 3) payments in excess of the regularly scheduled principal repayment

Asset-backed securities market - Cards

Asset-backed securities market - Cards

Role of players a. collateral/borrower b. origination c. servicing: often by originator d. credit-enhancement: e. Special Purpose Trust: f. investors g. underwriters h. rating agency i. government

Role of an investment bank An investment bank provides consultants to a broad spectrum of issues, including corporate, bankruptcy, regulatory, securities, and security-interest questions. An investment bank serves as an representative of issuers and underwriters in the public and private sale of securities secured by a variety of nonmortgage assets.

Evaluation of mortgage-backed securities Pricing is a function of: - interest rate risk - default - risk of delayed payment - prepayment possibilities - PSA model - FHA prepayment experience - empirical models

Measuring price volatility:

Price/Yield Relationship for a Callable bond - negative convexity

The Option pricing methodology callable bond price = noncallable bond price -call option rice

Option-adjusted spread methodology

Total return framework