Securitization Manual Final Draft

8/12/2019 Securitization Manual Final Draft

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Securitization Manual: Structure, Analysis, and

Implementation*

By

Ghassem A. HomaifarProfessor of Financial EconomicsMiddle Tennessee State University, Murfreesoro T! "#$"% USA

2009

*& 'ould li(e to than( Mostafa Beheshtirouy )e*uty Mana+in+ )irector of the ParsianBan( for his insi+ht on various issues relevant to this *roect that sustantially im*rovedmy understandin+ of the microeconomics of the securiti-ation *rocess in &ran. The authoralso e*resses +ratitude to /euen 0yle, 1im Feller, Ste*hanie 2ri+ht, 3arol 2hite,

Fran( Michello, Bicha(a Fayissa and Mahmod Haddad for readin+ and su++estin+revisions that im*roved the clarity of my *resentations. My research assistants Andre'3oleman, Adam )utton, 1oey Scavone, 3hristo*her 2hitely, 1onathan Adon+o and GaoGuan+'ei*rovided valuale in*uts in editorial assistance and com*letion of this *roect.As al'ays the author remains solely res*onsile for any remainin+ errors.


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I: Introduction 1

II: Major Players 2

II.1 atin! A!ency"s #unction in a $ypical Securitization %

III: &redit 'n(ancement %

III.1: ')ternal &redit 'n(ancements

III.2: Internal &redit 'n(ancements +III.2.1. -ercollateralization +

III.2.2. SeniorSu/ordinated Structure 9

III.2.. eser-e #unds 10

I: ynamics o3 4nder5ritin! Process 11

: In-estors 12

I.1. e6uirements 3or Success3ul Securitization 17

I.2. Secondary Mar8et Pro-ider 1

I.. ene3its o3 Securitization 1%

I.7.&ost o3 Securitization 1I.7.1. #i)ed and aria/le &osts o3 Securitization 19

II. ;ome o5ners(ip 3acts 20

III. #inancial 'n!ineerin! Process 21

III.1. Is t(e 3irm 3acin! (i!(er 3undin! cost4 22III.2. &(aracteristics o3 Assets to e Securitized 2

III.. Structure o3 t(e Assets &reated in a Securitization 2

1. esidential Mort!a!e ac8ed Securities MS 2

2. &ommercial Mort!a!e ac8ed Securities &MS 2 . Pass: =e!al #rame5or8 7>I: Macro 'conomics o3 Securitization 77

>II: Implications 1

>II.1: &onstruction o3 Mont(ly &as( #lo5 3or PassII.2: Multi &lass Se6uentialIII.2: Accrual onds %0

>I: &ross order Securitization %1

>I.1: ?apanese Securitization o3 @P=s %2

>: #uture #lo5 Securitization %%

>.1: &(aracteristics o3 #uture #lo5 Securitization %

>.2: Miti!atin! is8 in #uture #lo5 Securitization $ransactions

>.2.1: Per3ormance ris8

>.2.2: Product ris8 %

ii


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>.2.: So-erei!n ris8 %

>.2.7: i-ersion ris8 %

>I: ')ternal #actors %

>I.1: #rozen an8 Accounts %

>I.2: =i6uidity &risis

>I.: ;i!( In3lation >I.7: =ost Purc(asin! Po5er

>I.: S(arp &urrency epreciation +

>I.%: =oan Per3ormance eterioration +

>II: Ad-anta!es o3 #uture #lo5III: &apital &(ar!es 3or Securitized e/ts

>I: Potential 3or #uture #lo5 ecei-a/le Securitization in Islamic epu/lic o3

Iran +7

>>: Synt(etic Securitization +%

>>.1. &redit>.2. Synt(etic &ollateralized =oan /li!ations +

>>.. /jecti-es o3 Structurin! &= +9>>.7: Synt(etic &= 90

>>.: Synt(etic Ar/itra!e &= 91

>>.%: Synt(etic alance S(eet &= 9

>>.: &apital Ade6uacy e6uirements 97

>>.+: &redit ')posure Met(od 67>>.9: $otal eturn S5aps 9

>>.10: Moti-ations o3 t(e ecei-er o3 $S 9+

>>.11: =e-era!e Impact o3 &apital Structure on an8 alance S(eet 100

e3erences 102

Appendi) 1 10

Appendi) 2 110

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Fore'ord

8ver the *ast %9 years the 'orld has e*erienced remar(ale chan+es in its economic

affairs. Perha*s most im*ortant amon+ those chan+es are a reduction in the role of+overnment as a re+ulator of *rivate usiness, dramatically seen in the demise ofcommunism, the retrenchment of socialist economies, and the ra*id e*ansion ofeconomic interde*endence across the 'orld. 8ne *roduct of oth of those chan+es is ane*losion of innovation in financial services. Financial innovation has ta(en many formsfrom the +ro'th of hu+e multinational financial service *roviders to the develo*ment of amyriad of ne' financial *roducts and services. Those ne' financial *roducts includeasset:ac(ed securities, the suect of this manual.

)r. Homaifar has *rovided the reader 'ith a com*lete discussion of the *rocess y 'hichilli;uid financial assets are transformed into mar(etale securities. An eam*le of this*rocess may e a security ased on residential mort+a+es. An individual *urchases ahouse 'ith a loan secured y the house and *ro*erty and a+rees to re*ay the loan on are+ular re*ayment schedule. The mort+a+e is a valuale financial asset in the form of thate*ected future stream of *ayments. &t is, ho'ever, not readily mar(etale and,individually, suect to ris( from several sources. Securiti-ation is the *rocess y 'hich a*ortfolio of such mort+a+es is or+ani-ed to create a security that is oth mar(etale andless ris(y than the ori+inal mort+a+es. As a result, securiti-ation enefits society ylo'erin+ costs to oth orro'ers and lenders.

The manual e+ins 'ith an eamination of the foundations of this *rocess ofsecuriti-ation from definitions and eam*les of ty*es of assets that may form the asis forthe securities. The introduction outlines the *rocess, identifies the *artici*ants in creation

of the security, and discusses the enefits and cost of securiti-ation. !et the manualthorou+hly eamines the ste*s of creatin+ a securiti-ed asset. &t concludes 'ith thedescri*tion of im*ortant eam*les of securiti-ed assets.

This manual re*resents the *roduct of a +reat deal of meticulous research of ahi+hly so*histicated financial tool. &n rin+in+ this research to+ether )r. Homaifar hasmade the to*ic accessile to *ractitioners, academic *rofessionals, and students. &t is amost im*ressive *iece of scholarly 'or(., ust another eam*le of )r. Homaifar


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I. Introduction

Securitization, a *rocess y 'hich illi;uid financial assets are transformed into tradalecommodities, is one of the most si+nificant innovations of the $6#=s. Havin+ ori+inatedin $6#= in mort+a+e mar(ets in the USA, securiti-ation has already converted over >6=trillion 'orth of non:tradale assets into mar(etale securities. As a *o'erful tool of

li;uidity and ris( mana+ement securiti-ation has had a tremendous im*act on the 'elfareof the 'orld economy. &n mort+a+e mar(ets in many countries it *rovides a chea*ersource of financin+, and thus *romotes the demand for housin+. &n the an(in+ sector,securiti-ation is 'idely used for allocatin+ ca*ital more efficiently, transformin+ ris( intoa tradale security, and reducin+ the overall cost of ca*ital. &t has enaled develo*in+countries to finance infrastructure *roects at lo'er costs, and has allo'ed emer+in+mar(et institutions to raise their soverei+n ratin+s ceilin+s and therey ta* internationalca*ital mar(ets for lo'er:rate financin+.

Securiti-ation, also (no'n as asset:ac(ed securiti-ation or structured financin+, haseen defined as a financin+ instrument 'herey a com*any transfers ri+hts in current orfuture receivales or other financial assets to an entity that serves as a ?s*ecial *ur*ose

vehicle@ SPC, 'hich in turn issues securities to ca*ital mar(et investors and uses the*roceeds from the issue to *ay for the financial assets. The source of the receivalescould e any ri+ht of *ayment or asset that +enerates an income 'ith a stale cash flo'.The eistin+ or future receivales could e the income +enerated, amon+ others thin+s yresidential or commercial mort+a+es, credit card receivales, automoile loans, studentloans, airline tic(et *ayments, health care receivales, insurance fee receivales, royaltieson intellectual *ro*erty, sales of oil, ta receivales or any other income source that isre+ular and *redictale. Former chairman of 3iticor*, 1ohn /eed, defines securiti-ation as ?D the sustitutionof more efficient *ulic ca*ital mar(ets for less: efficient, hi+her cost, financialintermediaries in the fundin+ of det instruments.@ $As lon+ as re+ulatory constraints*revent entry into the loan ori+ination usiness, an(s and thrift institutions 'ill not eunder *ressure to com*ete and offer com*etitive rates in their lendin+ to orro'ers.Ban(s and other de*ository institutions in the United States, havin+ een insulated from*rice com*etition throu+h re+ulations in the cartel era of $6"" throu+h $6=%, o*erated'ith oth hi+h costs of fundin+ and hi+h ori+ination costs 'ith re+ard to detinstruments. 8nce com*etition 'as *ermitted in the ori+ination of loans as a result ofdere+ulation and the resultin+ favorale re+ulatory environment of the mid:$6=s, ne'*layers such as third:*arty credit enhancers, ratin+s a+encies, investment an(ers,under'riters, li;uidity enhancers secondary mar(et *layersC, *rivate conduits, and trustsentered the mar(et, and securiti-ation *aved the 'ay for disintermediation of the variousfunctions in a hi+hly efficient manner. The outcome 'as increased com*etition,innovative ne' instruments 'ith +reater a**eal to roader classes of investors, andreduced fundin+ costs. These tri++ered *ositive eternalities to individual orro'ers in*articular, and the overall economy in +eneral.

Securiti-ation can also e considered a form of aritra+e et'een a less:efficienttraditional det mar(et and a more:efficient ca*ital mar(et 'here old securities aredressed u* as ne' asset:ac(ed securities y financial firms for *rofit. Therefore, the

$See 0endall and Fishman, ?A *rimer on Securiti-ation,@ The M&T Press %===.%&id.

$


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slicin+ and dicin+ of cash flo's and credit ris(s of the underlyin+ *ools of assets intosecuriti-ed *roducts 'ith varyin+ ris(return *rofiles and maturity s*ectra, and thes*readin+ of ris( amon+ 'ider classes, serves the interest of consumers, orro'ers, andthe nation at lar+e.)ata from 3all /e*ortC y the Federal Financial &nstitution Eamination 3ouncil reveals

that on avera+e, commercial an(s 'ith total assets +reater than >%.9 illion securiti-e %=*ercent of their assets ;uarterly Mar(ose )on+, %==9C. Securiti-ation of mort+a+esinte+rates real estate finance 'ith the overall ca*ital mar(et, lo'ers the mort+a+e interestrate, and eliminates the re+ional variations in mort+a+e interest rates 1affee and /enaud$669C, 1affee and /osen $66=C and 8lson $66=C.

