CAPITAL MARKETS

6. SECURITIZATION

Stefano Bonini

ENTER THE WORLD OF GLOBAL FINANCE

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SECURITIZATION
•  The pooling and repackaging of loans into securities (structured products).
•  Securities are then sold to investors, who become the owners of the loans
represented by those securities.
•  Benefits for both originators and investors
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BENEFITS - ORIGINATOR
General
•  transform illiquid assets into marketable securities
•  off balance sheet financing - capital requirement ratios
•  higher efficiency - optimisation of debt/equity ratio (assets vs ongoing business)
•  credit quality enhancement
•  diversification of funding sources
Economic
•  ROA and ROE
•  efficient use of capital
Financial
•  matching asset/liability duration
•  selection of investors base
•  cost
•  financial market visibility
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BENEFITS - INVESTOR

•  yield premium - positive spread (anticipate future income)

•  asset diversification
•  duration
•  tailor made structures
•  yield curve
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WHY SECURITIZATION A BIG DEAL?

•  Rebalanced demand and supply that were completely displaced

•  Allowed better risk allocation (supposedly…):
-  Low risk (pension, insurance, universities, …) got their “safe” AAA slice
-  High yield (investment banks, hedge funds,…) got their nice A/BBB with equity like returns.
-  Banks got rid of the risk in their BS and kept on originating (supposedly their job)
-  And, most importantly, EVERYTHING has been securitized : from private equity and
corporate debt (CLO), to mortgages (MBS), to straight debt and working capital financing
(CDO), to credit cards and auto, and…you name it!!
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GLOBAL VOLUME OF AAA SUPPLY….

….AND AAA BUYERS AUM (PENSION FUNDS ONLY!) 7
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SECURITIZATION
Type of structured products
MBS = Mortgage-Backed Securities typically defines pass-through mortgage bonds (agency pass-through and nonagency pass-through).

CMBS = Commercial Mortgage-Backed Securities, which are trust certificates (bonds) backed by a pool of commercial mortgage loans. The
certificates are tranched on the basis of prepayment and credit.

CMO = Collateralized Mortgage-backed Obligations, which are pool of pass-through mortgage bonds tranched to reflect the degree of
sensitivity to prepayment (particularly, agency CMO).

ABS = Asset Backed Securities, for example home equity loans (HEL), credit cards, etc. These are securities backed by receivables [payments]
that are either secured (HEL) or unsecured (credit card), tranched on the basis of prepayment and default risks.

CDO = Collateralized Debt Obligation, for example, ABS CDO which consist of a portfolio of different ABS bonds, and the payments to the
holders of these trust certificates are derived from the cash flows of the ABS bonds.

CBO = Collateralized Bond Obligation, for example high yield [emerging market] CBO which consist of a portfolio of different high yield
[emerging market] bonds.

CLO = Collateralized [leveraged] Loan Obligation which consist of a portfolio of different leveraged loans.

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IT ALL BEGAN WITH MORTGAGES

1.  Prime versus Subprime Mortgages

a.  Prime: borrower meets traditional lending standards
b.  Subprime: borrower does not quality for prime loan
i.  Relatively lower income
ii.  High existing debt
iii.  Can make only a small down payment
2.  Insured versus Conventional Mortgages
a.  Insured: loan is insured by FHA or VA
b.  Conventional: loan is not insured by FHA or VA but can be privately insured
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RISK FROM INVESTING IN MORTGAGES

1.  Credit risk: the risk that borrower will make a late payment or will default.

2.  Interest rate risk: the risk that value of mortgage will fall when interest rates rise.

3.  Prepayment risk: the risk that the borrower will prepay the mortgage when interest
rates fall.
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CRITERIA USED TO MEASURE CREDITWORTHINESS

1.  Level of equity invested by the borrower

a.  The lower the level of equity invested, the higher the probability that the borrower
will default.
b.  One proxy for this factor is the loan-to-value ratio, which indicates the proportion of
the property’s value that is financed with debt.

