1. Prospects for Asset-Backed Securitization
National University of Singapore
July 23 – 30, 2001
Notes from lecture given by Jay Sa-Aadu at
National University of Singapore – July 2001
11/18/2018

2. Objectives of this session
When we finish this session you will understand the following:
Concept of Asset Backed Securitization
Primary Impetus/Incentives for Securitization
Potential for Securitization in Singapore
Strategic and Financial Considerations for Securitization
Types of Securitization Structures
Innovations in Asset Securitization
Economics of Asset Securitization
11/18/2018

3. Introductory Remarks
Asset Backed Securitization (ABS) has emerged as an active liquid, fixed-income market in a relatively short period
This is because ABS represents a technological advance and not a complex regulatory arbitrage
Indeed, ABS draws its lifeblood not from exploitation of regulatory loopholes but from the way it handles risks
It makes risks of lending more transparent and it allocates them far more precisely to the players best able to handle them
Far from threatening the well-being of well-managed banks and thrifts, this new technology could enable them to prosper
11/18/2018

4. What is Asset Securitization?
Asset-backed securitization (ABS) involves
combining loans of similar characteristics,
creating credit-enhanced claims against the cash flow of this portfolio,
selling these claims in the form of securities to capital market investors.
Cash flows from underlying assets support (or secure) payments to investors
Can be structured as sale of asset or simply as off balance sheet funding
11/18/2018

5. Asset Backed Securitization: Factoid
Securitization started in the U.S. in 1970
$4.02 trillion residential mortgages outstanding in US
About 57% (or $2.29 trillion) have been securitized
Roughly 80% of securitized mortgages have agency labels
guaranteed by GNMA or issued by FNMA or FHMC
Appeared in UK in 1985 with no government guarantee
Wide range of other assets have been securitized since 1984
credit cards, auto loans, trade receivables, equipment leases, student loans, junk bonds, telephone receivables
11/18/2018

6. Exhibit 1.1 Traditional Lending System: Bundles operations and risks
Originate
& underwrite
Guarantee
Book
Fund
Service
Why Does Traditional Lending Foster Bundling of Operation? -- funding advantage !!!!!
(1) Interest rate ceiling
(2) Underpricing of deposit insurance
(3) Entry restrictions
(4) Tax rules
Chief advantage of traditional credit system: personal relationship between borrower and the lender develop
11/18/2018

7. Why Traditional Bank Lending System is Costly
Financial institutions tend to concentrate credit risks on their portfolio – geographically, by industry, demographically
Financial institutions face other noncredit risks in the normal course of business, which are extremely difficult to eliminate
Interest rate risk
Prepayment risk/Reinvestment Risk
Liquidity and Marketability Risk
Discretionary lending activities
Lenders can use funds obtained from depositors and other creditors to fund existing loans as well as future loans
Since depositors, note holders and other senior creditors absorb these risks, capital markets require excess layer of equity protection from financial institutions
11/18/2018

8. Primary Impetus for Securitization
Erosion of Funding Benefits
Removal of interest rate ceiling
Increase in price of deposit insurance
Capital requirements and other regulatory taxes
Asset-Liability mismatch
Liquidity needs
Advances in information technology
Reduce information gaps between originators and investors
Investors are able to assess payoff attributes of loans
Information technology is key to originating, servicing and monitoring provided by financial institutions
11/18/2018

9. Securitization Unbundles Traditional Lending Operations and Risks
At the heart of new technology is the structuring process
Structuring involves the explicit underwriting and absorption of credit risk, through credit enhancement, and the use of special purpose vehicle
Structuring converts the loans into securities and transforms the quality of their risk and return to the end investors
In purchasing an asset backed security such as agency MBS, the investor assumes no credit risk but does assume prepayment risk
11/18/2018

10. Exhibit 1.2 Asset Securitization Unbundles Operations and Risks of Traditional Banking System
Credit
Enhance
Originate
Structure
Trade
Service
Place
Thrifts
Commercial
banks
Finance
companies
Mortgage
Investment
banks
Retail
securities
firms
Insurance
company
Government
entity
Banks
Internal
guarantee
Pension
funds
Thrifts
Insurance
companies
Banks
Individuals
Investment
banks
Commercial
Investment
banks
Commercial
Mortgage
Asset securitization unbundles the various operations in connection with traditional
lending. So under the new technology several different institutions might be involved
each playing a different functional role
11/18/2018