8n the other hand, 1affee and /osen $66=C sho' that risin+ mort+a+e foreclosurerates, increases in adustale:rate mort+a+e A/MC securities, and a *otentially decreasedrole for federali-ation in mort+a+e mar(ets eert a ne+ative influence on mort+a+esecuriti-ation.

3alomiris and Mason %=="C investi+ate the de+ree to 'hich securiti-ation *ermitsan(s to otain +reater return on ca*ital y avoidin+ re+ulatory ca*ital re;uirements,

thou+h they focus on securiti-ation of credit card receivales rather than home loans.3alomiris and Mason *oint out that the enefits of securiti-ation stem from three sources.First, less ca*ital is re;uired to e held in su**ort of the securiti-ed loans. Second,securiti-ation reduces other re+ulatory costs associated 'ith on:alance:sheet assets.Third, the value of the e;uity in the an(s is increased +iven that the de*osit insurance*remia remains the same.

Elul %==9C summari-es the main le+al factors and +overnment re+ulations that act asdrivers of asset securiti-ation. He *oints out that securiti-ation is driven y the an(


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increases its /8E. 3ost of securiti-ation, ho'ever, is ne+atively related to the *ortion ofsecuriti-ed assets, 'hich clearly ma(es sense. Another interestin+ findin+ of Mar(ose and)on+ is that, they find that an(s 'ith middle ran(in+s of asset value securiti-e more oftheir assets includin+ mort+a+e loans and other ty*es of assetsC. At the same time, thosean(s have hi+her /8E.

/ecent events hi+hli+hted y the su:*rime mort+a+e mess in the financial mar(ets havecast considerale douts on the aility of the financial mar(ets to 'eather a financial storminduced y the action of maor *layers, i.e., an(s, hed+e funds, investment an(ers,under'riters, ratin+ a+encies in *articular, and re+ulators at lar+e. As a result systematic ris(has risen to a *oint that threatens the 'ell ein+ of the economy.8ver the course of the last three decades, 'e have 'itnessed maor restructurin+ in the'orld economy e.+. floatin+ rate arran+ements in $6#", increased inte+ration of financialmar(ets around the 'orld, +reater coo*eration of economic units, lierali-ation of trade*olicies, friendly or la re+ulatory environments, and a mushroomin+ innovativefinancial *roducts that increased levera+e and encoura+ed ecessive ris( ta(in+ raisin+e*osure for the maor *layers such as an(s, insurers, investments an(s, and hed+e

funds. 8ver the course of the last $= years macro ris( has continued to rise as reflected inthe *henomenal +ro'th of hi+hly levera+ed transactions HTsC in derivatives 'ithnotional *rinci*al of over >7== trillion, accordin+ to the &nternational S'a*s and)erivatives Association &S)AC survey of %==. The increase in mar(et systematicC ris(to socially unacce*tale level needed only a tri++er event to send shoc( 'aves around the+loe. This tri++er 'as the >$ trillion su:*rime mort+a+e ori+inated in the real estateoom of early %=== at teaser rate initial lo' interest rateC and 'as ste**ed u* in %==#.The resultin+ hi+her mort+a+e *ayments induced mountin+ foreclosures, 'hich had asno'all effect leadin+ to the colla*se of real estate mar(ets and mar(ets for e;uities anddet.

Securiti-ation of the su:*rime mort+a+e into mar(etale securities of investment+rade com*lement of ratin+ a+encies asence of fiduciary res*onsiilities to investors in+eneral and society at lar+e *roved to e a catalyst for creatin+ credit tsunami in thefinancial mar(et. The action of maor *layers in the securiti-ation *rocess namely the+reedy mort+a+e an(ers, investment an(ers, and ratin+ a+encies led to severe loss ofconfidence and melt do'n of e;uity and real estate *rices in the +loal 'orld. By andlar+e ratin+ a+encies ear most of the res*onsiilities as an inde*endent and ultimatea**raiser of the underlyin+ collateral that *roved to e almost 'orthless. For their sharein this mess investors +ave vote of no confidence of tri*le F to ratin+ a+encies.The increased innovations in derivative *roducts has *roven to e a t'o ed+e s'ordIraisin+ efficiency of financial intermediation and increasin+ levera+e cou*led 'ith littlere+ulatory oversi+ht, 'hich has een very costly for the maor *layers in +eneral and theUS and 'orld economy in *articular. For eam*le, some of the innovations such asdefault insurance credit default s'a*C initially hailed as one of the most im*ortantvehicles for transferrin+ counter*arty credit ris(, is at the heart of the maor colla*se ornear colla*se for such 2all street +iants as A&G, ehman Brothers, and Bear Sterns.

as(in!ton Mutual2AMUC filed for 3ha*ter $$ an(ru*tcy *rotection on Se*temer%7, %== one day after re+ulators sei-ed its assets and sold it to 1PMor+an 3hase in thelar+est an( failure in the United States. The 8ffice of Thrift Su*ervision 8TSC sold2AMU$.6n J$nC after >$7.#n of de*osits had een

"


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'ithdra'n in $= days. 2AMU 'as hit y mort+a+e defaults due to its si+nificante*osure to su:*rime and other ris(y mort+a+es as 'ell as the colla*se of the UShousin+ mar(et. The an( had a**roimately >"=#n of assets ut only aout >$n ofde*osits, 'hich meant it, had to raise funds on money mar(ets, 'hich had ecomeincreasin+ly e*ensive.

=e(man rot(ers"holdin+ com*any filed for 3ha*ter $$ an(ru*tcy *rotection onSe*temer $K, %==, ut none of the U.S. susidiaries such as its ro(era+e:dealersusidiaries, asset mana+ement unit, and investment mana+ement division are su**osedto continue o*eratin+ as normal. &ndividual investors 'ho have accounts 'ith ehman


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&nvestors

The loan ori+inator ma(es the loan, or s*onsors loans ori+inated y others, y *oolin+them into a *ortfolio. The ori+inator may continue to service the loans y collectin+*ayments from the ori+inal orro'ers to *ass throu+h to the ultimate investors in the

asset:ac(ed securities collaterali-ed y the *ool of loans. The *rocess of creatin+ asset:ac(ed securities is sho'n in fi+ure $.$.

The assets removed are le+ally se*arated asset isolationC from the o'nershi* of the *arty'ho is ori+inatin+ s*onsorin+C the asset securiti-ation. Securiti-ation involves a transferassi+nmentsaleC from the ori+inator to investors. Therefore, an intermediary (no'n as aS*ecial Pur*ose ehicle SPC, is re;uired to act as an inde*endent entity on ehalf ofinvestors. The SP can e a trust, a limited *artnershi*, or a s*ecial *ur*ose enter*rise. All ty*esof SPs encoura+e and facilitate roader *artici*ation y non:ori+inatin+ entities orinvestors that may include an(s, *ension funds, insurance com*anies, or otherinstitutional investors. The SPs are usually incor*orated in lo':ta or ta:free areas andare li(ely to e dissolved as the underlyin+ assets e*ire.The methods em*loyed to transfer and ta(e assets off:alance sheet involve direct sales

usin+ SPs or other conduits. There are three ty*es of conduits5 sin+le:seller SP, multi:seller conduits, and securities aritra+e vehicles. The sin+le:seller SP *urchases assetsfrom a sin+le ori+inator. Ban(s ori+inatin+ lar+e uniform assets mort+a+e detsC usuallyuse these instruments. Multi:seller conduits are le+al entities administered and servicedy the an(s to *rovide funds either throu+h direct loans or asset *urchase a+reementsunder 'hich the SP *urchases trade receivales. The ori+inatin+ an( normally*rovides direct credit enhancements and *rovision of li;uidity facility to the conduit.Securities aritra+e vehicles are or+ani-ed to uy rated securities that are funded throu+h

9


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the structure of the *ro+ram, rather than y the underlyin+ assets. That is, the conduitmust e structured so as to ensure a steady inflo' of ne' assets or oli+ations. The assetscurrent or future receivalesC are transferred from an ori+inatin+ s*onsorC alance sheetto the alance sheet of an SP as sho'n in fi+ure $.%.

#i!ure 1.2: $ypical Securitization

8nce the receivale is sold to the SP it +enerates immediate cash for the ori+inator,therey roadenin+ the com*any


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The ratin+s a+encies< maor role in the securiti-ation *rocess is to hel* investors to ma(einformed decisions re+ardin+ investment in the underlyin+ securities. As +uardians of the*ulic throu+h their research, analysis, and +radin+ of various ris(s, ratin+ a+encies aree*ected to *rotect investors a+ainst ta(in+ ecessive credit ris(. The ratin+s a+enciesrate asset:ac(ed securities not +uaranteed y the U.S. +overnment or any of its

s*onsored a+encies such as Fannie Mae and Freddie Mac. The ratin+s allo' institutionssuch as insurance com*anies and *ension funds, 'ho are *rohiited to invest in securitiesrated elo' investment +rade y their res*ective re+ulators, to actively *artici*ate in thesecuriti-ed mar(et as investors. &nvestment +rade ratin+ conveys information to theinvestors that the underlyin+ instrument 'ill *ay cou*on interest and *rinci*al accordin+to the terms of the indenture. An eam*le of the summary of cor*orate ond ratin+ssystems and symols 'ith rief descri*tion is *resented in Tale $.$.

$a/le 1.15 &orporate ond atin!s

Summary of Corporate Bond Ratings Systems and SymbolsMoodys S&P Fitch Brief Definition

Investment Grade: High Credit QualityAaa AAA AAA Gilt edge, prime, timely

payment of interestma!imum safety

Aa" AA# AA#

Aa$ AA AA %ery high grade, high&uality

Aa' AA( AA(

A" A# A#

A$ A A )pper medium grade

A' A( A(Baa" BBB# BBB#

Baa$ BBB BBB *o+er medium grade

Baa' BBB( BBB(

istin-tly Spe-ulative: *o+ Credit+orthiness

Ba" BB# BB#

Ba$ BB BB *o+ grade, spe-ulative

Ba' BB( BB(

B" B# B#

B$ B B Highly spe-ulative

B' B( B(.redominantly Spe-ulative: Substantial Ris/ or in efault

CCC#

Caa CCC CCC Substantial ris/, in poorstanding

CCC(

Ca CC CC 0ay be in default,

#


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e!tremely spe-ulative

C C C 1ven more spe-ulativethan those above

CI CI2 In-ome bonds3 nointerest is being paid

efault

/atin+ a+encies *lay a *ivotal role in the securiti-ation *rocess as the ultimate a**raiserof the underlyin+ *ool of collateral. &n their *rocess of a**raisin+ and evaluatin+ theli(elihood of default y suectin+ the cash flo's of the *ool of underlyin+ assets tostress tests under severe mar(et conditions, various ris(s are *riced to determine the fairmar(et value of the ne' securities. &nvestors< acce*tance of the ratin+s as a 'ell: definedstandard, as 'ell as the a**ro*riateness of the amount of credit enhancement, are*aramount for a successful securiti-ation *rocess for ABS, as they need not *erformindividual a**raisals for the ne' instruments that could e *rohiitively costly. Assumin+credit ris( analysis is underta(en for a rated security, the decision to invest turns intoconsideration of mar(et or interest rate ris(, and analysis of duration and conveity of theunderlyin+ instrument.&ssuers see( ratin+s to im*rove the li;uidity and mar(etaility of their issue, and to

ca*ture the interest rate savin+s associated 'ith a hi+her ratin+I 'ithout a ratin+, theissuer mi+ht not secure credit, or mi+ht secure it only at a sustantially hi+her cost.Furthermore, state and federal la's e*licitly incor*orate ratin+s in investment decisionsof financial institutions. For eam*le, under the &nvestment 3om*any Act, money mar(et

funds can not hold more than 9 *ercent of their assets in securities that are rated lo'erthan the to* tier ratin+ of the t'o ratin+s a+encies.

