The research paper is an attempt to explore the historical background of securitization and how this vital funding source has spread its tentacles across the globe from its humble beginnings back in the late 1970s (Hill 2002). A scholarly definition of the term securitization is also provided. In addition, the research paper shall also endeavor to explore the structure of securitization, starting from pooling and transfer of the contractual debt, followed by the issuance of the same, credit enhancement, structures of payment, as well as structural risk. An example of securitization in the United States is provided, along with the impact of the 2008 subprime crisis on securitization. Finally, the research paper shall also examine the motives of securitization. Specifically, the benefits and risks of securitization to both the issuer and investors shall be examined.
History of securitization
The history of securitization dates back to 1909, when Samuel W. Strauss is thought to have started the first mortgage security. Securitization of mortgages gained a lot of popularity in the two decades that followed but it plummeted with the start of the Great Depression. However, this popularity would once again be renewed in the 1970s, thanks to the National Mortgage Association, sponsored by the US government. Mortgage insurance companies helped to popularize securitization in the 1920s with the sale of mortgage participation certificates, which they guaranteed (Chorafas 2005, p. 137). Investors in the real estate market actively traded in these pools of mortgage loans up to the start of the Great Depression, when the market crashed.
However, securitization would once again gain immense popularity later in the 1970s. This was before the economy had been dealt a big blow by the twin energy crises experienced in the early 1970s. Consequently, banks were faced with severe disintermediation. Businesses were forced to replace private credit enhancements by first ensuring that their pools of assets were over-collaterised. Thereafter, businesses improved structural and third-party enhancements (Sabarwal 2005). By 1985, there securitization techniques were already being used in automobile loans. A year later, the same techniques were used in the sale of credit card, realizing $ 50 billion in revenue. Since this initial transaction was a success, credit card receivables could now be accepted as collateral by investors (Raynes & Rutledge 2003). Also, banks developed various structures to facilitate the normalization of cash flows.
The insurance and reinsurance markets started embracing securitization technology in the early 1990s. By 2006, the activity had grown into a $ 15 billion industry. In 1997, a CRA (Community Reinvestment Act) loans were started publicly for the first time in the securitization market (Morrison 2005, p. 623). These loans target moderate and low income borrowers. By 2004, home equity-backed securities were the main sector in the securitization market, at 25 percent. Others included credit-backed securities at 21 percent, while collaterised debt obligations were at 15 percent. Although the UK was the first country in Europe to adopt the securitization of mortgages during the late 80’s, however, the technology took more than a decade to take off because innovative structures had already been implemented across the various asset classes, including insurance-backed transactions, and UK Mortgage Master Trusts. In 2008, the subprime mortgage crisis precipitated the credit crunch, and this weakened the securitization market (Goel 2009, p. 65). There was a resultant rise in interest rates for hitherto securitized loans including home mortgage, auto loans, student loans, and commercial mortgage.
Securitization is defined as the financial practice that transforms a claim into liquid stock. The transfer of the claim (usually in the form of a non-liquid asset) to a third party takes place once the price has been paid to the assignor (Stone & Zissu 2000, p. 133). To start with, the asset has to be placed on the funds market. It is important to note that the transfer ensures an immunization of the assets in readiness for a possible insolvency. As such, one of the fundamental elements of securitization is bankruptcy remoteness. Securitization enables a company to pool most of its contractual debts. These may include residential and commercial mortgages, as well as auto loans. The different investors involved often receive the principal amount and the interest accruing from the debt on a regular basis. Pools of securitized assets are characterized by a high level of granularity and this effectively helps to mitigate the possibility of individual borrowers encountering a credit risk. Securitized debt is different from general corporate debt in terms of credit quality in that it is non-stationary owing to its volatility as a result of structure-and-time dependent changes.
Structure/ Procedure of securitization
Pooling and transfer
Initially, the originator, often a company keen on restructuring debt, raising capital or adjusting its finances, owns the assets in question. Traditionally, companies could only raise the needed capital through issuing ob bonds, taking a loan, or by stock issue. Offering stocks dilutes the control and ownership of a company (DeMarzo 2005, p. 8). On the other hand, bond or loan financing tends to be quite expensive owing to the company’s credit rating, coupled with the expected increase in interest rates. This is where securitization comes in. It involves the pooling of diverse portfolio of an organization’s assets after which they are then transferred to the issuer. A financing or sale of such assets is often governed by accounting standards. In case of a sale, the originator gets the nod to strike out the transferred asses from the company’s balance sheet. The structural issue involved in the securitization of assets means that the originator has to be assisted by the arranger (an investment bank) to set up the transaction process.
Tradable securities are needed to finance the purchase of the assets of the originator. Interested investors have the choice a private offering if they are an institution. Otherwise, the securities are available in open market. The securities are then rated by a credit rating agencies and a correlation drawn between the performance of assets and the securities (Gorton& Souleles 2005). This way, the investors can have arrived at a more informed decision. In case of static assets, the underlying collateral has to be assembled by a depositor.