11. Figure 1.3: How Securitization Unbundles and Diversifies Risk
Other Credit
Enhancers
Takes Catastrophe credit risk
Syndicate
Originator
Credit
Enhancer
Takes market risk
but little credit risk
Takes prepayment
risk
Investor
Takes
first-loss
risk
Rating
Agency
11/18/2018

12. ABS Manages Risks Better
ABS isolates the loans to be securitized from the originators balance sheet
The risks of ABS is separate from general risk of the originator
Pooling and sale of assets create transparency and reduce uncertainty for capital market investors
Investors are funding clearly delineated existing pool of loans
Not funding future discretionary lending or risk-taking the original lender may undertake
ABS typically splits credit risk into several levels and places it with institutions in the best position to absorb it (see exhibit 1-3)
ABS also segment interest rate risk and prepayment risk so they can be tailored and placed among appropriate investors
11/18/2018

13. Benefits of Securitization
Securitization isolates credit of assets backing an issue from credit of the originator -- risk transparency
Means of channeling different sources of capital into consumer lending -- institutional and geographic
Provides link between primary market for consumer credit and capital markets -- market integration
Provides a means of transforming illiquid assets into liquid tradable securities -- lower cost of capital
Means to participate in traditional lending without having to originate or service -- economies of scope
11/18/2018

14. Incentives to Securitize Assets
Capital Requirement
Banks are required to maintain adequate capital to cover risks assumed in making loans
Reserve Requirements
Central Banks or Monetary Authorities also imposed noninterest-bearing reserve requirement on the liabilities of banks
Deposit Insurance
Banks must annual deposit premium if such a program exists
11/18/2018

15. The total size of mortgage pool = 1,000x$100,000 = $100 million.
Effects of Securitization on Balance Sheet of Financial Institution seeking to Securitize Mortgages
Suppose a bank has just originated 1,000 new residential mortgages in its local market. Each mortgage is worth $100,000.
The total size of mortgage pool = 1,000x$100,000 = $100 million.
Suppose the bank relies mostly on liabilities eg. demand deposit and its own capital to finance these mortgages.
Assume risk-based capital requirement is 12%.
Assume each $1 of mortgage must be backed by some capital, and the risk-adjusted value of residential mortgages is 50% of face value.
Also assume reserve requirement is 10% and there is deposit insurance of 27 basis points.
11/18/2018

16. Incentive to Securitize Mortgages
Bank faces three levels of regulatory costs:
Capital requirement ( 12%)
Reserve requirement (10%)
Deposit insurance (27 bsp)
Two risk exposures:
Gap exposure
bank funds 30-year mortgages with short term liabilities and demand deposits
Illiquidity exposure
Risk of conducting mortgage asset sale at short notice to meet unexpected demand deposit withdrawal
Issue: How to mitigate these problems
11/18/2018

17. Decision Analysis
Bank capital (equity) needed to back $100 million of mortgage portfolio would be:
$100 M x.5x.12 = $6 million
The difference between $100M and $6M is $94, but liabilities to be issued by the bank must be
$94/(1-.10) = $104.44M
Reserve requirement (noninterest-bearing)
($104.4)x(.1) = $10.44
Bank really has only $94M of the $104.4 to fund the mortgages
With deposit insurance premium of 27 basis points, the insurance premium is
$104.4Mx.0027 = $281,880
11/18/2018

18. Exhibit 1-7: Banks’ Balance Sheet After Securitization
Exhibit 1-6: Bank’s Balance Sheet Before Securitization
Assets
Liabilities
Cash Reserves $10.44
Mortgage Loans
$110.44
Demand deposits $104.44
Capital
$110.44
Exhibit 1-7: Banks’ Balance Sheet After Securitization
Assets
Liabilities
Cash reserves $10.44
Cash proceed from asset
securitisation
$110.44
Demand deposits $104.44
Capital
______
$110.44
11/18/2018

19. Bank’s Situation after Securitization
Illiquid mortgages replaced by liquid cash
Asset liability mismatch is reduced
Bank has enhanced ability to deal with regulatory costs or taxes
Capital requirement is reduced since risk-adjusted asset value of cash is zero
Reserve requirement and deposit insurance are reduced if part of cash are used to retire demand deposits
Note: The real logic of asset securitization is that cash proceeds from the mortgage sale can be reused to create more mortgages and book the fees
11/18/2018