II.1 atin! A!ency"s #unction in a $ypical Securitization5

Analy-es individual assets in the *ool, com*ares them to the historical

*erformance of assets in its data an(, and suects the *ool to stress tests asedon severe mar(et conditions.

oo(s at the seasonin+ of the *ool, as mort+a+es are more li(ely to default in the

first four years.

Evaluates +eo+ra*hic diversification of the loans. Proects the amount of credit enhancement needed ased on the 'orst:case

scenario.

Secures le+al certification that assets transferred to the SP are ?true sale@, and

thus le+ally isolated from the reach of ori+inator.

/atin+s a+encies and investors *refer a diversified *ool of mort+a+es s*read acrossthe nation as o**osed to one concentrated in a *articular re+ion, as re+ional recessions


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may eo*ardi-e the *erformance of the *ool. Furthermore, a lar+er *ool *rovides enefitsto oth investors and the conduits, as the fied cost of securiti-ation is s*read over alar+er amount, thus *rovidin+ economies of scale. The ;uality of the *ool of the loans and+eo+ra*hic dis*ersion determines the ;uality of the underlyin+ securities credit:enhancedy a third *arty. Private mort+a+e conduits are financial entities usually affiliated 'ith

maor an(s, insurance, and or manufacturin+ com*anies that uy residential orcommercial loans and *ool them into a *ortfolio from 'hich asset ac(ed securities areissued to investors in the ca*ital mar(et. The *rivate conduits com*ete 'ith +overnment:s*onsored enter*rises GSEsC such as Ginnie Mae, Fannie Mae, and Freddie Mac, inreducin+ the overall cost of fundin+ for an avera+e home uyer in the United States. Theto* three *rivate conduits are Prudential, GMA3, and GE 3a*ital: all three, 'hich aresusidiaries of Prudential &nsurance, General Motors and General Electric res*ectively,accounted for over K6 *ercent of all *rivate conduit securiti-ation in the United States."

Securiti-ation ta(es *lace in a ne+otiated mar(et in 'hich ori+inator or s*onsorne+otiates 'ith various *arties concernin+ the ty*e of securities i.e. fied or floatin+ rateto e issued, the si-e of the ecess collateral, the amount of credit enhancement, the

amount of fees for the under'riter or arran+er, and other costs that *ertain to there+istration of the entire issue.III: &redit 'n(ancement

3redit enhancement is used to im*rove the li;uidity, mar(etaility, a**eal, and safety ofthe underlyin+ cash flo's interest and *rinci*alC of a ne' instrument in the ca*italmar(et. &t is a form of dressin+ u* an illi;uid asset y eefin+ u* its *ay:off, 'hilereducin+ the variaility of cash flo's so that 'ider classes of investors find the rate ofreturn commensurate 'ith ris(. The amount and ty*e of credit enhancement de*ends onthe etent to 'hich one 'ishes to ma(e the ne' instrument in *ar to a hi+hly:ratedsecurity. For eam*le, assumin+ an issuer 'ishes to see( a *articular ratin+ for its issue,the ratin+ a+encies can determine the amount of credit enhancement that is re;uired torin+ the underlyin+ *ool of collateral to a *oint 'here the ne' issue 'ill e rated, say,tri*le A, doule A or sin+le A. There are t'o ty*es of credit enhancement5 eternal andinternal. The follo'in+ section descries each ty*e.

III.1: ')ternal &redit 'n(ancement

This ty*e of enhancement is offered y a third:*arty insurer 'ho +uarantees the first lossof, say, five or ten *ercent of the *ool of the collateral. For eam*le, assumin+ anunderlyin+ collateral is >%9= million, #O *ercent, %9 year residential mort+a+es from'hich a *ass:throu+h security is created: y uyin+ a five *ercent first loss for the *oolfrom a tri*le A:rated insurance com*any. This credit enhancement insures the *ass:throu+h investors u* to >$%.9 million loss on the underlyin+ collateral. Eternal creditenhancements come in variety of different forms and financial mar(ets continue toen+ineer ne' vehicles to *rotect a+ainst *articular losses. These include5 letters of credit,cor*orate +uarantees, *ool insurance, ond insurance, and credit default insurance. A letter o3 creditis usually issued y a third:*arty an( or insurance com*any that*rovides *rotection a+ainst default or foreclosure of the underlyin+ *ool of collateral u*to certain *re:s*ecified amount that ensures safety of the *rinci*al and interest of the

"See 0orell, M. %===C, A Primer on Securiti-ation M&T Press.

6


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senior class. The *arties that issue letters of credit or *rovide third:*arty cor*orate+uarantees in a securiti-ation *ro+ram are usually hi+hly:rated com*anies 'ith a tri*le:Aratin+. 8ther'ise, the ratin+ of the securiti-ed instruments may e adversely affected asthe do'n+rade of the third *arty insurer *rom*ts the ratin+ a+encies to do'n+radesecuriti-ed loans, des*ite the fact that the underlyin+ collateral assets are conformin+ and

*erformin+ assets. This is the ?'ea(est lin(@ a**roach that ratin+ a+encies use inassi+nin+ a ratin+ to a securiti-ed *roduct. Assumin+ an ori+inator 'ishes to see( tri*le:Aratin+ for the ne' securities, the third *arty +uarantor cannot e a sin+le:A or doule:Ainstitution. Therefore, the ratin+ of the third *arty +uarantor has to e as hi+h as the ratin+of the securiti-ed instrument. Principal mort!a!e insurancePM& is a ty*e of *ool insurance that is intended to*rovide sto*:losses for individual home loan mort+a+es 'ith loan:to:value TC ratiosaove = *ercent. Pool insurance *ays $== *ercent of losses on defaulted and foreclosed*ro*erties after the e;uity in the *ro*erty and any other *rimary insurance is ehausted,and the a++re+ate *ool level covera+e is reached at sto*:loss as sho'n in ehiit $.$. Theamount of covera+e say for eam*le five *ercent of the *ool continues over the life of the

underlyin+ collateral. Ho'ever, some *ool insurance is structured so that the amount ofcovera+e continues to decline as the underlyin+ *ool seasons, aleit assumin+ ratin+a+encies are 'illin+ to allo' such structure *rovided that the *erformance of theunderlyin+ *ool is not deterioratin+ over time. The losses stemmin+ from other thandefault and foreclosure such as fraud arisin+ in the ori+ination *rocess, events notcovered y homeo'ners insurance, and other unforeseen events need to e covered yother su**lementary insurance such as ond insurance.

Ehiit $.$

e3ault InsuranceThis is an over:the:counter 8T3C contract et'een t'o *arties,'hereparty A, the uyer of the *rotection, *ays an annuity insurance *remiumC over thelife of the contract or the occurrence of the ?events,@ 'hichever comes first, toparty B,

the seller of the *rotection on the ris(y det instrument ?reference asset or assets@ issuedyparty C, oli+atin+ *arty B to *ay the face value of the reference assetsC tri++ered ythe default or any other chan+e in the credit ;uality of the issuer, as outlined in thecontract. The default insurance is therefore similar to an insurance *olicy 'here the uyerof the *rotection *ays an annuity of, say, = asis *oints on a five:year det issued y*arty 3 'ith the notional *rinci*al of >$= million over the five:year *eriod or theoccurrence of si+nificant ?events,@ 'hichever comes first, and is e*ected to receive the*ar value of the ond less the recovery value of defaulted reference asset.

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III.2: Internal &redit 'n(ancements

These come in several different forms and are custom desi+ned to enhance the ;uality ofthe underlyin+ *ool of the collateral. They *ossily may alter characteristics of the cashflo' of the securiti-ed *roducts. They can e classified as follo's5

8ver:collaterali-ation Seniorsuordinate structure

/eserve funds

Ecess s*read

III.2.1. -er$ million denomination *ass:throu+h,there needs to e >$.$%"9699 million in collateral to cover ust the interest income toinvestors. Allo'in+ for ecess s*read of t'o *ercent over the *ass:throu+h rates of %=*ercent, %".96 *ercent over:collaterali-ation is needed. Ho' much over:collaterali-ationis needed in our *revious eam*le4 Ans5er 1.29 million. This amount of collateral'ith 2A3 of $#. *ercent can su**ort a *ass:throu+h 'ith an interest rate of %= *ercentand an ecess s*read of % *ercent for all other *arties in the securiti-ation *ro+ram. Thisre*resents a %".96 *ercent over collaterali-ation in our eam*le. The amount of over:collaterali-ation of the first +eneration of the *ass:throu+h 'as 9= *ercent or more in thelate #=s in the United States. Ehiit $.% *rovides an indication of the amount of over:

collaterali-ation levels for various securities issued in the United States in the early$66=s.

')(i/it 1.2: Indication o3 o-er


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Source5 Federal /eserve Board.

III.2.2. SeniorSu/ordinated Structure

This is a self:im*osed structure y the issuer to *rovide *rotection for a class of seniorondholders at the e*ense of another uniorC class throu+h *rioriti-in+ cash flo' of theentire *ool of the underlyin+ collateral. This is also the most 'idely used internal creditenhancement structure in securiti-ation of credit here in the United States and else'here.The senior class of ondholders is 'illin+ to sacrifice yield in securin+ *riority of claimsover suordinate classes in the event of an(ru*tcy or default of the issuer. Thesuordinate class therefore is com*ensated 'ith hi+her yields for assumin+ first loss inthe underlyin+ *ool. For eam*le, assume an underlyin+ *ool of residential mort+a+es ise;ual to >9== million. Furthermore, su**ose a 6= *ercent senior class has een carved outof the *ool that is >K9= million, leavin+ $= *ercent suordination level or >9= millionsuordinated class. The *ool can asor u* to >9= million loss on the underlyin+

mort+a+es efore the senior class 'ill start to incur any losses thereafter. Su**osin+ the*ool reali-es a >"9 million losses, the suordinate class 'ill asor this loss or "99=, aloss of #= *ercent. 8n the other hand if the loss is >99 million, the suordinate class is'i*ed out y asorin+ a >9= million loss or a loss of $== *ercent, the remainin+ >9million loss to e asored y senior class or a loss of 9K9=, $.$$$ *ercent.

