Charles Davì

Securitization Demystified

In Politicized Economy, Systemic Counterparty Confusion on October 30, 2008 at 1:02 am

What Is Securitization?

Securitization is a process that allows the cash flows of an asset to be isolated from the cash flows of that asset’s original owner. There are countless variations on this theme, and since our purpose here at derivative dribble is to foster clarity and simplicity, we will discuss only the main theme, and will avoid the Glen Gould variations.

Cui Bono?

We will explain how securitization works by first exploring the most basic motivation for isolating assets: access to cheaper financing. Assume B is a local bank that focuses primarily on taking deposits and earning money through very low risk investments of those deposits. Further, assume that B is a stable and solvent bank, but that it lacks the credit quality of some of the larger national banks and as such it has a higher cost of financing. This higher cost of financing means that it can’t lend at the same low rates as national banks. B’s local community is one in which home values are high and stable, and as a result the rate of default on mortgages is extremely low. As such, B would like to be able to compete in the local mortgage market, but is struggling to do so because its rates are higher than the national banks. What B would really like to do is borrow money for the limited purpose of issuing mortgages in its local community. That is, B wants to separate its credit quality from the credit quality of the mortgages it issues in its community. Securitization is the process that facilitates this isolation.

The Nuts And Bolts

The overall process is quite simple and reasonable, despite its portrayal in the popular press. We know that so long as B owns the mortgages, B’s creditors will still consider B’s credit as an institution when lending to it, even if that lending is for the limited purpose of issuing local mortgages. The solution to that problem is simple: B sells the mortgages off shortly after issuing them. But to whom? Well, common sense tells us that investors are not going to be too excited about buying mortgages piecemeal. So, B will wait until it has issued a pool of mortgages large enough to attract the attention of investors. Then, it will set up a special purpose vehicle (SPV) where that SPV’s special purpose is to buy the mortgages from B, using money from the investors, and issue notes to those same investors.

So, the SPV owns the mortgages since B is completely bought out by the cash from the investors. And the notes issued to the investors are basically bonds issued by the SPV with the mortgages as collateral. As a result, B is out of the picture from an investor’s perspective. In reality, B might still service the mortgages (i.e., sending bills to borrowers, maintaining address information on borrowers, etc.) but because the mortgages have been sold to the SPV, the notes issued by the trust have no credit risk exposure to B. So if B goes bust, the assets in the SPV are safe and will continue to pay.

So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee.

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  1. Charles, Great post. How about CDO’s and PRDC’s now? I reconsidered the Bloomberg article. However, you’re explaining things so clearly, it’s beginning to look to me like everything boils down to lack of capital or collateral, or simply poor judgment on particular loans or investments, not the investments themselves, however intricate they at first seem to be. Thanks again, and take care

  2. The best explanation for these sorts of structures is the one at S&P (also listed at the bottom of the Wikipedia entry). It takes time to work through, and there are some details in the above structure that explain what has gone wrong in the market.

    http://www2.standardandpoors.com/portal/site/sp/en/us/page.article_print/2,1,1,0,1031342466642.html

    The bank B who created the SIV, also has to provide a “back stop”, in other words be obliged to pump money into the SIV should there be no other source.

    Additionally, the SIV (or SPV above) is offered to investors in layers of risk, with high risk takes getting a better return, and lower risk takes getting the least return.

    And also, the investors can use the CDS market to buy protection from the SPV as a belt and braces approach to their money.

    So, when the sad people in Town B realise they were sold mortgages with a huge kick up in repayments after the two year introductory period, the SPV discovers they are in deep doo doo, as the cashflows they expect to receive (repayments on mortgages) don’t occur.

    Now bad things happen: Bank B becomes the back stop and has to pay into the SPV, so that the SPV can pay investors. Investors become aware through their access to information on the SPV, that it is in a bad situation and begin to stop re-investing.

    Most of the notes issued above, are short term, a few months. At the end of the period, the investors (you hope) re-invest and keep their money rolling forward.

    If they don’t the SPV is obliged to repay their investment (which oh dear was used to buy houses in Town B) which Bank B has to provide via the back stop.

    So now, you’re the CEO of Bank B, and your bank account drops like an anchor. As you will see in the press, some firms took their SPVs in house so they could stop the outflow of cash to the investors and close down the SPV.

    The investors can also claim against the SPV if it reaches rock bottom by using their CDS contracts, usually placed with other firms than Bank B.

    A big question which I don’t get, is that these structures (SIVs, SPVs, CDOs) were examined by the ratings agencies in order to provide an independent view on the risk of the various layers. I hear that in many cases the ratings agencies actually told firms like Bank B how to put together such an SPV, in order to meet their criteria for a rating.

    So: Bank B mis-sold mortgages. Did the ratings agencies mis-rate these structures? The OTC community used Credit Swaps to spread the risk around, but much like an STI gave everyone a bad case of failed assets.