20. Necessary Conditions for Asset Securitization
Predictable risk characteristics
history of payoffs, delinquencies, and write off that can be used to guide future prepayment and default behavior
Diversifiable risk characteristics
sizable number of loans allows for diversification of risk necessary for securing credit enhancement
Predictable duration
investors (pension funds, insurance companies etc) want to have good idea about prepayment behavior
Homogeneity and standardization and relative ease of valuation of assets
30-year mortgages were first to be secuiritized in US
11/18/2018

21. Do Financial Institutions have the Size and Ability to Generate and Support ABS?
Financial institutions must attain certain economies of scale in origination, packaging, and servicing for securitization to make economic sense
In US markets economics of ABS are such that issues must be in the range of $200 to $300 million
The financial institution must be large enough with proper system and procedures to support and service assets
Sophisticated system for tracking the cash flows (principal, interests, prepayment) from collateral.
Securitization is computer, legal, and accounting intensive.
11/18/2018

22. Types of Asset Securitization Contracts
There are three basic structures of asset-backed securities
Pass-Through Security
Pass-throughs guaranteed by GNMA, Ginnie Mae
Pass-through guaranteed by FHLMC, or Participation Certificates (PC)
Pass-Throughs guaranteed by FNMA, or Mortgage-Backed Securities (MBS)
Pay-Through Security
Collateralized Mortgage Obligations (CMOs)
Asset Backed Bonds (ABB)
11/18/2018

23. The Pass-through Security
The creation of Pass-through security starts with the pooling of assets (mortgages) with similar characteristic by originator.
The pool of mortgage assets are sold to a grantor trust who issues certificates.
The certificates (equity interests) are in turn sold to investors which entitles them to receive pro rata cash flows from pool of mortgages.
Assets are removed from originators balance sheet
The Pass-throughs provide only one prepayment risk profile
11/18/2018

24. Asset Securitization Issue Structured as a Pass-through
Exhibit 1-8
Asset Securitization Issue Structured as a Pass-through
Purchases Credit Enhancement
Credit
enhancement
Sells
loans
Credit Enhancer
Originator/Seller
Special Purpose
Vehicle
Transfer
rights under
loan contracts
Cover
Loss $
Trustee
Issues Certificates
Rates
issue
Rating Agency
Investment
Banker
Distributes certificates
Proceeds( $) go to seller
Investors
11/18/2018

25. Asset-Backed Bond Structure
The second type of ABS is asset-backed bonds (See Exhibit 1.9)
Like the PTS, the ABB is collateralized by a portfolio of loans or receivables
The originator in ABB segregates a group of assets and transfers the assets to a wholly owned subsidiary, e.g captive finance company
The subsidiary issues notes secured solely by its assets and any credit enhancement obtained for the purpose and sells them to investors
However, unlike PTS, there is no direct link between the cash flow on the underlying loans backing the bonds and the interest and principal payments on the bonds -- the bonds are in effect general obligation of the issuer
However, if the issuer were to fail the bond holders have first claim to a segment of the financial institutions assets --- ie the ABB is in effect a senior debt
Unlike PTS the assets remain on the originator’s (consolidated) balance sheet.
11/18/2018

26. Exhibit 1.9: Asset Backed-Bond Structure
Originator/
Servicer
Pays insurance
fees for credit
enhancement
Rating
Agency
Provides credit
enhancement
Finance Company
(subsidiary of
originator)
Transfers loans
Trustee
Principal & interest
Issues notes
Investment
Banker
Proceeds from sale
of notes
Disburses cash flow to
investors
Distributes
notes
Note: (1) typically the pool will be
overcollateralized to minimize the
impact of prepayment.
Investors
11/18/2018

27. Asset Backed Bond Has Lower Funding Costs
First, the issuer is required to overcollateralize, that is set aside more assets or loans than there are bonds.
Second, the assets are typically marked-to- market to ensure maximum coverage
Third, the trustee periodically monitors the segregation of assets to ensure that the market value of the collateral does not fall below that of the bonds.
Fourth, ABB bondholders have first claim to a segment of the issuer’s assets in case of insolvency or failure of the issuer.
The combination of these factors results in higher rating for the ABB than the rating of the financial institution issuing them.
This results in lower cost of funding especially for an originator with lower credit rating, and a better matching of assets and liabilities
11/18/2018