The hi+her the default ris( of the underlyin+ collateral, the +reater 'ill e the ris(*remium for the suordinate class. The default ris( *remium is not static and has atendency to increase or decrease over the economic cycles, risin+ durin+ recessionary*hase and fallin+ durin+ the time of economic *ros*erity. Ho'ever, for a +eo+ra*hically'ell:diversified *ortfolio of residential mort+a+es, default ris( is e*ected to increase inthe first four years and decline after'ard as underlyin+ mort+a+es season and themort+a+ors uild e;uity on the underlyin+ *ro*erties as 'ell as enefit from risin+*ro*erty values.

All securiti-ation *ro+rams involvin+ seniorsuordinated structures have incor*orateda s(i3tin! interest structure, 'hich allo's dis*ro*ortionate redistriution of*re*ayments of the underlyin+ collateral from suordinate class to senior class accordin+to a 'ell:defined *re:s*ecified schedule. An eam*le is *rovided in tale %5

$a/le 2: S(i3tin! Interest Structure

Months Percenta+e of Pre*ayments)irected to

Senior 3lass

$:7= #=

7$:#% 7=

#":K K=

9:67 %=

6#:$= $%

$=6 *ro rata

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Source5 Fran( 1. Fao--i, ?Bond Mar(ets, Analysis, and Strate+ies.@ Fifth Edition, %==K,Prentice Hall P. %"K.

Shiftin+ interest structure is intended to miti+ate future losses y redirectin+ *re*aymentsfrom suordinate to senior class so that sufficient insurance is outstandin+ for asorin+

une*ected losses. Because of this feature the level of suordination may increase overtime *articularly 'hen the underlyin+ mort+a+es *re*ay ;uic(ly and the *ool e*eriencesa lo' default rate. For eam*le, assumin+ underlyin+ collateral *re*ays of >K= million yyear four, the rate of the level of suordination in the *revious eam*le rises to 9=K9=:K=C, or $%.$6 *ercent 'ithout any net losses to the suordinated class. Su**osin+ thesuordinated class asors >9 million cumulative losses y year four, the rate ofsuordination level 'ill e 9=:9CK9=:K=C, or $=.6# *ercent.

III.2.. eser-e #unds5 There are t'o ty*es of reserve fundsI cas( reser-e 3unds ande)cess ser-icin! spread account.

&as( reser-e 3undsare created from the *roceeds of the under'ritin+ *rofit of

creatin+ asset:ac(ed securities. These cash de*osits are +enerated from the s*readet'een the cou*on of the underlyin+ collateral and the cou*on *aid to ABS investors,and are dedicated to a fund that invests the cash de*osits in money mar(et instruments.This reserve is used to retire a *articular class of ond, or used in conunction 'itheternal credit enhancements, such as a cor*orate +uarantee or a letter of credit, to asorune*ected losses in the *ool.

')cess ser-icin! spread accounts are created 'hen the ecess s*read et'een thecou*on of the collateral and the cou*on of the *ass:throu+h, net of servicin+ fees, costs oftrust administration, and other e*enses, are de*osited into an account on a monthlyasis. For eam*le, assumin+ the 2A3 of the underlyin+ collateral is $% *ercent,servicin+ fees are %9 asis *oints, costs of trust administration are 9= asis *oints, theunder'ritin+ cost is 9= asis *oints, and the 'ei+hted:avera+e of cou*on of ABS is $=.9=*ercent, %9 asis *oints remain to e de*osited in the ecess:servicin+ s*read account.This account is e*ected to +ro' over time, and can e used to *ay for une*ected lossesin the *ool not covered y other forms of insurance.

The under5riter or arran!erhas the res*onsiility to *rice, mar(et, custom ma(e, anddistriute various security classes 'ith the clientele to 'hich it is most li(ely to a**eal.The under'ritin+ team, havin+ an understandin+ of mar(et forces, the le+al re;uirementsof the investors, and the issuer, can *rovide the SP 'ith ona fide information re+ardin+the ty*e of the security and the *rice at 'hich the ABS 'ill e sold to the investors undereistin+ mar(et condition. The under'riter or lead arran+er may also act as s5apcounterparty to the SP for miti+atin+ interest rate ris( for the floatin+:rate tranche, orfor mana+in+ forei+n currency echan+e rate ris( involvin+ cross:order securiti-ation.

I: ynamics o3 4nder5ritin! Process

&t is useful to s*ell out issues involved in the financial en+ineerin+ and *ricin+ of a ne'Participation &erti3icatesP3sC as related to the dynamics of the under'ritin+syndicationC *rocess. Stoc(s, onds, and ne' securiti-ed *roducts are not sold in the

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*rimary mar(et the 'ay real +oods and services such as home, food, icycles are sold.The *rocess of sellin+ financial assets ta(es a fe' 'ee(s to several months from start tofinish, as it has its o'n idiosyncratic 'rin(les that need to e ironed out y the financialen+ineerin+ team. A hy*othetical time tale for an under'ritin+ *rocess is set do'nelo', aleit variations eist de*endin+ on the s*ecific mar(et, instrument, economic

sector, and investor mood *revalent at the *articular time of issue. The *rocess descriedelo' *rovides an eam*le of a Euroond issue, and differs from that involvin+ loansyndications, li;uidity facility, &P8s, and ne' securiti-ed *roducts: althou+h the asicstructure and ideas 'ill e similar.

$. The 'ee( of ):%$5 Mana+er is chosen and +iven the mandate. &ssuin+ strate+y is'or(ed out, follo'ed y documentation of the ta*e:to:file.

%. The 'ee( of ):#5 )ocumentation is com*leted, and co:mana+ers are chosen.". ):)ay5 ?aunch@ date. The P/ e+ins 'ith sendin+ fa or e:mail to under'riter

and sellin+ +rou* memers. &ssue is *ulished in the ne's *a*er.K. )$=5 Preliminary allotment 'or(ed out y lead mana+er.

9. )$$5 Pricin+ day, 'hich 'e e*ect to ta(e a lon+er time in &ran


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&nsurance ele+antly descries ne' securiti-ed *roducts and mar(ets in the follo'in+*ara+ra*h.K

?2hen a family of investment *roducts reaches mar(et, the learnin+ curve tends to e stee*:aleit uneven from firm to firm. 2ith standardi-ed *roducts, 'e are still early on that learnin+curve for many investors. This ma(es the field more interestin+ and more ris(y than it may elater. & am concerned *articularly aout some of the mar(etin+ illusions that have +ro'n u*around securiti-ed *roduct. The illusion of li;uidity, the illusion of the tri*le:A ratin+, as 'ell asthe illusion of yield should e addressed.@

2all Street has a tendency to *romote the (ey features of ne' *roducts to +iveinvestors a false sense of hi+her:than:attainale true total returns. For eam*le, mostmoney mana+ers *romote their *erformance in terms of arithmetic returns as o**osed tothe +eometric returns that reflect true economic returns. The tri*le:A ratin+ does not+uarantee the timely *ayment of *rinci*al, it only ensures that the underlyin+ security ishi+hly li(ely to *ay the cou*on and *rinci*al *ayment. 3M8s are *articularly *la+ued'ith the *romise of hi+h returns that may not e reali-ed in the hetero+eneous securities

offered in this mar(et. Furthermore, the li;uidity of the underlyin+ securities are affectedy the very structure of the securities as 'ell as the underlyin+ collateral and the amountof levera+e that is attached to a *articular tranche: 'ith varyin+ amounts of duration andconveity that corres*ond to si+nificant chan+es in *rice level o'in+ to small chan+es ininterest rates.

&nvestors have effectively *rovided a free *ut o*tion to orro'ers as there are no*re*ayment *enalties. This free *ut o*tion is not free after all, as orro'ers are li(ely to*ay hi+her interest rates for havin+ the o*tion to *ut the ond to the investor usually inthe 'orst time 'hen rates have fallen. The callale onds all mort+a+e onds residentialand commercial are callaleC sell at discount to their non:callale counter*arts, anddifferentials in *rice reflect the value of the short call o*tion +ranted to the orro'ers y

investors. As rates fall the call is activated and an issuer is li(ely to call the ond toreissue at a lo'er rateI ho'ever, as rates +o u* the call is out of the money, and the issueris not li(ely to *re*ay. Thus, the maturity of the issue is etended, e*osin+ investors toe)tension ris8. Furthermore, the res*ective yield on the underlyin+ securities must esufficient and com*etitive to entice investors to uy these instruments. The mar(etim*erfections of the cartel era *rovided the financial en+ineers in the 2all Street theo**ortunities to address shorta+es of fundin+ in various sectors *articularly the housin+sector to innovate securiti-ation as a vehicle in miti+atin+ the fundin+ *rolem.

I: alue &reated in Securitization

Assets off:alance sheet are 'orth more than on it. The volume of securiti-ed

instruments in the United States and the rest of the 'orld im*licitly confirms the valueadded throu+h securiti-ation. This value added is filtered do'n to various *layers in asecuriti-ation *rocess that ma(es every *layer etter off 'ithout ma(in+ some one 'orseoff, therey increasin+ overall economic 'elfare for the +loal economies. Fi+ure $.9illustrates the value added and increased trans*arency throu+h securiti-ation ycom*arin+ assets loansC on alance sheet and the asset ac(ed securities ABS createdoff:alance sheet usin+ the *ool of loans as collateral in the Fi+ure $.9.

K0ochen .!, %===C, iid.

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#i!ure 1.: alue &reated in Securitization

Loans on balance sheet Asset backed securities ABS off-balance

sheet&lli;uid and non:tradale Hi+hly li;uid and tradale

!ot trans*arent Trans*arentalued y ori+inator alue is determined in the mar(et daily/is( assessed y ori+inator /is( assessed y ratin+ a+encies8ri+inator has hi+h cost offundin+

8ri+inator has lo' cost of fundin+

Have lo'er ratin+s 3redit enhanced 'ith hi+her ratin+s3oncentration ris( is hi+h )iversifiedMar(et is local Mar(et is national and +loalimited in terms, rates, duration,conveity, etc.

8ffers investorsorro'ers variety of o*tions

Securiti-ation needs to e distin+uished from ?factorin+@ of account receivale, as theformer is related to the securiti-ation of current and future flo's, 'hile the latter isrelated to securiti-in+ *ast flo's, or money already due. Assets off:alance sheet areconverted to mar(etale asset:ac(ed securities, therey increasin+ li;uidity, reducin+ris(, and increasin+ overall economic efficiency.Securiti-ation *rovides more trans*arency of transactions in terms of standardi-ation ofa**licale +overnin+ la's, contracts, under'ritin+ *rocesses, and ris(s that reduce costsand im*rove li;uidityI investors are 'illin+ to acce*t lo'er returns. The costs of funds tothe ori+inator and the orro'er or oli+or are +enerally lo'er even after includin+ costsof credit enhancements and securiti-ation fees, due to access to a roader and morediversified ase of investors.