Credit enhancement and tranching
Securities emanating from a securitization deal tend to be “credit enhanced”. This means that their credit quality is usually higher compared with the underlying asset pool or the originator’s unsecured debt. Consequently, investors are more likely to obtain the cash flows that they deserve, thereby increasing the credit rating of the securities relative to the originator. In case of individual securities, these usually grouped into various categories of subordination (DeMarzo 2005, p. 11). Each of these groups (often known as a trache) is characterised by a different risk exposure, that is, senior class or junior class. The senior classes get the privilege to lay the first claim to the cash received by the issuer. Once all the more senior classes have received payment, then the junior classes get their repayment. In case the underlying asset pool is unable to finance the securities sufficiently, the subordinated tranches are the first to absorb the ensuing loss. The upper-level tranches only get affected if the losses are more than the combined subordinated tranches.
Senior securities benefits from an AAA rating, which carries a lower risk. A lower credit rating than this is indicative of a higher risk. The equity class is the most junior class and is also highly susceptible to payment risk. In case the underlying assets happen to be mortgages, there may be the need for a special class that would essentially take in the early repayments (DeMarzo 2005, p. 12). However, it becomes hard to differentiate between revenue generated from principal repayment or income in case of income- based transactions. An example would be rental deals whereby all he income realized offsets bonds cash flows once they are due. Credit enhancements act as a cushion to the cash flows of a given security. With added protection, a security could also attain a higher rating. There are other ways of enhancing credit besides subordination including over-collaterisation, a spread or reserve account, and cash funding.
The payments of a security are collected by a servicer, who also monitors the assets. Also, loan repayments have to be paid to the issuer. Since the servicer manages the collection policy, it has a huge impact on the flow of cash to the investors (Sabarwal 2005). The servicer not only has he power to influence the process of recovering the loan, but also the charge-offs as well. Once payments and expenses have been settled, the remaining income is usually accumulated in a spread or reserve account. The additional income thereafter is usually sent back to the seller.
Most securitizations tend to be amortized, that is the payback period of the principal amount has to extend over the entire duration of the loan, as opposed to making a single lump sum once the loan matures. Fully amortising securitizations therefore require fully amortising assets as collateral. These include home equity loans, student loans, and auto loans. Prepayment rates differ, and are often determined by the nature of the underlying asset pool. Investors need an amortization structure that is well controlled so that the repayment schedule remains very predictable (Gorton & Souleles 2005). There is often a fixed “revolving” phase and during this time, the only payments made are hose that involves interest. This is often an attempt at ensuring that the investors get back the principal in specific periodic payment stages, often within a year.
The soft bullet structure is the most common. Under this structure, the anticipated maturity date does not guarantee the final bullet payment (Fabozzi 2001). Nonetheless, most of these securitizations are characterized y early payment. The hard bullet is the second form of bullet structure. The soft bullet structure acts as a guarantee that the principal amount shall be paid in full on the maturity date without any delay.
Structural risks and misincentives
To a mortgage originator, the volume of the loan involved appears more attractive, in comparison with the quality of the credit. This is because the loan volume enables the originator to assume a risk of the assets in the long-term without having to absorb the ensuing risk. They can easily profit from the fees of securitization and origination, and hence the lack of motivation.
Types of securitization
There are different types of securitization, all of which involves the establishment of special purpose vehicle charged with the responsibility of making the securities available to the public for purchase (Keiding 2009). Due to this construction, it means that there is an extra layer between the investors and the originating bank. Should a loan defaulting occur the other assets of the bank cannot be tied to the loan? Although SPVs may be established with a view to serving a specific portfolio, sometimes the SPVs may also deal with various securitization arrangements.
Here, investors obtain ownership of the assets. The portfolio is first placed in a trust to facilitate the purchase of certificates of ownership by investors. The issuer of the loan (usually a bank) services the portfolio, in addition to collecting the interest accruing from the principal (Keiding 2009). Thereafter, the issuer deducts the agreed fee for services provided before passing the reminder of the revenue to the investors. In case of a fixed property, the certificate holders retain ownership of the mortgages and loans. Accordingly, the loans do not feature in the balance sheet of the originator. A static pass-through is a classic example of a pass-through securitization. A credit enhancer is usually part of the setup. This enables the investors to purchase the debt certificates with relative ease. The credit enhancement is actually a guarantee against possible defaulting. This means that even if the lender refuses to pay, the investors are guaranteed of a definite payoff.
The credit default swap is a perfect example of this form of insurance arrangement. It is usually purchased in the market as opposed to having the investor sign with an insurance agency. The credit enhancer receives a certain fee from the originator. Freddie Mac and Fannie Mae, some two mortgage credit institutions in the US that became quite notorious in the 2008 financial turmoil, are some of the most well-known examples of pass-through. The first pass-through security was developed by Freddie-Mac in 1971, in the US. A similar construction was developed a decade later by Fannie Mae. The two securities are supported by privately uninsured and insured mortgage loans (Keiding 2009). Freddie Mac guarantees the payment of principal in full and the monthly interest as well. However, the credit institutions do not guarantee the timely payment of the principal. There is a difference between a static pass-through and a dynamic one, with respect to the loans portfolio structure selling the securities. In a dynamic pass-through security, the loans tend to be short-term. On the other hand, the maturity period of securities issued is much longer. As such, expired loans from the pool of assets have to be replaced with new ones. As such, the SPV has a revolving period whereby the certificate holders only receive interest payments. The design is very common with credit card loans.