28. Problem with Pass-through Securities
Investors in pass-through security grantor trust cannot be sure what the Weighted Average Life (WAL) of their certificates will be – single prepayment risk profile
Contraction risk
lower interest rates increase prepayment rate
Extension risk
higher interest rate decrease prepayment risk
Is there a way to manage prepayment risk?
11/18/2018

29. Pay-through structure: Collateralized Mortgage Obligations (CMOs)
Designed to take advantage of yield curve by assigning cash flows to classes of bonds (tranches) designed to better meet investor needs.
Pay-through structure permit the restructuring of cash flows to offer bonds of varying maturities to investors.
Sequential distribution of cash flows so that each bond varies in the amount of prepayment risk it absorbs
Quarterly or semi-annual payment rather monthly
Can qualify as sale of asset with trust (REMIC) or as debt obligation
11/18/2018

30. Exhibit 1-10: Pay-Through Security Structure
Sales Proceeds $
Sales Proceeds $ $ $
Sells mortgage
backed
notes
Bond Investors
Servicing
fee
Originator A }
Limited Purpose
Corporation B
Investment
Bank D
Class A
3 yr
Sells
Mortgages
Or Pass-through $
5 yr
Class B
Trust
(REMIC)
Class C
10 yr
Note:
(1) Issuer owns mortgages or collateral
(2) Issuer simply sells bonds backed by the assets or collateral
(3) Interest income from assets is taxable to issuer
(4) Issuer may deduct interest payable to bondholders
(5) Deduction of interest depends on whether transaction is “true sale” or debt
Class Z
15 yr
Residual
Class
11/18/2018

31. Residual Class
CMOs vary somewhat according to the issue, but they share a common feature: overcollateralization
At every point in time, the amount of outstanding bonds must be small to assure that the cash inflows from the remaining collateral will be sufficient to pay the promised obligations to bondholders
The overcollateralization is the residual class, which is in effect the equity supplied by issuer to support the bonds
The value of the residual class increases as interest rate increases, while normal bond values fall with interest rate increase – exhibit negative duration
Banks take advantage of this negative duration to hedge their regular bonds and fixed income portfolios
11/18/2018

32. Innovations in the CMO
This instrument first appeared in the US in 1984
Its extraordinary success suggests that it represents a significant innovation and it satisfies previously unfilled niche
CMO’s provide return and risk combination that is impossible to obtain by direct investment in MBS or mortgages
For investors, CMOs provide risk reduction across a spectrum of holding periods
Some securities created as part of CMO offer an enhanced ability to hedge interest rate risk exposure or bet on direction of interest rate
CMOs are an excellent example of financial innovation that makes the market “more complete”
Thus CMOs create value; mortgages are now selling for lower yields (an thus higher prices) than before the appearance of the CMO
11/18/2018

33. Arbitrage Opportunities in the CMO
It is said that the repackaging of cash flows in the CMO results in the sum of the parts (class of bonds) being greater than the value whole (collateral)
How can this be possible?
pricing at various interest rates that more closely tracks the yield curve results in lower blended yield (and thus higher price) to investors and lower blended cost to issuer
This is the value additivity of CMOs
11/18/2018

34. Exhibit 1-11: MORTGAGE SECURITIZATION
TASK SEQUENCE
TRADING
WAREHOUSING
SECURITIES
INVESTORS
BORROWERS
ORIGINATION
UNDERWRITING
STRUCTURING
CLOSING
DISTRIBUTION
MORTGAGE(S)
ADMINISTRATION
TRANSFILE
Mortgages
RATING
SERVICING
MASTER
SERVICING
CREDIT
ENHANCEMENT
DUE
DILIGENCE
11/18/2018

35. Players in Mortgage Securitization
Issuer
Investment Bank
Rating Agency
Credit Enhancer
Master Servicer
Bond Trustee
Owner Trustee
Initiates transaction
Underwrites and structures transaction
Rates the bonds and structure
Improves the bond rating
Collects collateral payment and takes care of delinquencies and defaults
Pays bondholders and trust expenses
Supervises owner’s interest in trust’s excess cash flow
11/18/2018