I.1. e6uirements 3or Success3ul Securitization

To sum u* the ar+ument in favor of securiti-ation 'e need to have three necessaryconditions satisfied in order to convert it to a *o'erful mechanism for lo':cost financin+y connectin+ orro'ers at a minimum under'ritin+ and other costs to investors in theca*ital mar(et. These conditions are5 3han+es in securities and investment la'sI chan+esin information and com*utin+ technolo+yI and chan+es in investors understandin+ aoutsecuriti-ation *rocess. The mar(ets for credit securiti-ation need to have the follo'in+structure in *lace for successful im*lementation. These re;uirements are listed in Fi+ure$.7.9

#i!ure 1.%: Summary o3 t(e /asic re6uirements 3or Securitization

Standardi-ation of contracts

Standardi-ation of under'ritin+ and a**raisal *rocess

Actuarial analysis of ris(

Standardi-ation of +overnin+ la's

Historical data ase for estimation of default and delin;uencies

9see iid.

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/eliale secondary mar(et *layers

/eliale su**ly of third *arty +uarantor

/eliale mana+ement information system

The standardi-ed contract increases the inte+rity of transactions y outlinin+ the terms,

si-e, ty*e of the collateral, and the le+al oli+ations of the *arties in the transaction that isenforceale in a court of la'. An under'riter arran+er determines the mar(et value of theasset ac(ed securities and matches the su**ly of the securities 'ith the demand yintermediatin+ et'een investors and the ultimate orro'ers. &n this *rocess theunder'riter analy-es various ris(s to 'hich investors are e*osed, and focuses on anys*ecific ris(sC a class of investor 'ishes to avoid y custom tailorin+ asset:ac(edsecurities that meet the investors< desire in terms of *rice, yield, and other characteristics.

Standardi-ation of a**licale la's smooth a+ency relations and *rolems associated'ith the securiti-ation *rocess y ensurin+ that a uniform code across various local,states, and federal la's conforms investors< and issuers< ri+hts to a securiti-ed instrumentinto a le+ally enforceale contract in the urisdiction of the issuer. This uniformity in the

a**licale la's is essential to im*rovin+ li;uidity and efficient *ricin+ of the securiti-edinstruments. &nvestors are *rotected from the an(ru*tcy of the ori+inator s*onsorCandor servicin+ entity, since the underlyin+ *ool of collateral is an(ru*tcy:remote andthe ori+inator has no recourse to transferred assets that are clearly identified andtrans*arent to the mar(et *artici*ants in a securiti-ed transaction. There eist reliale historical data that ratin+s a+encies can use for +radin+ ris( andestimatin+ the *roaility of default for ratin+ various classes of securities issued toinvestors. This ;uantification of ris( ensures the ca*ital mar(et investors 'ith res*ect tothe ;uality of the underlyin+ *ool of collaterals and reco+nition and *ricin+ of variousris(s to 'hich they are e*osed. The t(ird party !uarantor, usually a an( or insurancecom*any that *rovides credit enhancement to the securiti-ed instrument, must *ossess the

hi+hest credit ratin+ and *referaly have no si+nificant relationshi* 'ith the ori+inaloli+ors. For eam*le, a third *arty +uarantor 'ith sin+le QA< ratin+ can not +uarantee asecuriti-ed instrument 'ith ratin+ of QAA< or hi+her. Furthermore, asence of correlationet'een third *arty +uarantor and oli+ors ensures that in the event the oli+orsC fallsCinto an(ru*tcy, this 'ill not *reci*itate do'n+radin+ credit enhancer.

I.2. Secondary Mar8et Pro-ider

The *resence of a reliale secondary mar(et *layer is essential for successfulsecuriti-ation ecause the li;uidity of the securiti-ed instruments is directly related to thereadth and de*th of the volume of transactions. The securiti-ation mar(et in the United

States o'es its success to +overnment s*onsored a+encies, such as Ginnie Mae, FannieMae and Freddie Mac, 'hich *rovide li;uidity in the secondary mar(ets. Finally, areliale mana+ement information system needs to e in *lace for dia+nosis of *rolemloans, analysis and trac(in+ of cash flo's in timely fashion, and *ricin+ variousinstruments y *lacin+ loans 'ith different maturities, rates, and other idiosyncraticstructures into a *ool from 'hich asset:ac(ed securities are created.

The success of the *rocess is measured to the etent the fundin+ re;uirements ofvarious sectors of the economy are met throu+h reduced cost of transferrin+ funds from

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investors to the orro'ers. Ban(s and Savin+s oans 'ere lar+ely res*onsile for*erformin+ all functions of originating, servicing, credit risktaking and managingit,and investingin a ty*ical mort+a+e loan. 3urrently, disintermediation has shuffledvarious functions into different entities that are s*eciali-ed to *erform them. For eam*le,an ori+inator does not need to use its o'n funds to finance a mort+a+e. /ather, usin+ the

ca*ital mar(ets to ac;uire funds chea*ly has created thousands of mort+a+e com*anies,therey increasin+ *rice com*etition and the ran+e of availale *roducts. The volume ofsecuriti-ed instruments s*ea(s loudly of the success, as securiti-ation encoura+es ne'entrants for *rice and *roduct com*etition that have *rovided *ositive eternalities indisintermediation of various s*eciali-ed functions and allo'in+ for efficient division oflaor amon+ the maor *layers. The enefits of the securiti-ation *rocess have not eenevenly distriuted across all sectors of the economyI some sectors have fared etter thanothers. The housin+ sector has rea*ed the most enefit, as the evolution of securiti-ationin mort+a+e det instruments and its synthetic variants *rovided the mar(et 'ith an arrayof *roducts that meet the investors< and orro'ers< needs. The (eys for the success ofmort+a+e dets securiti-ation in the United States are related to the follo'in+

*henomena5 Attractin+ *rivate ca*ital to the housin+ sector y meetin+ investors needs.

Providin+ lo'er cost financin+ for home o'nershi* throu+h increased *rice and

rate com*etition amon+ various lenders in a securiti-ation *rocess.

/educin+ overall ris(iness of the *ool of mort+a+es throu+h diversification to

increase income staility and enhance the mana+ement of ris(s inherent inmort+a+e *roducts.

To e*and investors ase Freddie Mac introduced collaterali-ed mort+a+e oli+ations3M8sC in $6", 'here the investors received dis*ro*ortionate cash flo's ased on 'elldefined rules from the *ool of the underlyin+ mort+a+es that could a**eal to roaderclasses of investors. The first 3M8 had three tranches 'here investors 'ere *aid off

*ro+ressively in the shortest *eriod to the lon+est *eriod. The third tranche 'as lon+ termin nature and a**ealed to uy and hold investors such as insurance com*anies.')ample5 3onsider a home uyer in Murfreesoro Tennessee 'ho a**lies for a >$9=,===loan ori+inated y Guarantee Trust 'ho has ;uoted 7 O *ercent $9 year 'ith one *ercentori+ination fee. The ori+inator< ;uote reflects the *rice that secondary mar(et *roviderssuch as Fannie Mae, Freddie Mac, and other *rivate conduits are 'illin+ to *ay for amort+a+e det 'ith characteristics in line 'ith their under'ritin+ re;uirements *lus a*rofit mar+in and cost of servicin+ and *rocessin+ of the loan. As lon+ as the mort+a+eori+inated meets the under'ritin+ and a**raisal +uidelines of loan uyersI that theorro'er 'ill e ale to service its det oli+ation and the ;uality of collateral issufficient in the event of foreclosure the ori+inator is assured that the fundin+ 'ill e

availale for the ori+ination of the loan. The uyer of the loan finances the *urchase of the loan in the secondary mar(et yre*ac(a+in+ the *ortfolio of loans and credit:enhancin+ mort+a+e ac(ed securitiesMBSC y +uaranteein+ the interest and *rinci*al *ayment to investors even if theunderlyin+ mort+a+es default. The yield that is offered to mar+inal investors in the asset:ac(ed securities determines the mort+a+e interest rate *aid y an avera+e home uyerthat is com*etitively determined y the su**ly and demand forces in the ca*ital mar(et.The MBS are sold throu+h a net'or( of secondary mar(et *layers, o'n dealers and

$


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dealers in 2all Street to an(s, insurers, *ension funds, money mar(et and other s*ecialtyfunds. The outcome of the aove *rocess enales the home uyers in the United States toaccess funds in the +loal ca*ital mar(et very com*etitively.Gro'th and evolution of the financial mar(et has een affected y chan+es in ta la's,accountin+ and re+ulatory reforms that enaled hi+hly re+ulated investors, domestic and

forei+n,such as thrifts, insurers, *ension funds, and other institutions to uy asset:ac(edsecurities. The mort+a+e and other asset:ac(ed securities are no ece*tion.

I.. ene3its o3 Securitization

The enefits of securiti-ation to the maor *layers such as orro'ers, ori+inators,investment an(ersarran+ers, and investors are summari-ed from the *ers*ective of a*articular *arty as follo's5

Benefits to orro'ersconsumers

Access to com*etitive rates and terms Access to chea*er financin+

Availaility of array of financin+ alternatives

Fundin+ availaility for all ty*es of orro'ers

/educed *rocessin+ time

Benefits to ori+inators

/educe fundin+ cost

&m*rove *rofit mar+in on asset and e;uity

/emovin+ illi;uid assets off:alance sheet &m*rove assetliaility mana+ement

/educe concentration ris(

Benefits to arran+erinvestment an(ers

&ncreased *roduct lines and fees

&ncreased o**ortunities to e*and o*eration nationally and +loally

&ncreased tradin+ volume and *rofit

&m*roved efficiency and s*eciali-ation

Benefits to investors

Attractive yields on rated securities

)iversification of ris(

&m*roved li;uidity

Availaility of vast array of *roducts that meet their desire in terms of duration,

conveity, etc

$6


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I.7.&ost o3 Securitization

The *rocess of securiti-ation in the United States has +one throu+h a trial:and:error

*hase, 'ith chan+es in le+al, accountin+, re+ulatory, ta, and other issues, occurrin+.First, numerous mort+a+e:ac(ed securities 'ere *erfected. Then the *rocess 'as a**liedto other classes of receivales. To address a risin+ demand for housin+ credit, and toincrease the su**ly of funds, seasoned mort+a+es 'ere used y thrifts as collateral tocollaterali-e mort+a+e:ac(ed onds. 2hile issuin+ this ty*e of det instrument reducedthe cost of funds for thrifts, it did not *rovide necessary ca*ital to meet the demands ofthe *ulic at lar+e. The ne'ly:issued mort+a+e:ac(ed onds 'ere over:collaterali-ed att'o to three times the face amount of home loans, therey ma(in+ them inefficient in theuse of collateral to attract fundin+ to the housin+ sector.