2.  Borrower’s income level - Borrowers who have a lower level of income relative to
the periodic loan payments are more likely to default on their mortgages.
3.  Borrower’s credit history - Borrowers with a history of credit problems are more
likely to default on their loans.
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ABS STRUCTURE
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ABS BASIC STRUCTURE
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VALUATION OF MORTGAGE-BACKED SECURITIES

1.  The valuation of MBS is difficult because of limited transparency.

2.  There is no centralized reporting system that reports the trading of MBS in the
secondary market.
3.  Reliance on Ratings to Assess Value
a.  Investors may rely on rating agencies (Moody’s, Standard & Poor’s, or Fitch).
b.  Many institutional investors will not purchase MBS unless they are highly rated.
4.  Fair Value of Mortgage-Backed Securities - may attempt to rely on prices of MBS
that are traded in the secondary market in order to determine the market value.
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MORTGAGE CREDIT CRISIS

1.  Interest rates increased in 2006, which made it more difficult for existing
homeowners with adjustable-rate mortgages to make their mortgage payments.
2.  Low initial “teaser rates” were expiring and these homeowners also faced higher
mortgage payments.
3.  By June 2008, 9 percent of all American homeowners were either behind on their
mortgage payments or were in foreclosure.
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THE PERFECT STORM: 1

Source: S&P Case-Shiller Index

2…..
17

Source: Mian and Sufi (2008)

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AND 3……KABOOM!!!

Legend
FC – Foreclosure rate
SD – Serious Delinquency (90+ days past due) rate
60+ – 60+ days past due rate
Source: First American Core Logic
THE EVIL SPIRAL… 19

Source: Brunnermeier and Pedersen (2007)

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EFFECTS

1.  Mortgage insurers that provided insurance to homeowners incurred large expenses
i.  ~$2.3 tril in “AAA” guarantees supported by six monolines with less than $20 bil in equity (0.8%).
AIG figures

2.  Some financial institutions with large investments in MBS were no longer able to access
sufficient funds to support their operations during the credit crisis.
3.  Individual investors whose investments were pooled (by mutual funds, hedge funds, and
pension funds) and then used to purchase MBS experienced losses.
4.  International Systemic Risk - Financial institutions in other countries (e.g., the United
Kingdom) had offered subprime loans, and they also experienced high delinquency and
default rates.
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IMPACT OF THE CREDIT CRISIS ON FANNIE MAE AND FREDDIE MAC

1.  The agencies had invested heavily in subprime mortgages that required
homeowners to pay higher rates of interest.
2.  By 2008, many subprime mortgages defaulted, so Fannie Mae and Freddie Mac
were left with properties (the collateral) that had a market value substantially
below the amount owed on the mortgages that they held.
3.  Funding Problems
a.  With poor financial performance, Fannie Mae and Freddie Mac were incapable of
raising capital.
b.  FNMA and FHLMC stock values had declined by more than 90 percent from the
previous year.
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IMPACT OF THE CREDIT CRISIS ON FANNIE MAE AND FREDDIE MAC

4.  Rescue of Fannie Mae and Freddie Mac

a.  In September 2008, the U.S. government took over the management of Fannie
Mae and Freddie Mac.
b.  The Treasury agreed to provide whatever funding would be necessary to
cushion losses from the mortgage defaults.
c.  In return, the Treasury received $1 billion of preferred stock in each of the two
companies.
d.  The U.S. government allowed Fannie Mae and Freddie Mac to obtain funds by
issuing debt securities so that they could resume purchasing mortgages and
thereby ensure a more liquid secondary market for them.
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WHAT HAS REALLY NOT WORKED?

1.  Risk distribution was never achieved because securitized tranches were not really diversified.
2.  Rating agencies did a horrendous job in delivering correct signals. Correlation was way more high
than expected (see article and papers)
3.  Originators stopped doing their job: classical moral hazard issue: Why doing the homework if you
always get an A (actually, a triple AAA?)
4.  Prices artificially growing due to excessive risk taking (also because of 3)
5.  Monetary authorities provided too much cheap money for too much long time.
6.  Regulators seem to have been complacent of the obvious conflict of interest (see 2)
7.  A lot more…
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WHAT HAS REALLY NOT WORKED?

