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Agency Conflicts, Asset Substitution, and Securitization Yingjin Hila Gan (Lehman Brothers) Christopher Mayer (Columbia Business School & NBER) June 2007.

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Presentation on theme: "Agency Conflicts, Asset Substitution, and Securitization Yingjin Hila Gan (Lehman Brothers) Christopher Mayer (Columbia Business School & NBER) June 2007."— Presentation transcript:

1 Agency Conflicts, Asset Substitution, and Securitization Yingjin Hila Gan (Lehman Brothers) Christopher Mayer (Columbia Business School & NBER) June 2007

2 Motivation As of end of 2006, the ABS (asset backed securities) market totaled $7.6 trillion * About ½ of mortgages, ⅓ of trade receivables, and ¼ of consumer credit are securitized * Little research on how securitization structures perform Securitizations face some of the same organizational conflicts as corporations do * ABS and mortgage pools, Federal Reserve Flow of Funds, Tables L1, L4, L125, L126

3 Private ABS outstanding, by type of collateral

4 CMBS Market is Growing Quickly!

5 What is a Mortgage-Backed Security? Mortgage is approved by an originator Underwriter purchases mortgages  Pools mortgages in a trust  Trust issues bonds backed by the underlying principal and interest payments  Underwriter sells multiple classes of bonds(senior- subordinated structure)  Earns difference between cost of mortgages and value of bonds Investors purchase securities Servicer, trustee, special servicer manage structure

6 Typical CMBS Structure

7 A Typical Multi-Tranche CMBS Deal Losses Payments Example: $1 billion issuance ClassRatingPrincipal A-1AAA150 mm A-2AAA250 mm A-3AAA300 mm BAA50 mm CA50 mm DBBB80 mm EBB60 mm FB20 mm Gunrated40 mm

8 Benefits of Securitization Complete Market: Match risk/return characteristics of securities with buyer preferences Liquidity: Securitization potentially allows buyer/sellers to more easily trade securities Transparency: More public information available and easier to value securities Better legal protections: Stricter cash flow prioritization Specialization: Possible economies of scale associated with performing individual functions

9 Organizational Costs of Securitization Principal-Agent Conflicts: ABS separates ownership and control of assets (versus a vertically integrated lender)  Better informed managers may maximize own fees versus profits of securities holders  Managers may not exert optimal effort in identifying and managing troubled loans and liquidating assets Asset Substitution: Junior and senior securities holders may prefer different actions  ABS divides economic interests into thin tranches  The manager may only hold a narrow equity stake

10 Organizational Costs of Securitization Focus on special servicer (SPS), who performs key managerial functions in a CMBS securitization  Transfer (in conjunction with master servicer): Should a loan be transferred to costly special servicing?  Liquidation: When a loan gets in trouble does the special servicer wait, renegotiate the loan, or foreclose? Special servicer earns a monthly fee plus a fixed percentage of loan balances subject to special servicing  Incentives to push “too many” loans into special servicing  May slow the foreclosure process

11 Loan becomes delinquent (exogenous event): e.g., Late payment(s) or default on covenants Loan cures Loan goes to Special Servicing SPS earns additional fees Renegotiate Loan Liquidate Greater effort, No more fees Special servicer makes important decisions Watch the Loan Exert effort to decide If the loan is really in trouble and work with borrower to avoid special servicing

12 How to mitigate agency costs Special servicer might want to maintain a strong reputation to earn future business  Information asymmetries make it hard to monitor performance  Cannot observe effort Special servicer holds lowest rated security: B-piece  SPS becomes residual claimant (owns worst loans)  The SPS pays the full cost of placing a loan into special servicing  SPS gets full benefits from efficiently handling troubled loans  What if losses get too large?

13 Why not always have SPS own B-Piece? Special servicer may be more risk averse than other investors  Specialized skills make it hard for special servicers to diversify risks  Special servicers must be publicly rated and hold capital  Exposed to large risks if they hold all of the first-loss positions (defaults are likely correlated across deals) Largest Special Servicers LennarArcap GMACBanc One MidlandLend Lease OrixAmresco Crimmie MaeClarion

14 Why not always have SPS own B-Piece? Asset substitution problem: securitization exacerbates conflicts between owners of junior and senior tranches  If the special servicer owns the B-piece, she may take additional risks (extend a loan instead of foreclosing)  The incentive to take additional risk is bigger when the B- piece is at substantial risk of being entirely wiped out  Similar to the incentives of managers of troubled S&Ls Typical B-piece represents 3% of less of the nominal balances in a deal Less than the capital held by many S&Ls in 1980s

15 Empirical Predictions Underwriter is more informed than investors; chooses structure to enhance success High powered incentives are more valuable when:  Agent must exert more unobservable effort  Monitoring actions by investors is more difficult H1: The special servicer is more likely to own the B- piece in deals with:  Higher expected delinquencies  More asymmetric information—proxy with realized delinquency rates after controlling for observable information

16 Empirical Predictions As an agent, SPS is conflicted  Earns higher fees for loans in special servicing  Exert costly effort to help ensure that only truly risky loans are placed in special servicing When SPS owns the B-piece, she is residual claimant  Effectively pays fees to herself  Realizes losses if she does not manage a loan properly H2: When special servicer owns the B-piece, she will work to avoid unnecessary transfer of delinquent loans into special servicing