To esca*e doule taation a ne' security must convey all ri+hts and ta oli+ationsfrom the ori+inator to investors. The first tri*le:A rated "=: year *ass:throu+h security

issued y Ban( of America in $6##, entitled the investor to a *ro rata share of the cashflo's from the underlyin+ *ool of mort+a+es 'ithout creatin+ doule taation for theissuer and investor. &t turned out that ne' *ass:throu+h security y the /lue


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interest rates caused the mar(et value of homes *articularly in 3alifornia to dro*sustantially. The second mort+a+es sold and successfully securiti-ed early on *roved toe disastrous, as homeo'ners in 3alifornia, havin+ secured a second mort+a+e in the*ro*erty from a lender at relatively hi+h a**raisal value to +et ac( their e;uity, 'al(edout of their residence y turnin+ over the *ro*erty to the lender in the real estate scam of

the century.Securiti-ation of mo/ile (omes'as also a soerin+ e*erience for the industry. As itturns out, unli(e home mort+a+es, moile homes are detached units 'ith no land or lot assecurity interest. The underlyin+ asset tends to de*reciate, rather than a**reciate, overtime. The aility to estimate actuarial e*erience of default is crucial for successfulim*lementation of securiti-ation involvin+ any ty*e of assets. For eam*le, securiti-ationof air*lane leases is difficult as a sin+le air*lane crash can e catastro*hic for theunderlyin+ ond issue. The cost of credit enhancement for such a deal can e etremely*rohiitive. The elimination of emedded call *rotection on the early *ass:throu+hs has raisedresidential mort+a+e rates, as investors re;uire hi+her *remiums for holdin+ onds that

are callale y the issuer. As rates fall, the issuer is li(ely to call the ond and refinance ata mar+inally lo'er rate, leavin+ investors e*osed to contraction ris8and reinvestmentrate ris(. Ho'ever, as rates rise, durations of the *ass:throu+hs are etended e*osin+investors to e)tension ris8as mort+a+ees are not li(ely to *re*ay, and investors aresaddled 'ith a security 'hose *rice is li(ely to fall more than a non:callale detinstrument.

Securiti-ation of other *roducts, such as !raduated payment mort!a!esGPMCinitially desi+ned to *rovide home o'nershi* to youn+ families 'ho could not afford inearly years to ma(e re+ularly:scheduled monthly *ayments in a standard thirty:yearmort+a+e, *roved a failure. The GPM allo'ed homeo'ners to ma(e +radually lar+er*ayments in future *eriods, *redicated on the assum*tion that their incomes 'ould risefaster than their mort+a+e *ayments. Unfortunately, GPMs *roved to have relativelymuch hi+her default rates than the actuarially allo'ale rate of three to four *ercent.

Securiti-ation of early adustale:rate mort+a+es A/MsC, first introduced in 3aliforniaalso *roved to have much hi+her default rates than actuarially acce*tale standards. Themar(et develo*ed insurance *roducts such as ca*s, floors, and collars in res*onse torisin+ default rates for the A/Ms. The *ayment ca*s effectively reduced cash flo'saccruin+ to investors on the underlyin+ securities in risin+ interest rates scenarios, andreduced their relative values. These came to e (no'n on 2all Street as Qsin8ers< aso**osed to Qfloaters


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cou*led 'ith hi+her rollover ris( induced y securiti-ation, effectively caused thecolla*se of the S industry in the United States.

I.7.1. #i)ed and aria/le &osts o3 Securitization

The costs of securiti-ation +enerally include fees for estalishin+ the le+al entity as

SP, havin+ the SP rated y the ratin+ a+encies, addin+ credit enhancement features,and coverin+ servicin+ fees, s*ecial reserve fees, value:added taes, 'ithholdin+ taes,stam* duties, and other such costs. These costs can e ro(en do'n into fied andvariale costs. Fied costs include arran+ement fee, le+al fees for oth transferor and thearran+er, and auditin+ costs. ariale costs include the fee for the use of SPs, dealercosts for the issuance of asset ac(ed securities, and the cost of li;uidity commitmentsecured from the ori+inatin+ or s*onsorin+ institution to enhance the credit 'orthiness ofthe issue should there e events adversely affectin+ credit ;uality of the asset:ac(edsecurities in the mar(et.

Furthermore, the total cost also de*ends on the si-e of the *ool, ty*e of asset, and the+eo+ra*hic location of the ori+inator. Fied costs are etter s*read over lar+er *ools,

*rovidin+ increasin+ economies of scale. Arran+ement and le+al fees are less sensitive tothe si-e of the transactions. Assets such as mort+a+e dets, credit card receivales, andauto loans 'ith a sim*le collection *rocess cost less to securiti-e than assets 'ith morecom*le structure. The cost is also lo'er in urisdictions havin+ e*erience in *revioussecuriti-ation *rocesses, such as !orth America and Euro*e, as o**osed to EasternEuro*ean and develo*in+ economies 'here there has een less e*erience. /ecent studies conducted for the *ool of assets that 'ere common*lace in each of thefour +eo+ra*hic locations in Euro*e5 vehicle finance in Germany, consumer loans inFrance, credit cards in U0, and e;ui*ment lease in &taly, shed some li+ht as far as thefied and variale costs of ABS and AB3P securiti-ation. The variale costs for each ofthe cate+ories for tranches rated QA< or etter y Standard Poors or QA$< y Moody


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Fied costs are related to the si-e of the transaction, the arran+er, and dynamics of themar(et that can e ne+otiated. They include le+al fees, re+istration costs, ratin+ a+encyfees, auditin+, *rintin+, trustee, and structurin+ fees. These costs may add u* to %= to %9asis *oints for ABS *ro+rams.6Similar costs are normally no more than 9 to $= asis*oints for securiti-ation of the AB3P *ro+ram in the Ban( 8!E study.$=The fied costs

associated 'ith the ABS transactions are amorti-ed over the life of the issue 'ith a lon+ertenor than transactions for the AB3P *ro+rams, *rovidin+ accountin+ advanta+es for theABS transactions. 2hen oth fied and variale costs are considered, the Euro*eanfunded AB3P securiti-ation *ro+ram can cost si+nificantly less than its ABS counter*art.

II. ;ome o5ners(ip 3acts Freddie Mac *urchased >"K illion of sin+le:family $:K unitC mort+a+es in %==$.

Freddie Mac *urchased %,K9,7 sin+le:family mort+a+es in %==$.

The median alance of a sin+le:family mort+a+e *urchased y Freddie Mac in %==$ 'as

>$"K,6#9. Freddie Mac has financed homeo'nershi* for more than "= million families since $6#=.

Freddie Mac *urchased one mort+a+e every 7 seconds in %==".

The hi+hest mort+a+e rate ever re*orted on Freddie Macs 'ee(ly national survey 'as$.7"N the 'ee( of 8ctoer 6, $6$.

The lo'est mort+a+erate ever on the Freddie Mac survey 'as 9.%$N the 'ee( of 1une$%th, %=="

Source Freddie Mac

Since $67, Fannie Mae has *rovided >9.6 trillion of mort+a+e financin+ for 7= million families.

Source Fannie Mae

III. #inancial 'n!ineerin! ProcessSecuriti-ation is financial en+ineerin+ in a classic sense. The *rocess of financial

en+ineerin+ is *resented in fi+ure $.# as follo's5

ia!nosis5 is the firm facin+ hi+h fundin+ cost4Analysis5 Are the assets suitale for securiti-ation4Production5 /e*ac(a+in+ and unundlin+ the *ool into mar(etale securitiesunder'ritin+CPricin!5 The structure of securities created from the *ool. 2hat is the ris(return *rofileof ne' securities and ty*es of credit enhancement attached to them4

&ustomization5 Tailorin+ the ne' *roduct to the s*ecific needs of customers=e!al #rame5or85 The la' +overnin+ securiti-ation in the country of issuance.

#i!ure 1.: #inancial 'n!ineerin! Process

6See iid.$=See 2orld Trade Eecutive, &nc. 1anuary $9, %==K. *$%

%"


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III.1. Is t(e 3irm 3acin! (i!(er 3undin! cost4 The lender is li(ely to securiti-e its loan

assets 'hen removin+ assets than 'hen (ee*in+ them on alance sheet creates morevalue. Firms rated QAAA< can secure credit in the mar(et at a sustantially lo'er cost thantheir counter*arts 'ith lo' ratin+s and 'ith hi+her fundin+ cost. &t is the latter ty*einstitutions that +arner most enefits from securiti-ation than the former ty*e. The *riceat 'hich assets are sold to the SP, 'hich in turn issues asset:ac(ed securitiesdetermines the relative success of the securiti-ation *rocess.

The ne' secondary securities issued y the SP are ac(ed y the underlyin+ assets,'hose ;uality and history of loss can e a si+nificant factor in the *ricin+ of the ne'issue alon+ 'ith the credit enhancement internal and or eternalC attached. The ne'lyissued securities in the mar(et are usually e*ected to *rovide hi+her returns as com*aredto *rimary securities of the same maturity class, since mar(et conditions such as su**ly

and demand, investors< *erce*tions and attitudes to'ard ne' securities, the readth andde*th of the mar(et, and the *resence or asence of secondary mar(et 'ill determinetheir ris( *remium. Securiti-e or not securiti-e5 )oes the firm need cash to +ro' and e*and its eistin+o*eration, to retire maturin+ det, or uy ac( firm


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;uestions mi+ht arise 'hen a firm considers the issue of securiti-in+ its illi;uid assets asan alternative to an unsecured or secured fundin+.')ample5 3onsider 3om*any A 'ith the follo'in+ alance sheet see Panel AC thatneeds to raise >%9 million cash.

Panel ABalance Sheet of 3om*any A as of =$=% in ===C

3ash %,=== Short term notes $,===/eceivales $9,=== Senior notes %6,===/esidential mort+a+es %9,=== Su:dets %=,===8ther $,=== E;uity ca*ital $=,===

First alternative5 The firm can orro' >%9 million y issuin+ #:year unsecured det atall:in:cost of #.%9 *ercent from its an(. Second alternative5 Secured det can e issuedy *led+in+ mort+a+e loan assets as collateral at all:in:cost of 7.#9 *ercent. Both fundin+

scenarios are achieved y increasin+ assets and liailities on alance sheet. The ratin+ ofthe ne' det is ca**ed y the current ratin+ of the firm and dets covenants maysuordinate ne' det to the eistin+ dets in the alance sheet therey raisin+ the cost oforro'in+. As com*any issues ne' det, the det e;uity ratio increases from 9.= to #.9due to an increase in levera+e see Panel BC.

