Securitization

Traditionally, financial intermediaries originated loans that they then held on their balance sheets until maturity. Starting around 1990 pools of loans began to be sold in capital markets, by selling securities linked to pools of loans held by legal entities called “special purpose vehicles” (SPVs). These securities, known as asset-backed securities (ABS) (or mortgage- backed securities (MBS), in the case where the loans are mortgages) are claims to the cash flows from the pool of loans held by the SPV. Such securities can be issued with different seniorities, known as tranches. Securitization has fundamentally altered capital markets, the functioning of financial intermediation, and challenges many theories of the role of financial intermediaries.

cont Securitization is not only important because it is quantitatively significant. It also challenges theoretical notions of the role of financial intermediation. Financial intermediaries make loans to customers, loans that traditionally were held on their balance sheets until maturity. They did this to ensure themselves an incentive, so the theory goes, to screen borrowers and to monitor them during the course of the loan. The logic of the argument is that were banks not to hold the loans, then they would not screen or monitor. Providing the banks with these incentives explained the nonmarketability of bank loans. Many firms, however, issue bonds, which do not involve banks and the associated screening and monitoring, so somehow Securitization blurs the line between bonds and loans, suggesting that the traditional arguments about screening and monitoring were not correct or that the world has changed in some important way.

Securitization: Some Institutional Details “Securitization” means selling securities whose principal and interest payments are exclusively linked to a pool of legally segregated, specified, cash flows (promised loan payments) owned by a special purpose vehicle (SPV). The cash flows were originated (“underwritten”) by a financial intermediary, which sold the rights to the cash flows to the special purpose vehicle. The securities, called “asset-backed securities” (ABS), are rated and sold in the capital markets. Historically, the financial intermediary would have held the loans on- balance sheet until maturity. But, with securitization the loans can be financed off-balance sheet.

The SPV purchases the loan cash flows by selling securities based on seniority, called “tranches,” to investors in the capital markets, shown at the bottom of the figure. These securities are claims that are linked to the cash flows of the portfolio of loans that the SPV then purchases from the operating firm (the intermediary). The cash flows are passive in the sense that the underwriting decision has already been made, so there is nothing further to do except wait to see if the cash flows are repaid as promised.

CDOs and CLOS are special purpose vehicles that buy portfolios of ABS, in the case of CDOs, and commercial and industrial loans, in the case of CLOs. These are financed by issuing different tranches of risk in the capital market, rated Aaa/AAA, Aa/AA to Ba/BB. These vehicles are also managed, that is,not completely passive. CDOs are described by Duffie and Garleanu (2001) and Benmelech and Dlugosz (2009); also see Longstaff and Rajan (2008). CLOs are discussed by Benmelech, Dlugosz, and Ivashina (200?)

Agency MBS are created by one of three quasi-government agencies: Government National Mortgage Association (known as GNMA or Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corp. (Freddie Mac). GNMA bonds are backed by the full faith and credit of the U.S. government and thus are free from default risk. While FNMA and Freddie Mac securities lack this same backing, the risk of default is negligible. Securities issued by any of these entities are referred to as “Agency MBS.”