    The regulators shout and say the OTC market is ‘unregulated’ and lacking in transparency, but in truth, this tidal wave in the capital markets is a systemic effect, which cannot be blamed on one OTC product. Therefore, how could a regulator invent a rule that would have stopped this happening? It seems that the regulatory issue is with mortgage lenders, and not the OTC folks.

    Bill.

  3. Hi Bill,

    While I normally cherish your comments, you’ve added facts that weren’t in my narrative.

    I never said the bank had to serve as a back stop.

    I never said the mortgages had adjustable rates.

    I didn’t even discuss the issue of banks taking SPV’s back on balance sheet.

    My goal in this article was to explain the concept of securitization, not particular examples (like an SPV with the capital backing of the originator).

    That said, I agree with your last sentence: in my opinion, this crisis is all about making bad loans.

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  4. Bill- Why do you say that the bank would have to pump cash into SPV? In most cases the banks dont have to fork up any dough, typically the servicer of the deal would have to advance on any shortfalls in payments on notes to investors, with one catch – if they think that the money they advanced will not be recaptured in the future by the underlying collateral/mortgages. If I am mistaken, let me know.

    Bill to answer your question – the rating agencies always told the securitizer how to structure these deals. It was essentially public knowledge. They would say if you want X amount of AAA rated notes then you need this much enhancement (protection), ie. reserve accounts, overcollateralzation (more collateral than notes), interest rate coverage, etc etc…. essentially they say “you need this much room for losses and we know what losses will be like” – so that the losses will not “hit” the AAA. In most cases they based these loss predictions off historical delinquency, defaults and recoveries on forclosed properties. No matter how bad the collateral/loans are if you have enough protection, notes can be rated AAA.

    What went wrong with the rating agencies is that in their modeling for losses, they didnt predict any of the current statistics we are seeing today. so a $1B deal that takes 100 MM in losses could still have safe AAA rated notes. But when the loss models are wrong and those losses come in at 500 MM they agencies have to readjsut their standards for AAA rating.

  5. Another major reason that so many businesses got involved in securitizing their recievables (you can securitize anything that is a recievable, like law suit settlements, or tax liens by the gov) is that it get this stuff off the balance sheet and it free up cash – Banks didn’t necessarily want to hold onto mortgages and have to wait 30 yrs to get paid (thats risky). They wanted to make loan take a fee and sell those loans to Joe Schmo the hedge fund manager. Thats an easy business and a relatively risk less one. That way they free up cash sitting in long term illiquid assets. With all that cash they make more loans and it goes on forever until it breaks.

  6. Hi All,

    In reply to erdosfan, point taken, I was elaborating.

    In reply to jay212, my understanding is that the firm who contructs and SIV/CDO can be obliged to act as ‘back stop’ for the package, the S&P link explains this.

    In reply to jay212 on the ratings agencies, I see your point.

    If the current crisis is due to a black swan, i.e. all the measurements of risk are off the chart, then why does regulating CDS contacts make any difference? If the CDS market was ‘regulated’ already, would that have prevented the bubble in lending?

    Bill.

  7. [...] Securitization is a fairly simple process to grasp in the abstract. In reality, turning millions of mortgages into interest bearing notes is not a simple process. However, we can at least begin to understand the process by considering how a payment waterfall can be used to streamline the payments to investors. Viewed as a bond, a mortgage is a bond where the borrower, in this case the mortgagor, has a right to call the bond at any point in time. That is, at any point in time, a mortgagor can simply repay the full amount owed and terminate the lending agreement. Additionally, even if the mortgagor doesn’t pay the full amount owed, it is free to pay more than the amount obligated under the mortgage and allocate any additional amounts to the outstanding principle on the mortgage. For example, if A has a mortgage where A is obligated to make monthly payments of $100, A could pay $150 in a particular month, and request that the lender allocate the additional $50 to reduce the outstanding principle on the mortgage. [...]

  8. [...] A Mortgage Backed Security (MBS) is just that, a security and not a derivative. Investors that own MBSs receive regular income from these securities. What distinguishes them from traditional securities, such as corporate bonds, is that the MBS is backed by a pool of mortgages. That is, investors buy MBSs, and as a result, they have a right to the cash flows produced by that pool of mortgages. As the homeowners whose mortgages are in the pool pay off their mortgages, the money gets funneled to and split up among the MBS holders. In effect, MBSs offer investors the opportunity to finance a portion of each mortgage in the pool and receive a portion of the returns on the pool.  For more on MBS, go here. [...]

  9. [...] Securitization takes money from the capital markets and funnels it into the consumer credit market by bundling individual loans, lines of credit, and mortgages that would otherwise be unattractive to investors on a piecemeal basis. Tremendous sums of money are funneled to consumers using this process, particularly in the mortgage space. If the boring banking regime precludes securitization, we can expect this capital to either sit idle or go elsewhere, thereby depriving consumers of credit and spending power. [...]

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