Foreign Investment Securitisation and Financial Crisis

8/13/2019 Foreign Investment Securitisation and Financial Crisis

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Session Outline

• Portfolio Lending

• Types of Risks Associated with Mortgage

Finance

• Risk Measurement and implications

• Managing Mortgage Related Risks

•

Mortgage securitisation and recent globalfinancial crises



Portfolio lenders



What are portfolio lenders?

• Loan originated by lenders who retain themin their portfolio

– Usually deposit institutions e.g. banks

– May include finance companies,insurance companies or other lenders

• Lenders have access to central liquidity

facility as supplementary source of funds – Sell low risk bonds, finance mortgages

lenders



HomeBuyer

Bankssavingsinstitutions Saver

Direct lending

Loan savings

Perform financial intermediation



Activities of portfolio lenders

• Originate loans

• Service loan

• Manage risk• Fund through deposits and bonds



Borrower PortfolioLender

Originate

Service

Manage Risk

Fund

Deposits

Bonds

Model of Portfolio lending



Strengths of portfolio system

• May provide personalised service to

borrowers because the same entity

originates and service loan

• Lenders can cross serve other services

• Originator take delinquency/default risk

and therefore incentivised to control risk

• Originator has access to permanent funding

source



Weaknesses of portfolio system

• Interest rate management is difficult becauseborrowers want long, depositors seek short

duration

•Default risk may be highly concentrated especiallyif loans cover small geographical area

• Operating efficiency may be low because one

entity does wide variety of functions• Competition may be weak because lending

limited to those with permanent funding



Risks Associated with Mortgage Finance

• Legal risks (possible violation of rights)

– Loan agreement

– Enforceability

– Property rights

– Consumer protection

– Business fraud

• Borrower credit risks

– Default

– Prepayment

– Collateral



Risks Associated with Mortgage Finance

Cont’d

• Interest rate risks

– Prepayment risk

– Pipeline risks

• Operations risk

– Failure of performance of mortgage market institution

– Institutional bankruptcy

– Mismanagement

• Liquidity risks

– Ability to buy and sell asset in a timely manner



Risk Measurement & Policy

Implications



Assessing credit risk

• Use underwriting principles of 5C’s

– Character, capacity, Collateral, Capital & Conditions

• Credit scoring

– A statistical technology that calculates the risk of

default and translates default probability into a

useful standard score (measure)

• Mortgage score factors – LTV ratios, property type, borrower attributes, local

real estate price changes



Mortgage Securitisation

Definition: It is a device of structured

financing whereby an entity seeks to pool

together its interest in identifiable cash flow

over time, transfer the same to investorseither with or without the support of further

collateral, and thereby achieve the purpose of

financing.



Originaor/

Seller of

asset

S

PV

Note

Holders

Rating agency Insurer

Cash

Borrowers

Notes proceed

Sells secured notesSale of assetsLoan

Borrowers

Borrowers

Cash flow from

assets

Mortgage Securitisation structure



Key functions within structure

• Design of the mortgage product

• Selling or marketing of the loan

•

Packaging the loan• Administration

• Funding

• Assumption of risk• Delinquency/default management



Lenders

• Banks and depository institutions receive

savings etc from customers in the form of

deposits

• Banks lend money to customers to buy a

house, i.e.- mortgage lender makes loans to

individuals. This may involve in-house staff

or mortgage brokers.



Special Purpose Vehicles (SPV)

• SPVs are companies that are set up for the purpose of

holding assets on which Mortgage Backed Securities(MBS) are secured, and for issuance of the securities.

• SPV are legal entities

– Can be owned by the lender

– Or can be independent company

– Can be partly state owned

• The lender does this to achieve

– Better cost of funding – Avoid potentially having to maintain capital against the assets

• SPV issues securities and sell to investors



Rating Agencies

• Potential investors depend on independent

assessment of quality of the underlying pool

of assets by rating agency before purchasing

notes, e.g. S&P.



Insurer

•The quality of the asset may not be highenough on its own so credit enhancement

(insurance) is usually necessary to lower

the credit risk on the notes which are sold

by the SPV

• Insurance may be provided

– By public sector institutions as by the US

government through Fannie Mae and Freddie

Mac

– Privately provided e.g. AIG



Note Holders

• These are investors who participate in

purchasing the investment assets and taking

on the risk and receiving the benefits in

returns



Potential Benefits of securitisation

• Specialisation and efficiency

• Increase in liquidity

• Balance sheet management

• Investor flexibility (able to reassess assets held)

• Range of products available to borrower



Moral Hazards

• Mortgage broker receives immediatepayment between 0.5 to 3% on origination

• Lender paid 0.5 to 2.5 on sale

• Bank or Bond issuer paid 0.2 to 1.5% onissuance

• Rating agency paid fee by Bond issuer

immediately on issuance• No incentive for participants to exercise due

diligence



What can be done?

• Providing better incentives to participants?

• Mortgage broker bonded or licensed

•

Lender responsible for mortgage originatedand purchased

• Rating agency paid in shares of securities



Concluding remarks:

Important lessons

• Effects of mortgage innovations

• Sub prime lending benefits ownership rate

•

Beware of moral hazards• Use manageable options available

Foreign Investment Securitisation and Financial Crisis

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