36. Players in Mortgage Securitization
Owner
Lawyer
Accountant
Investor
Owns residual interest in trust
Provides legal opinion of trust structure
Provides due diligence and post-closing services
Purchases bonds for investments
11/18/2018

37. Exhibit 1-12: Necessary Transaction Support Functions for a
Standard Mortgage Backed Security (MBS)
MONTH END PROCESSING
DAILY PROCESSING
Create
File
Excess
Obligors
Remit
Payments S E R V I C
Produce
Reports
Process
Payments
Deposit S E R V I C
Produce
Settlement
Statements
Apply
Funds
Distribute
Statements
Reports
Total $
Deposit
Disbursement
Instructions
Collection/
Disbursement
Account
Transfer Deposit
Rating Trustee
Agency
Investment Credit
Banking Firm Enhancement
Statements
Collection
Account
Invest Funds
11/18/2018
Investors
Price/Yield Tables

38. Innovations in Asset Backed Securitization
There are four innovations that investment bankers use to add value to asset back securities
Special Purpose Vehicle
This is the trust or corporation that is established for the sole purpose of owning the loans
Its exact form depends on specific nature and risk of assets, legal, regulatory, tax issues and objective of issuer/fund raiser
In every case it sole purpose is to isolate the risk inherent in the loans from all other risk of the issuer
11/18/2018

39. Innovations in Asset Back Securities
Pooling of loans
Diversifies credit risk
Credit structuring and enhancement
Credit enhancement raises credit risk of the pool to investment grade levels
Attractive to investors such as pension funds, insurance companies and individuals
Repacking of cash flows into tranches
Tailor cash flows to specific investors
Short tranch for thrifts and longer term for pension funds
11/18/2018

40. Economics of Asset Securitization Issuers Prospective Benefits
Management of interest rate risk
Pass-through structure and CMOs can mitigate asset/liability maturity gap for thrifts with fixed rate loans
Replacing mortgages in portfolio with pass-throughs and CMOs helps thrifts to diversify prepayment risk
Mortgage backed bonds could also be used to lengthen the average maturity of liabilities
While other products can be used to hedge interest rate risk, securitization may be superior in terms of transaction cost and overall effectiveness
11/18/2018

41. Economics of Securitization Issuers Prospective Benefits
Increased Liquidity
Securitization achieves initial measure of liquidity before trading in two ways
Third party credit enhancement reduces informational asymmetries between issuer and investors
Pooling of large number of assets and the subsequent partitioning of cash flows --- CMOs
The importance of the issuer’s private information about future portfolio returns diminishes as one moves up the priority ladder
11/18/2018

42. Economics of Securitization Issuer’s Prospective Benefits
Enables banks to focus on key economic functions of intermediation
Origination, servicing and monitoring are three activities that banks generally perform more efficiently than others
Absent regulatory help it is not clear banks and thrifts have any special advantage in funding
11/18/2018

43. Economics of Securitization Issuer’s Prospective Benefits
Facilitates the avoidance of “adverse selection costs”
Investors who provide funding through deposits and equity to the bank are in effect purchasing claims against the bank’s entire asset portfolio
Investors in securitized loans are purchasing claims only against the assets
With little informational asymmetry there is virtually no adverse selection cost – lower funding cots
11/18/2018

44. Economics of Securitization Issuer’s Perspective
Avoidance of regulatory taxes
Banks avoid regulatory taxes such as reserve and capital requirements and deposit insurance premiums
Because regulatory taxes are flat taxes securitization avoids “subsidization” of low quality assets by high quality assets
11/18/2018

45. Economics of Securitization: Investors Perspective
Provides investors with access to higher credit quality claims than otherwise
Typically claims offered via securitization are often of higher quality than the institution itself
Provides investors with greater variety of cash flow streams than the underlying asset -- CMOs
Liquidity
Asset backed securities market is big and trading is very active
11/18/2018

46. Potential Costs
Costs of public/private credit risk insurance and guarantee
Cost of overcollateralization
Cost of pooling/packing/underwriting
Valuation and packaging costs
Other costs: legal fees, accounting fees, reporting fees, registration fee, etc
11/18/2018