1. Loan Securitization The Basics
Class #20; Chap. 26

2. Outline
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

3. Loan Securitization – From the Daily Show

4. Loan Securitization – Basic Idea
Package loans or other assets into a pool of assets
Sell securities backed by the pool of assets
Basics
Package assets – Almost any type of asset can be securitized (mortgages, credit card loans, student loans …)
Create a conduit, a subsidiary, sell the packaged assets to the subsidiary (SPV, SIV) – assets go off balance sheet
The subsidiary finances the purchase of assets by issuing debt or assets backed by the pool.

5. How Are Assets Securitized?

6. Mechanisms for securitizing assets
Through a Special Purpose Vehicle (SPV)- Bank creates a SPV and sells it a bundle of assets, which removes them from its balance sheet
Through a Structured Investment Vehicle (SIV) - Bank creates a SIV and sells it a bundle of assets, which removes them from its balance sheet

7. Securitization through a Special Purpose Vehicle (SPV)

8. SPV Securitization: Convert Assets to Securities
New Assets
New asset (bonds) sold
to investors
SPV repackages assets
Bank
SPV
Investors
Creates SPV
SPV pays bank for mortgages
Investors purchase securities and pay SPV an initial sum
Why does the bank go through all that trouble?
Pension Funds and Insurance Companies
To remove assets from its balance sheet
Allows them to free-up regulatory capital (tax)

9. Asset Backed Securities
SPV Security Issue
The SPV create securities based on the pool of assets
The pass-through is one type of securitization
Loan pool
SPV
Asset Backed Securities
CDO
CMO
CLO
RMBS
Pass Through
Principal
$ $ $
Interest
SPV:
Collects fees for creating and servicing the Asset Backed Security (ABS)
The SPV exists until cash flows from the assets are fully distributed

10. SPV Mechanism Summary 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
SPV pays bank for loans
SPV collects origination and servicing fees for the asset-backed security

11. Securitization through a Structured Investment Vehicle (SIV)

12. SIV Securitization: Convert Assets to Securities
Bank
SIV
Creates SIV
Receive Payment $$
Payment for mortgages
Commercial Paper Market
Asset Backed Commercial
Paper (ABCP)
Commercial paper is secured by loans
Profits = –
Rate on Mortgages
Rate on ABCP
+ Fee income

13. SIV Mechanism Summary Bank creates SIV
Bank Sells SIV assets (loans) – removes assets (loans) from its balance-sheet
SIV offers an issue of commercial paper to finance the purchase of assets
Commercial paper is backed by the purchased assets making it asset backed commercial paper (ABCP)
SIV pays bank using the proceeds from commercial paper

14. Difference between SIV & SPV
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)

15. Pass-Through Securities

16. Pass-Through Asset Backed Security
SPV Security Issue
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
25% of principal
and interest payments
SPV
25% Share
Principal
$ $ $
Interest
75% of principal
and interest payments
75% Share
Question – who owns the loans?

17. Pass-Through Securities Summary
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.

18. Who Securitizes Assets & Which Assets?

19. Who Securitizes Assets?
Financial Institutions – Banks
Usually securitize riskier assets
Securitizations are usually more complicated: RMBS CDO CMO …
Government Sponsored Enterprise (GSEs)
Securitize less risky home mortgages
Usually more simple assets: Pass-through
Why do we have the GSEs?

20. Government Sponsored Enterprise
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)

21. FNMA – Fannie Mae
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

22. FHLMC – Freddie Mac
Public (stock holder owned) corporation founded in 1970
Performs similar tasks as FNMA
Purchases loans from FIs
Sells MBS
Swaps MBS for loans
Charter

23. Difference between FNMA & FHLMC
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?
policy/2014/10/20/frannie-freddie-to-ease-credit- requirements/

24. GNMA – Ginnie Mae 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

25. GNMA Pass-Through

26. What is Securitized? 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?
Yes any asset that produces a string of cash flows can be securitized – but there is a cost – the harder it is to value the pool the more overcollateralization is need to induce investors to buy. Over collateralization is extra collateral that is not trenched out – ie if the pool has a value of 200 mill and 190mill in bonds are issued then there is 10 mill in overcollateralization.
Pool are hard to value if the collateral in the pool is hard to value
If the collateral in the pool looks very different ie different interest rates different maturities …

27. Costs and Benefits of Securitization for Banks & Risks Faced by Investors

28. Banks’ Main Cost of Securitization
Main Coast: Increase off-balance sheet risk exposure
SIV:
The sponsoring bank guarantees the issue.
Bank can issue a Standby letter of credit
Bank can sell the loans with recourse
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
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
– Issues commercial paper (high or low quality?)
How does an SIV raise funding?
How?
How can the SIV issue high-quality CP?
How would this affect a bank’s capital adequacy?
There is really no risk to the bank with an SPV
SIV seems more risky why not just use the SPV?

29. Banks’ Main Benefit of Securitization
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
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
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.

30. Risks Faced by Investors
Default Risk
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)
Bond holders will likely lose interest income on prepaid principal
Interest rate risk
Just like a treasury bond, the price of bonds generated through securitization are sensitive to changes in interest rates.

31. Is Securitization Bad? Bank Creates SPV/SIV
Bank Sells Assets to SPV/SIV
SPV/SIV creates securities and sells them to investors
Bank
SPV/SIV
Is there anything wrong in this process that is there do things breakdown?

32. Example Benefits of Securitization

33. Example – Reduction of Regulatory Tax
Bank
Bank issues 1,000 loans with $100,000 principal
Size of mortgages are small so they need insurance
The average maturity is 30 years
The aggregate mortgage coupon is 12%
100 Mill
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

34. Example – Reduction of Regulatory Tax
Bank
Bank issues 1,000 loans with $100,000 principal
Size of mortgages are small so they need insurance
The average maturity is 30 years
The aggregate mortgage coupon is 12%
100 Mill
Capital Requirements:
50% risk weight in risk-based capital
If we increase RAAV by $100, then we need to increase capital by (0.08)($100) = $8 to maintain the RBC ratio
So you have raised 4M in capital assume through an equity issue reduction in dividends …
Current capital ratio is 8%
$100M in mortgages
50% risk weight
8% capital requirement

35. Example – Reduction of Regulatory Tax
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
$96M to fund mortgages $10.67M to meet reserve requirements
Excess Reserves
FDIC: bank needs to pay a 40 basis point insurance premium

36. Example – Reduction of Regulatory Tax
Cost of holding mortgages on balance sheet:
Securitizing mortgages removes them from the balance sheet and frees up all the regulatory capital associated with holding mortgages
Capital Adequacy Requirements =
$4,000,000
Excess Reserve Requirements
$10,670,000
FDIC Insurance Premium
$426,680
Total Regulatory Tax
$15,096,680
Why do banks want to securitize mortgages?

37. 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

38. Lecture Summary Securitization through and SPV or SIV
Pass-through security
Who securitizes assets – which assets
Costs, Benefits and risks associated with Securitization
Regulatory tax