Panel

Balance Sheet of 3om*any A as of =$=% in ===C

3ash 2,000 Short term notes $,===/eceivales $9,=== Senior notes %6,===/esidential mort+a+es %9,=== Su/


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/eceivales $9,=== Senior notes %6,===&nvestment in mort+a+es 1,20 Su:dets %=,===8ther $,=== E;uity ca*ital $=,===

As can e verified from Panel 3, the cash increased y >%",#9= 69 *ercent of the assets

soldC, and the investment in mort+a+es decreased y >%",#9= as it 'as transferred off:alance sheet, and retention of the 9 *ercent of the assets as an unrated interest to asor9 *ercent first loss is seen in investment in mort+a+es of >$,%9=. To the etent the*roceeds from the sale of asset ac(ed securities = *ercent QAAA


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#inancial Assets

: Mort+a+e loans: 3redit card receivales: Auto loans: 3ommercial loans

: Aircraft lease finance receivales: !on:*erformin+ loans: Students loans: ar+e and small usiness loans: Preferred em*loyee loans: Mar+in lendin+ *ortfolios: 3atastro*he loans

&orporate assets Bcas( 3lo5sC

: Trade and e*ort receivales: Pro*erty rental cash flo's: &nstallment sale contracts receivales

: Healthcare receivales: Time sharin+ cash flo's: Franchise *ayments: /ecord and film royalties: Utility receivales

#uture #lo5 Securitization

: 8il and +as e*ort receivales: Proect finance: !on:oil e*ort: 3redit card receivales: Tele*hone receivales international callsC: /emittances: 8ther receivales

The innovations accordin+ to Ban( for &nternational Settlements B&S have to e classified'ith res*ect to the ty*e of intermediation function *erformed. B&S have identified fourty*es of innovations in the financial mar(ets.$$

&nnovations transferrin+ *rice and creditC ris( &nnovations enhancin+ li;uidity &nnovations +eneratin+ det ca*ital &nnovations +eneratin+ e;uity ca*ital

Most of the +ro'th in derivatives transactions such as o*tions, futures, s'a*s, andfor'ard contracts can e attriuted to their valuale function of transferrin+ ris( in theca*ital mar(et.III.. Structure o3 t(e Assets &reated in a Securitization

1. esidential Mort!a!e ac8ed Securities MS

$$See B&S $67C /ecent &nnovations in &nternational Ban(in+ Basle5 Ban( for &nternational SettlementsC.

%#


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Mort+a+es 'ere first securiti-ed in the United States in the early $6#=s ecause they 'ereeasily standardi-ed. The securiti-ation in the U.S. mort+a+es mar(et 'as heavilyinfluenced y creation of +overnment and ;uasi +overnment institutions, *rovidin+li;uidity in the secondary mar(ets to the *artici*ants in the ca*ital mar(et. The !ationalHousin+ Act of $6"K can e considered as a catalyst for *romotin+ home o'nershi* and

securiti-ation of mort+a+es. As a result of this Act, the Federal Housin+ AdministrationFHAC 'as formed to insure loans made y *rivate lenders so as to ma(e them less ris(yand attract *rivate ca*ital to the housin+ sector. &n order to attract more ca*ital to housin+ sector FHA created secondary mar(et formort+a+e dets, the Federal !ational Mort+a+e Associations F!MA or Fannie MaeC in$6", to uy and sell federally insured mort+a+es. The mar(et did not develo* until thelate $67=s, 'hen con+ress s*lit the F!MA into t'o cor*orations in $675 a *rivately:o'ned federally:chartered F!MA, and Government !ational Mort+a+e AssociationG!MA Ginnie:MaeC as a federal a+ency.

F!MA$==,=== 'ere sold to a small numer of investors y Ginnie Mae in $67. The *ool ofloans +radually e*anded y ;uasi:+overnment secondary mar(et institutions such asFannie Mae and Freddie Mac, to include *rivately issued su:*rime loans lo'er ;ualityCy conduits, Q1umo< loans lar+eC 'ith varyin+ de+ree of diversity in terms of si-e, ty*es,rates, maturity, and date of issue. From the *ool of the mort+a+es standardi-ed Q*ass:throu+h< certificates issued to the investors that entitled them to a *ro*ortional interest,*rinci*al, and *re*ayments less cost of securiti-ation, fied and variale, cost of creditenhancementC +uaranteed y the federal +overnment, *rivate insurers and or ori+inators.The *ool of investors continued to +ro' that included, an(s, insurance com*anies,mutual funds, real estate investment trust /E&Ts and individuals.The +ro'th in securiti-ation of /MBS may e attriuted to several reasons.$%

$%See 0erry andell., ?Securiti-ation of the U.S. Mort+a+e Mar(et5 Pro+ress and Pitfalls, 'ith lessons for1a*an,@ The Seventh &nternational and *olicy Forum, 8ctoer "$, %===.

%


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Homo+eneity of the residential mort+a+es in terms of under'ritin+ standards

encoura+ed y federal +overnment involvement to *romote home o'nershi* thathel*s to increase o creation in a laor intensive sector of the U.S. economy.

Miti+ation of default ris( on the /MBS due to the eistence of +overnment or

*rivate insurers in this mar(et.

Availaility of a lar+e historical data ase reflectin+ *erformance of the *ool ofmort+a+es in terms of delin;uencies, default rates, *ayments, and *re*aymentsthat hel*ed the investors to *rice various ris(s in determination of the fair mar(etvalue of these asset ac(ed derivative instruments.

Government and ;uasi +overnment a+encies created throu+h 3on+ress"66 illion assetsoo( valueC collected from the failed Ss, 'hich is a recovery rate of 6= *ercent.

$"See 1un+man, %===, A Primer on Securiti-ation M&T Press.

%6


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Furthermore, the /T3 has *rovided *rotection to over %% million insured de*ositors 'ithan avera+e alance of >6,===.== that fre;uently 'as called a ailout:nearly >"== illiondollar ailout s*ent in *rotectin+ de*ositors 'ithout *ayin+ a dime to o'ners,stoc(holders, or o*erators of the failed savin+s and loans association.$K

The first +eneration of the multi:family rental *ro*ertyC 'as securiti-ed y Ginnie

Mae in $6#= y issuin+ FHA insured *ass:throu+h. Fannie Mae and Freddie Mac e+anissuin+ multifamily conventional mort+a+e *ass:throu+hs in late $6#=s. Penn Mutual ife&nsurance 3om*any securiti-ed office:uildin+ mort+a+es in $6K.$9

The /T3


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*ool are multi:family *ro*erties, office uildin+s, retail *ro*erties, and other *ro*ertiess*read over many different +eo+ra*hic re+ion of the country. The 3ommercial real estate securiti-ation differs from the residential mort+a+es asrelated to the servicin+ involvin+ foreclosure for the defaulted loans. &n the event ofhomeo'ner defaults, foreclosure immediately is follo'ed y the sale of the residential

*ro*erty, for the commercial *ro*erty the foreclosure may not e an o*timal course ofaction, as it is *ossile to restructure the loan 'ith the o'ner or o*erator to ensure +reaterrevenue in the future. Most loans in the *ortfolio of commercial *ro*erties are alloonty*es. For eam*le, a *ortfolio of seasoned commercial *ro*erties may have 'ei+htedavera+e maturity of $K years, 'hile the *ass:throu+hs issued have thirty years to maturity,'hich should *ermit the servicer to roll over at the end of the alloon *eriod u* to the fullterm of the securities issued to investors.By $669, res*ectively 7N and $KN of the commercial mort+a+es and multi:family*ro*erties in the U.S. 'ere securiti-ed. Mar(ets for 3MBS *roducts e+an to +etacce*tance y institutional investor as familiarity 'ith these instruments increased andthe *ool of investors +re' that included an(s, insurers, *ension funds, and individuals as

they assumed e*osure to these ty*es of securities throu+h mort+a+e /E&Ts.The *ace of securiti-ation for 3MBS mar(et did not develo* as ;uic(ly as theirresidential counter*art for the follo'in+ reasons5

Hetero+eneity of commercial mort+a+es in terms of ty*es, maturity, rates, and

under'ritin+ standards.

Asence of commercial mort+a+e insurance that could miti+ate default ris(.

Ho'ever, develo*ment of ratin+ system y ratin+ a+encies in $69, and senior:suordination of the derivative *roducts have miti+ated default ris( to some etenty shiftin+ and transferrin+ ris( from senior class to suordinated and unratedresidual class.

Asence of historical data on the *erformance of the commercial mort+a+es in

terms of *re*ayments, *ayments, default, and delin;uencies made it difficult if notim*ossile to *rice these ris(s into determination of the fair mar(et value of theseinstruments in the mar(et.

Asence of secondary mar(et *layers such as Ginnie Mae, Fannie Mae, or Freddie

Mac to uy commercial mort+a+es for securiti-ation. The /T3 came to life tocreate secondary mar(et for this ty*e of mort+a+es in the late $6=s and early $66=sand dissolved in $667 havin+ accom*lished its intended *ur*oses.

There 'as disincentive to hold 'hole loan commercial mort+a+es in a an( or

insurance com*any


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The 3MBS *roducts evolution from fairly un(no'n to an acce*tale one to hold in

most *ortfolios did not ha**en overni+ht. First5 re+ulatory chan+es made itattractive to hold these securities in the investors< *ortfolio. Second5 *rofit mar+insim*roved as various ris(s are correctly *riced in determination of the fair mar(etvalue. Third5 ris( ased ca*ital 'as reduced ma(in+ it less costly to hold these

securities in the *ortfolio *articularly for an(s and insurance com*anies. Fourth5investors +ained acce*tance as their understandin+ of these *roducts im*rovedovertime. Fifth5 +reater standardi-ation and lar+er *ool si-e reduced the cost and*rovided economies of scale in securiti-ation of this class of loans.

The level of credit enhancement *rovided for the residential and commercial mort+a+esare a**roimately e;ual to and K9 *ercent of *rinci*al res*ectively. An *ercent creditsu**ort as a *ercenta+e of the *rinci*al is considered as a si-ale amount to secure atri*le:A ratin+ for the residential mort+a+e ac(ed securities, ho'ever, to secure the sameratin+ for the 3MBS, ratin+ a+encies re;uire K= to 9= *ercent credit su**ort that isusually invested in the Treasury securities.