1.  Risk distribution was never achieved because securitized tranches were not really diversified.
2.  Rating agencies did a horrendous job in delivering correct signals. Correlation was way more high
than expected (flawed CDS copula function)
3.  Originators stopped doing their job: classical moral hazard issue: Why doing the homework if you
always get an A (actually, a triple AAA?)
4.  Prices artificially growing due to excessive risk taking (also because of 3)
5.  Monetary authorities provided too much cheap money for too much long time.
6.  Regulators seem to have been complacent of the obvious conflict of interest (see 2)
7.  A lot more…
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WHAT HAS REALLY NOT WORKED?

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WHAT HAS REALLY NOT WORKED?

80.9%=
AAA!!!!!

99%
Investment
Grade!!!!
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WHAT HAS REALLY NOT WORKED?

1.  Risk distribution was never achieved because securitized tranches were not really diversified.
2.  Rating agencies did a horrendous job in delivering correct signals. Correlation was way more high
than expected
3.  Originators stopped doing their job: classical moral hazard issue: Why doing the homework if you
always get an A (actually, a triple AAA?)
4.  Prices artificially growing due to excessive risk taking (also because of 3)
5.  Monetary authorities provided too much cheap money for too much long time.
6.  Regulators seem to have been complacent of the obvious conflict of interest (see 2)
7.  A lot more…
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WHAT HAS REALLY NOT WORKED?

Source: Rajan, Seru, Vig 2010

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WHAT HAS REALLY NOT WORKED?

1.  Risk distribution was never achieved because securitized tranches were not really diversified.
2.  Rating agencies did a horrendous job in delivering correct signals. Correlation was way more high
than expected
3.  Originators stopped doing their job: classical moral hazard issue: Why doing the homework if you
always get an A (actually, a triple AAA?)
4.  Prices artificially growing due to excessive risk taking/levearge (also because of 3)
5.  Monetary authorities provided too much cheap money for too much long time.
6.  Regulators seem to have been complacent of the obvious conflict of interest (see 2)
7.  A lot more…
 THE LEVERAGE GAME 30

Notwithstanding the existing underlying leverage, banks could lever AAA securities by over 100:1!

Consumer 10 to 1

Mortgages Cash

Loan Origination 50 to 1 (Warehouse)

Mortgages Cash

Wall Street 50 to 1

Mortgages Cash & Fees

Structured ABS 15 to 1
Ratings Agencies
AA
Cash AAA Below Cash
70% 30% Bank
FNMA Insurance CDOs Wall Street
FHLMC Companies
Notes Cash
AAA’s, AA, A, BBB,
BB
Equity 30 to 1 400 to 1
Leverage
Source: Wachovia Securities, “Lifestyles of the Rich and Living Rich,
A Tale of Two Consumers,” 2005
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ANECDOTES OF LEVERAGE
•  ~$2.3 tril in “AAA” guarantees supported by six monolines with less than $20 bil in equity (0.8%)
•  In June 2007, financials made up 20.9% of S&P 500
–  Implies that approximately 30% of every dollar earned by an S&P 500 company was earned
by a financial services firm
•  Total assets of the top 5 brokerage houses in the U.S. equaled approximately 35% of the total
U.S. annual GDP. Balance sheets were levered on average 30:1
•  In 1998, failure of Long Term Capital brought markets to their knees, based on a loss of $4.6 bil.
To-date system has incurred approximately 75x this amount. Industry’s capital base increased by
only 2.5x that during this time
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WHAT HAS REALLY NOT WORKED?

1.  Risk distribution was never achieved because securitized tranches were not really diversified.
2.  Rating agencies did a horrendous job in delivering correct signals. Correlation was way more high
than expected
3.  Originators stopped doing their job: classical moral hazard issue: Why doing the homework if you
always get an A (actually, a triple AAA?)
4.  Prices artificially growing due to excessive risk taking (also because of 3)
5.  Monetary authorities provided too much cheap money for too much long time.
6.  Regulators seem to have been complacent of the obvious conflict of interest (see 2)
7.  A lot more…
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ANY SECURITIZATIONS WE NEED TO WORRY ABOUT?

ANY OTHER SYSTEMIC BUBBLES?
•  Car loans
•  Student loans
•  Credit cards…
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MASTER IN CORPORATE FINANCE

ENTER THE WORLD OF GLOBAL FINANCE