17 Empirical Predictions Once a loan is in special servicing, SPS must decide when to liquidate  Liquidation locks-in some losses  Delaying liquidation allows SPS to earn more fees, but with greater risk for investors Owners of highly leveraged assets cut back on maintenance Owners take greater risks with property Ultimate action of the SPS depends on the extent of potential losses in a deal

18 Empirical Predictions H3A: When potential losses are small, the SPS who owns the B-piece will liquidate loans more quickly  SPS must exert costly effort to decide when to liquidate  Greater fees are effectively paid by SPS  SPS realizes any losses H3B: When potential losses are large, the SPS who owns the B-piece will liquidate loans more quickly  Classic asset substitution problem

19 Empirical Predictions H4: Bond prices (yields) should reflect the benefits of incentive alignment  Yields should be lower on deals in which the SPS owns the B-piece  Yields effects should be most pronounced for the lowest rated tranches which suffer the greatest losses if the SPS does not perform efficiently Rating agencies do not consider whether the SPS owns the B-piece in determining ratings  Ratings are determined prior to the marketing of the bonds  Underwriter cannot guarantee that the SPS will not sell the B-piece

20 Potential empirical problems Do not observe losses, only actions of the agents Unobserved quality of deals: If the SPS is well- informed, she might only purchase the B-piece in deals with unobserved high quality loans  We will show that delinquencies and liquidations are higher in deals in which the SPS owns the B-piece  Bond yields reflect market’s perception of value We condition on bond ratings to control for expected losses (quality) Investors should price impact of incentive alignment

21 Data Trepp  Annual performance data from 1998-2003  Deal and loan level information Commercial Mortgage Alert  Name of B-piece buyer  Initial pricing data and yields for some bonds Restrict sample to non-agency deals in which we know the name of the SPS and B-piece buyer  357 (out of 839 deals in Trepp)  46,000 loans

22 Deals, By Year

23 SPS owns B-piece in deals with higher ex-post delinquencies (H1)

24 List of Special Servicers

25 SPS holds B-piece in deals w/low unobserved quality (H1) Dependent Variable: Deal delinquency rate (% of balance that is delinquent)

26 SPS w/ B-piece transfers fewer loans into special servicing (H2) Dependent variable: Dummy=1 if loan is transferred to special servicing Note: All regressions contain dummy variables for year, deal type and property type, Probit regressions, marginal effects

27 SPS liquidates loans more quickly when she owns the B-piece (H3A) Note: All regressions contain dummy variables for year, deal type and property type, Probit regressions. Marginal Effects Dep var: Dummy=1 if loan is liquidated, Sample is all loans in special servicing

28 SPS liquidates loans less quickly when she owns the B-piece and potential losses are large (H3B) Note: All regressions contain dummy variables for year, deal type and property type Dependent variable: Dummy=1 if loan is liquidated Probit regression, Sample is all loans in special servicing

29 Bonds in which the SPS owns the B-piece have lower spreads, especially the lowest rated bonds (H4) Dependent Variable: Spread over benchmark (basis points or.01%) Note: All regressions contain dummy variables for fine ratings category, year, and quarter

30 Conclusions Evidence suggests that agency conflicts are important in CMBS securitizations SPS more likely to own B-piece in deals with higher delinquency rates and greater asymmetric information (H1) When special servicers hold the B-piece, agency conflicts are reduced  Fewer delinquent loans are transferred into special servicing (H2)  Once in special servicing, loans are liquidated more quickly when losses are small (H3A)

31 Conclusions Asset substitution is still a problem when potential losses are large—SPS liquidates loans more slowly when she owns the B-piece (H3B) Market values structure of SPS holding B-piece (H4)  Bond spreads are lower when SPS owns B-piece  Spread effect is most pronounced in lowest rated bonds

32 So why does the SPS only own the B-piece in 62% of deals? Theory suggests that most informed party and the party who makes decisions (SPS in both cases) would have the highest WTP for the B-piece Asset substitution cannot explain this puzzle  Underwriter wants to protect investors in senior classes  Yet bond yields are lower in deals when SPS owns B-piece, despite higher delinquencies & liquidations Must be risk aversion in special servicers  SPS must maintain credit ratings and cannot diversify  Evidence: SPS holds B-piece less when issuance is highest

33 When Does the SPS Hold the B-piece?

34 Policy Implications and Future Research Securitization enhances conflicts between junior/senior credit holders with many tranches If delinquencies rise significantly, SPS ownership of B-piece could lead to serious inefficiencies Regulation matters: Risk-based capital requirements have helped drive securitization  Institutions often hold less capital for rated bonds than whole loans (is the risk really lower?)  Banks participate much less than insurance companies  Will liquidity and transparency continue in a downturn?


36 Growth of the CMBS Market Asset Default Risk Factors according to National Association of Insurance Company (NAIC) rules Stocks & BondsRisk Factor Common Stock30% Preferred Stock 5% US Government Bonds 0% A-AAA Bonds0.3% CCC-BBB Bonds 1-20% Bonds in default 30%

37 Growth of the CMBS Market Real Estate FactorRisk JV and LP interests 20% Company Occupied & Investment Props.10% Foreclosed Properties 15% Commercial Mortgages In good standing 3% In delinquency 15% In foreclosure 20% Noninsured Residential Mortgages0.5% For more information, see “ Risk and the Capital of Insurance Companies ” by Richard Kopcke (New England Economic Review, July/August, 1996, 27-42).

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