The Asset ac(ed securities usually trade at %= to "= asis *oints over the same ratedcor*orate onds. The 3MBS traded at %== to "== asis *oints over com*araly ratedcor*orate dets in $66". The s*read has narro'ed to under $== asis *oints. Theinvestor


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is smaller than the cou*on of the underlyin+ *ool of mort+a+es y an amount that is e;ualto the administrative, servicin+, and cost of credit enhancement.The cash flo' of a *ass:throu+h security is un(no'n as the *re*ayments y theunderlyin+ *ool of mort+a+es are suect to the chan+es in various micro and macroeconomic conditions to 'hich 'e return later. Ginnie Mae, Fannie Mae, and Freddie Mac

issued *ass:throu+hs res*ectively +uaranteed y the federal +overnment, Federal !ationalMort+a+e Association, and Federal Home oan Mort+a+e 3or*oration that came to e(no'n as a+ency *ass:throu+hs. These +uarantees im*roved the ;uality of the *ass:throu+hs ma(in+ them a close sustitute to U.S. Treasury securities. Ho'ever, *ass:throu+h securities *ossessed characteristics in terms of duration, conveity, *re*ayments,and default similar to that of the underlyin+ mort+a+es. Private conduits, an(s and other financial institutions *urchased a *ool ofnonconformin+ mort+a+es and issued *ass:throu+h securities that came to e (no'n asissue non:a+ency *ass:throu+hs. The *ass:throu+hs are ac(ed y the underlyin+mort+a+es and credit enhanced y third *arty *rivate +uarantors 'ithout any +uarantee ythe federal +overnment or any of its a+encies. These securities are re+istered y the

Securities and Echan+e 3ommission and are rated y four ratin+ a+encies in the UnitedStates that im*roved mar(et acce*tance and a**eal of these instruments. Ho'ever, a+ency and non:a+ency *ass:throu+hs, similar to all mort+a+e loans, arecallale, thus ma(in+ them *articularly unattractive to uy:and:hold classes of investors.The call feature emedded in this instrument allo's the issuer to call the ond 'hen andif the issuer desires to do so. 2hen rates fall the *rice of mort+a+e det is not li(ely to +ou*, as com*ared to non:callale onds, since the u*side *otential is severely limited ythe *ros*ect of call.$#Ho'ever, 'hen rates increase, the *rice of callale onds ise*ected to decline more than its non:callale counter*art.$This *rice ehavior isattriuted to the *resence of negative convexityon this ty*e of det instruments. Those*ass:throu+hs 'hose *rice ehavior mimics that of an underlyin+ *ool of mort+a+es*rone to *rice com*ression u*side *rice is truncated due to the emedded call o*tionC'hen rates fall and do'nside ris( is +reater as rates +o u*, are also callaleI *re*aymentslo's, as mort+a+ors are not li(ely to *re*ay at times of risin+ interest rates. The mar(et needs innovative *roducts that differ in terms of duration, conveity,*re*ayment, and default. Early MBS, such as the P3, 'ere destined for modification,'ith cash flo's sliced vertically to miti+ate *re*ayment ris(, and hori-ontally to limitdefault and interest rate ris(. To a**eal to a roader +rou* of investors in the mar(et,senior and suordinate classes 'ere created.

$#This is due to contraction ris(, as the life of the det instrument is li(ely to e shortened due to callailityof this instrument y the issuer.$This is due to etension ris(, as the life of the det instrument is li(ely to increase as *re*ayments slo'.

""


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7. &Ms

The first +eneration of derivative mort+a+e:ac(ed securities 'as collaterali-edmort+a+e oli+ations 3M8sC issued y Freddie Mac in 1une $6". $6The 3M8s 'ere

$6See iid.

1,000 P&s

Issued to

in-estors

P3PP

oan %5 >$==,===P3PP

oan "5 >$==,===P3PP

oan K5 >$==,===P3PP

oan 95 >$==,===P3PP

oan 75 >$==,===P3PP

oan $=5 >$==,===P3PP

oan 65 >$==,===P3PP

oan #5 >$==,===P3PP

oan 5 >$==,===P3PP

oan $5 >$==,===

P3PP

e+end5 PV*rinci*al, 3V cou*on, PPV *re*ayment, 3V cou*on of *ass:throu+h

#i!ure 1.+:&reation o3 P&s 3rom (ole =oans in a Securitization Structure

"K


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desi+ned to shift *re*ayment ris( from some of the classes to another class yredistriutin+ *re*ayments of *rinci*al y rules other than *ro*ortional allocation. &n this*rocess of redirectin+ the allocation of cash flo's, neither *re*ayment ris( nor defaultris( is reducedI ris( is sim*ly reshuffled and redistriuted amon+ different classes ofinvestors.

For eam*le, 3M8 structure allocates cash flo's into different tranches 'ith different*riorities on the *re*ayment and scheduled *rinci*al *ayment, as 'ell as seniorsuordination of the cash flo's to miti+ate default ris( for senior class at the e*ense ofsuordinate class. An accrual or a W class is also included in some of the 3M8 structuresIinterest *ayments accrue and are deferred until all other classes are *aid off in full efore*ayin+ interest and *rinci*al to this class, 'ith relatively hi+her duration and conveity ascom*ared to other classes. This structure a**eals to lon+:term investors, such asinsurance com*anies, 'ho uy and hold the W class until its maturity and are averse toreinvestment rate ris(.Another class of derivative *roducts sliced the cash flo's hori-ontally y allocatin+dis*ro*ortionate amount of interest and *rinci*al to different classes of investors. For

eam*le, interest only &8 and *rinci*al only P8 securities allocated $== *ercent ofinterest to &8 class and -ero *ercent to P8 class, 'hile allocatin+ -ero *ercent of*rinci*al to &8 class and $== *ercent of *rinci*al to P8 class. To miti+ate *re*ayment ris( a ne' class of derivative MBS 'ere created to *rovideinvestors *rotection a+ainst oth contraction and etension ris(. The PlannedAmortization &lass PA3C and $ar!eted Amortization &lassTA3C re*resent financialen+ineerin+ desi+ned to reshuffle the *re*ayment ris( to the com*anion class. To addressthe interest rate ris( concern of some of the investors, a floater 'as carved out of theunderlyin+ *ool of fied rate mort+a+es collateral, alon+ 'ith an inverse floater 'hosecou*on is inversely related to the *revailin+ mar(et interest rates inde such as &B8/ orthe *rime rate.The financial mar(ets continue to create ne' *roducts that can miti+ate *rice ris( andtransfer ris(, enhance li;uidity, +enerate det or e;uity, transform one form of incomeinto another for ta *ur*oses, and create future *roducts for currently un*erceived ris(s.&n this *rocess of financial en+ineerin+ some of the *roducts 'ill fail to s*ur interest anddemand to survive the test of time, 'hile others 'ill flourish as they create value,increase trans*arency and im*rove efficiency, and therey lo'er the cost of ca*ital in theresidential and commercial mort+a+e or other mar(ets, im*rove *rofit mar+in, increaseavailaility and roaden the *ool of investors and the *ool of orro'ers in the mar(et*lace.Gro'th in securiti-ation can e attriuted to the follo'in+ factors5#irst, the im*osition of an *ercent minimum ca*ital reserve y the B&S has increasedthe safety of the financial intermediaries, and increased *ulic 'illin+ness to invest in thesecurities issued y these institutions. &n search of hi+her yields, and to defray the cost ofre+ulatory restrictions, an(s and other non:an( finance com*anies find securiti-ation ofassets a ne' means of financin+ for ori+ination of hi+her yieldin+ assets. By removin+illi;uid assets from alance sheets, securiti-ation allo's the financial institutions to servea lar+er customer ase 'ithout havin+ to raise ne' funds in the form of det or e;uityca*ital.

"9


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Second,as the +loal cost of ca*ital increases due to risin+ ris( *remium and +loalinflation, securiti-ation of current and or future receivales hel*s an(s and non:an(institutions to raise chea*er ca*ital for their usinesses at the asset level instead of thecor*orate enter*rise level.$(ird, as the 'orld economies move in the direction of +reater inte+ration of financial

mar(ets due to removal of arriers, and as these institutions com*ete for the same ca*ital,it ecomes im*erative to secure an efficient and lo' cost financin+ vehicle.#ourt(, vast im*rovements in com*uter technolo+y have reduced the cost of *rocessin+information for the maor *layers in the financial mar(et, enalin+ them to identify andisolate certain self:li;uidatin+ assets such as mort+a+e loans and other receivales 'iththe oective of removin+ them from alance sheets and lo'erin+ the cost of fundin+.Assets off a alance sheet at times are 'orth more than on it. &t is very li(ely that the SP'ill secure hi+her ratin+s for the assets removed from the alance sheets of an ori+inatorthan the ori+inator could command in the mar(et, therey reducin+ cost of fundin+.The first issue in the +ro'th of securiti-ation is related to the ;uestion of 'hy an(s andfinance com*anies ori+inate loans and suse;uently try to securiti-e them. Ban(s see(

usiness relationshi* 'ith cor*orate clients, some of 'hom can access ond mar(ets ontheir o'n +iven the introduction of un( ond mar(ets and the increasin+ numer of*rivately *laced det issues. &n this environment an(s analy-e mar+inal enefitscosts ofmaintainin+severin+ relationshi*s 'ith cor*orate clients 'ith the mar+inal enefits ofsecuriti-ation5 reduced fundin+ costs, increases in return on e;uity, and access to roadersources of fundin+. Maintainin+ this delicate alance et'een relationshi* an(in+,et'een orro'er and lender, and securiti-ation is essential for the lon+ run *rofitailityof these institutions.%=

IIII. e!ulatory &apital e6uirements

The Basle committee on an( su*ervision $6C, under the aus*ices of the an( for&nternational Settlement B&SC and senior memers of G:$= central an(s, estalishedcommon criteria for the measurement of an( ca*ital and a methodolo+y for 'ei+hin+and classification of ris(:ased assets for ris(:ased ca*ital.%$Based on the Basle Accord,an(s and their holdin+ com*anies are re;uired to maintain an ei+ht *ercent ca*italreserve for their ris(:'ei+hted value of assets. The Basle Accord classifies an( ca*italinto three Tiers5 Tier $ ca*ital is related to common stoc(s, non:cumulative *er*etual*referred stoc(s, and disclosed reservesI%%Tier % ca*ital re*resents dets 'ith fied orcumulative costs, such as cumulative *referred stoc(s, convertile dets, redeemale*referred shares, suordinated dets, and +eneral *rovisionsI and, Tier " ca*italre*resents short:dated suordinated deentures retained to su**ort the tradin+ des( andmar(et ris(s associated 'ith derivatives transactions. The Basle Accord further im*oses limits on the amount of ;ualifyin+ ca*ital for thean(s, i.e., for eam*le, Tier % ca*ital may not eceed $== *ercent of Tier $ ca*ital,%"and

%=See Alri+ht .T and Smith. S, %==KC ?3or*orate oan Securiti-ation5 Selected e+al and /e+ulatory&ssues,@ )u(e 1. of 3om*. &nt


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suordinated det may not amount to more than 7= *ercent of Tier $ ca*ital.%KTier "ca*ital that is retained to su**ort the mar(et ris( associated 'ith tradin+ des( may noteceed %9= *ercent of a an(


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Fully dra'n term loans are easy to securiti-e asent of *rovisions to rene' or etend arevolving creditfacility to the ori+inator. Ho'ever, revolving lines of credit*osecom*lications for the SP, as it is difficult to foresee fundin+ re;uirements of theori+inator. &n this scenario, if an SP assumes a commitment to lend and finds it difficultto secure credit in a timely fashion, it o*ens itself u* for a reach of contract la'suit. For

a financial institution that has *rovided a committed line of credit to a counter*arty 'ith acommitment *eriod eceedin+ "79 days, this commitment 'ill e ris(:'ei+hted off:alance sheet."K&n the event the SP assumes the commitment to fund the facility,'ithout *rovidin+ cash collateral for its oli+ation, the ori+inator may e oli+ated toassi+n a ris( 'ei+htin+ of $== *ercent to the commitment of the SP."9To *reventne+ative carry the SP may not issue dets for the *ar amount of committed lines ofcredit that is fundin+ for the ori+inator, ecause the undra'n *ortion of the det is li(elynot to earn a rate of return commensurate 'ith the SP


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ori+inator may e tem*ted to re*urchase the defaulted

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