Here, the investor does not get to own the assets; they remain with the originator. However, the revenue generated by the assets is used to service the bonds. This construction is similar to the CMOs (collateralized mortgage obligations) that Freddie Mac issued in 1983 (Keiding 2009).
With this type of securitization, the originator gets to retain assets as part of its balance sheet. The ensuing cash flow is attributed to the underlying assets but the investors cannot lay claim to it (Keiding 2009). The assets are instead transferred to a trustee. In turn, the trustee pays the investors on the basis of a fixed schedule.
Motives for securitization
Benefits to the issuer
Decreases funding costs: securitization enables a BB rated company but whose cash flow worth is rated AAA to obtain a loan on the AAA rating (Dwight Asset Management Company 2005).
Reduces capital requirements: regulatory and legal issues have forced some companies to embrace a predetermined leverage level; thus securitization has gained popularity with such firms. Securitizing some of the firm’s asset allows such companies to strike out the assets in questions from the balance sheet and at the same time, still retain the “earning power” associated with these assets (Dwight Asset Management Company 2005).
Decreased asset-liability mismatch: In most finance companies and banks, the liability book is tied with the borrowings. Such borrowings are often costly.
- Transfer risks: Through securitization, it is easier to apportion a risk to a willing entity from an unwilling risk. Examples here include entertainment securitizations and catastrophe bonds (Dwight Asset Management Company 2005).
- Liquidity: securitizing the investment book frees up the cash flows for investment or spending.
- Locking in profits: securitization may lock-up the profits of a company as well (Dwight Asset Management Company 2005). This passes on the super-profits that may be generated, as well as the non-emergent risk of profit.
Disadvantages to issuer
Costs: the securitization exercise is costly to the issuer in terms of the legal fees ad management fees involved. Other costs incurred include management and administrative costs, as well as rating fees.
Lowered portfolio quality: in case a company is securitizing out its AAA risks for example, the quality of the residual risk may deteriorate
Risks: securitization may involve credit enhancements and par structures prone to such impairment risks as credit loss and prepayment, and more so in case the structures have retained strips (Dwight Asset Management Company 2005).
Size limitations: one of the disadvantages of securitization is the issue of size. In this case, it may not be cost-effective to undertake either a medium-sized transaction or a small one.
Benefits to investors
With securitization transactions, investors have a chance to realize a higher return, albeit on a ‘risk-adjusted basis’. Also, investors have the chance to invest in a given pool of assets of their choice. This is because securitization enables facilitates the establishment of AAA or AA bonds of high quality. There is also the benefit of portfolio diversification to the investors. Through securitization transactions, investors are also in a better position to separate the credit risks of the parent entity with the securitized assets.
Potential risks to investors
Default is the greatest risk facing investors of securitized transactions. This normally happens when the borrower is unable to honor the obligation of submitting interest payment in a timely manner (Thomas 2001). One of the fundamental indicators of a security is its credit rating. For example, whereas lower class issues are often characterized by a lower rating, on the other hand, the opposite is true for senior classes.
Impact of subprime crisis in the U.S on securitization
The 2008 subprime crisis may be said to have borne a direct correlation with securitization from a fundamental point of view. This is because of the manner in which the investors, rating agencies and all modeled the risks associated with the loans in the securitization pools. The model of correlation, in this case meant to assess the statistical relationship between the risk of defaulting one loan with that of other loans, hinged on a technique modeled by David X. Li, a statistician, called a ‘Gaussian copula’ technique (Goel 2009, p. 66). Although the technique gained a lot of popularity by employing a simple correlation approach, nonetheless, the market participants only became privy to the flaws inherent to the technique after massive amounts of CDOs and ABSs tied to subprime loans had already been sold and rated. Once the investors realized this, this stopped to purchase subprime-backed securities. This technically acted to stop any potential extension of subprime loans by mortgage originators. However, the impact of the crisis could already be felt.
Although the first mortgages security was started as early as in 1909, securitization only gained popularity in the late 1970s. The housing market was the first to embrace securitization, followed by businesses, forced to replace private credit enhancements. The automobile loan was the first non-mortgage asset to embrace securitization. Securitization transforms a claim into a liquid stock. The procedure of securitization starts with the pooling of diverse portfolio of a company’s assets, followed by the transfer of the same to the issuer. The issuance of tradable securities to finance the purchase of assets can either take place in an open market or through a private offering. A servicer then collects the security payment, in addition to monitoring the assets. Most securitizations are fully amortized, meaning that they require fully amortized assets as collateral. The different forms of securitization include pay-through, asset-backed bonds, and pass-through. The issuer’s motives for securitization are different from those of the investors. For example, the issue could benefit from decreases in funding costs, reduced capital requirement, and decreases in asset-liability mismatch. On the other hand, investors could benefit from higher returns, and a diversified portfolio to invest in.
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