Presentation on theme: "Loan Securitization The Basics"— Presentation transcript:
1 Loan Securitization The Basics Class #20; Chap. 26
2 OutlinePurpose: Gain a basic understanding of what securitization is, why it exists and who the big players are.IntroductionHow assets are securitized (SPV or SIV)Pass-through securityWho are the main players in securitizationWhat can be securitizedCosts and benefits of securitization
4 Loan Securitization – Basic Idea Package loans or other assets into a pool of assetsSell securities backed by the pool of assetsBasicsPackage 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 sheetThe subsidiary finances the purchase of assets by issuing debt or assets backed by the pool.
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 sheetThrough 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 AssetsNew asset (bonds) soldto investorsSPV repackages assetsBankSPVInvestorsCreates SPVSPV pays bank for mortgagesInvestors purchase securities and pay SPV an initial sumWhy does the bank go through all that trouble?Pension Funds and Insurance CompaniesTo remove assets from its balance sheetAllows them to free-up regulatory capital (tax)
9 Asset Backed Securities SPV Security IssueThe SPV create securities based on the pool of assetsThe pass-through is one type of securitizationLoan poolSPVAsset Backed SecuritiesCDOCMOCLORMBSPass ThroughPrincipal$ $ $InterestSPV: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-sheetSPV repackages loans into pass-through securitiesPass-through securities are sold to investors – pension funds and insurance companiesSPV pays bank for loansSPV 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 BankSIVCreates SIVReceive Payment $$Payment for mortgagesCommercial Paper MarketAsset Backed CommercialPaper (ABCP)Commercial paper is secured by loansProfits = –Rate on MortgagesRate on ABCP+ Fee income
13 SIV Mechanism Summary Bank creates SIV Bank Sells SIV assets (loans) – removes assets (loans) from its balance-sheetSIV offers an issue of commercial paper to finance the purchase of assetsCommercial 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 riskSIV 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 ABSSIV earns fees as well as the spread between CP and mortgage ratesFinancing:SPV issues pass-through or asset backed securitiesSIV issues commercial paper (ABCP)
16 Pass-Through Asset Backed Security SPV Security IssuePass-Through Asset Backed SecurityThe SPV create securities based on the pool of assetsThe pass-through is one type of securitizationInvestorsLoan pool25% of principaland interest paymentsSPV25% SharePrincipal$ $ $Interest75% of principaland interest payments75% ShareQuestion – who owns the loans?
17 Pass-Through Securities Summary FI builds a pool of mortgages and sells interest in the pool as pass-through securitiesPass-through securities represent a fraction of ownership in the poole.g. a 1% share in the principal and interest payments of the poolThe originator of the pass-through collects payments from the pool and passes them through to the bond holdersInvestors 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.
19 Who Securitizes Assets? Financial Institutions – BanksUsually securitize riskier assetsSecuritizations are usually more complicated: RMBS CDO CMO …Government Sponsored Enterprise (GSEs)Securitize less risky home mortgagesUsually more simple assets: Pass-throughWhy do we have the GSEs?
20 Government Sponsored Enterprise Created to increase mortgage lending by facilitating securitizationFNMA – Fannie Mae (Federal National Mortgage Agency)FHLMC – Freddie Mac (Federal Home Loan Mortgage Corp)GNMA – Ginnie Mae (Government National Mortgage Association)
21 FNMA – Fannie MaeFounded 1938, oldest of the three Mortgage Backed Securities (MBS) sponsors – publicly traded (owned by share holders)Main FunctionsPurchases loans and creates pass-through securitiesSells MBS to outside investorsSwaps – engages in swap transactions swapping mortgages for MBS with the mortgage originatorSecuritizes conventional loans as well as government insured loansConventional loans must have the proper loan-to-value ratio normally not to exceed 80%Charter
22 FHLMC – Freddie MacPublic (stock holder owned) corporation founded in 1970Performs similar tasks as FNMAPurchases loans from FIsSells MBSSwaps MBS for loansCharter
23 Difference between FNMA & FHLMC Main Difference between FHLMC and FNMAOriginally FHLMC dealt mainly with savings banksOriginally FNMA dealt mainly with mortgage bankersNow they are pretty much the same – competition promotes capitalismWhere 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 FunctionsSponsoring mortgage backed securities programs by FIs – banks, thrifts, & Mortgages BanksProvides guarantees to investors in Mortgage backed securities for timely paymentsHas 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
26 What is Securitized? Home Mortgages: MBSs (Mortgage Backed Securities) Sub primeConventionalCredit Cards: CARDs (certificates for amortizing revolving debts)Auto Loans: CARs (certificates for automobile receivables)Small Business Loans guaranteed by the Small Business AdministrationCommercial 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 valueIf 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 exposureSIV:The sponsoring bank guarantees the issue.Bank can issue a Standby letter of creditBank can sell the loans with recourseIn either case, the guarantee increases the banks’ off-balance sheet riskIf the SIV defaults, the bank assumes responsibility for the issue or takes possession of the bad loansSPV:Pass-through payments are based on the cash flows of the poolIf 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 SPVSIV seems more risky why not just use the SPV?
29 Banks’ Main Benefit of Securitization Reduces Regulatory taxBanks face substantial regulatory costs for holding risky assets on their balance sheetBanks can avoid these regulatory costs by securitizing risky assetsReduces 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 constantIlliquidity RiskMortgages are illiquid and will likely need to be sold at a large discountSecuritizations are more liquid so they can usually be sold at less of a discount.
30 Risks Faced by Investors Default RiskIf 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 principalInterest rate riskJust 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/SIVSPV/SIV creates securities and sells them to investorsBankSPV/SIVIs there anything wrong in this process that is there do things breakdown?
33 Example – Reduction of Regulatory Tax BankBank issues 1,000 loans with $100,000 principalSize of mortgages are small so they need insuranceThe average maturity is 30 yearsThe aggregate mortgage coupon is 12%100 MillCapital 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 mortgagesThe 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 ratioraise capital to restore risk-based capital ratio
34 Example – Reduction of Regulatory Tax BankBank issues 1,000 loans with $100,000 principalSize of mortgages are small so they need insuranceThe average maturity is 30 yearsThe aggregate mortgage coupon is 12%100 MillCapital Requirements:50% risk weight in risk-based capitalIf we increase RAAV by $100, then we need to increase capital by (0.08)($100) = $8 to maintain the RBC ratioSo you have raised 4M in capital assume through an equity issue reduction in dividends …Current capital ratio is 8%$100M in mortgages50% risk weight8% capital requirement
35 Example – Reduction of Regulatory Tax Assume the remaining $96M needs to be funded by raising demand depositsReserve Requirements:For every $1 of demand deposits $0.10 needs to be held in reserves$96M to fund mortgages $10.67M to meet reserve requirementsExcess ReservesFDIC: 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 mortgagesCapital Adequacy Requirements=$4,000,000Excess Reserve Requirements$10,670,000FDIC Insurance Premium$426,680Total Regulatory Tax$15,096,680Why 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 securityWho securitizes assets – which assetsCosts, Benefits and risks associated with SecuritizationRegulatory tax