Loan Securitization The Basics

1. Loan Securitization The Basics Class #20; Chap. 26

2. Outline Purpose: Gain a basic understanding of what securitization is, why it exists and who the big players are. • Introduction • How assets are securitized (SPV or SIV) • Pass-through security • Who are the main players in securitization • What can be securitized • Costs and benefits of securitization

3. Loan Securitization – From the Daily Show

4. Loan Securitization – Basic Idea • Securitization: • Package loans or other assets into a pool of assets • Sell securities backed by the pool of assets • Basics • Package assets – Almost any type of asset can be securitized (mortgages, credit card loans, student loans …) • Create a conduit, a subsidiary, sell the packaged assets to the subsidiary (SPV, SIV) – assets go off balance sheet • The subsidiary finances the purchase of assets by issuing debt or assets backed by the pool.

5. How Are Assets Securitized?

6. Mechanisms for securitizing assets • Through a Special Purpose Vehicle (SPV)- Bank creates a SPV and sells it a bundle of assets, which removes them from its balance sheet • Through a Structured Investment Vehicle (SIV) - Bank creates a SIV and sells it a bundle of assets, which removes them from its balance sheet

7. Securitization through a Special Purpose Vehicle (SPV)

8. SPV Securitization: Convert Assets to Securities Investors New Assets Bank SPV New asset (bonds) sold to investors SPV repackages assets • Creates SPV SPV pays bank for mortgages Investors purchase securities and pay SPV an initial sum Why does the bank go through all that trouble? Pension Funds and Insurance Companies To remove assets from its balance sheet • Allows them to free-up regulatory capital (tax)

9. SPV Security Issue The SPV create securities based on the pool of assets • The pass-through is one type of securitization SPV Loan pool Asset Backed Securities CDO CMO CLO RMBS Pass Through Principal $ $ $ Interest SPV: Collects fees for creating and servicing the Asset Backed Security (ABS) The SPV exists until cash flows from the assets are fully distributed

10. SPV Mechanism Summary • Bank Creates SPV • Bank sells SPV loans – removing them from the Balance-sheet • SPV repackages loans into pass-through securities • Pass-through securities are sold to investors – pension funds and insurance companies • SPV pays bank for loans • SPV collects origination and servicing fees for the asset-backed security

11. Securitization through a Structured Investment Vehicle (SIV)

12. SIV Securitization: Convert Assets to Securities Bank SIV Rate on Mortgages Rate on ABCP Profits = – Creates SPV Payment for mortgages Asset Backed Commercial Paper (ABCP) Commercial paper is secured by loans Receive Payment $$ + Fee income Commercial Paper Market

13. SIV Mechanism Summary • Bank creates SIV • Bank Sells SIV assets (loans) – removes assets (loans) from its balance-sheet • SIV offers an issue of commercial paper to finance the purchase of assets • Commercial paper is backed by the purchased assets making it asset backed commercial paper (ABCP) • SIV pays bank using the proceeds from commercial paper

14. Difference between SIV & SPV • Interest rate risk: • SPV issues pass-through securities – payments to investors are based on cash flows from the pool so SPV is not subject to interest rate risk • SIV issues commercial paper so their profits depend on the difference between the commercial paper rate and the mortgage rate (interest rate risk) • Profits: • SPV earns profits from fees on originating and servicing the ABS • SIV earns fees as well as the spread between CP and mortgage rates • Financing: • SPV issues pass-through or asset backed securities • SIV issues commercial paper (ABCP)

15. Pass-Through Securities

16. SPV Security Issue Pass-Through Asset Backed Security The SPV create securities based on the pool of assets • The pass-through is one type of securitization SPV Investors Loan pool 25% of principal and interest payments 25% Share Principal $ $ $ Interest 75% of principal and interest payments 75% Share Question – who owns the loans?

17. Pass-Through Securities Summary • FI builds a pool of mortgages and sells interest in the pool as pass-through securities • Pass-through securities represent a fraction of ownership in the pool • e.g. a 1% share in the principal and interest payments of the pool • The originator of the pass-through collects payments from the pool and passes them through to the bond holders • Investors have direct ownership in this portfolio of mortgage loans or other securitized assets. • Ownership of loans rests with certificate holders (investors) and pass-throughs don’t appear on the originating bank’s B/S.

18. Who Securitizes Assets & Which Assets?

19. Who Securitizes Assets? • Financial Institutions – Banks • Usually securitize riskier assets • Securitizations are usually more complicated: RMBS CDO CMO … • Government Sponsored Enterprise (GSEs) • Securitize less risky home mortgages • Usually more simple assets: Pass-through Why do we have the GSEs?

20. Government Sponsored Enterprise Created to increase mortgage lending by facilitating securitization • FNMA – Fannie Mae (Federal National Mortgage Agency) • FHLMC – Freddie Mac (Federal Home Loan Mortgage Corp) • GNMA – Ginnie Mae (Government National Mortgage Association)

21. FNMA – Fannie Mae • Founded 1938, oldest of the three Mortgage Backed Securities (MBS) sponsors – publicly traded (owned by share holders) • Main Functions • Purchases loans and creates pass-through securities • Sells MBS to outside investors • Swaps – engages in swap transactions swapping mortgages for MBS with the mortgage originator • Securitizes conventional loans as well as government insured loans • Conventional loans must have the proper loan-to-value ratio normally not to exceed 80% • Charter

22. FHLMC – Freddie Mac • Public (stock holder owned) corporation founded in 1970 • Performs similar tasks as FNMA • Purchases loans from FIs • Sells MBS • Swaps MBS for loans • Charter

23. Difference between FNMA & FHLMC • Main Difference between FHLMC and FNMA • Originally FHLMC dealt mainly with savings banks • Originally FNMA dealt mainly with mortgage bankers • Now they are pretty much the same – competition promotes capitalism • Where are they now?

24. GNMA – Ginnie Mae • Founded in 1968 after splitting from FNMA • Ginnie Mae does not buy or sell loans or issue mortgage-backed securities (MBS) • Main Functions • Sponsoring mortgage backed securities programs by FIs – banks, thrifts, & Mortgages Banks • Provides guarantees to investors in Mortgage backed securities for timely payments • Has strict requirements for mortgages in the pool- • Each mortgage must be, and must remain, insured or guaranteed by a federal agency FHA, VA, RHS or PIH. • Mortgage insurance makes the lender whole if the borrower defaults

25. GNMA Pass-Through

26. What is Securitized? • Home Mortgages: MBSs (Mortgage Backed Securities) • Sub prime • Conventional • Credit Cards: CARDs (certificates for amortizing revolving debts) • Auto Loans: CARs (certificates for automobile receivables) • Small Business Loans guaranteed by the Small Business Administration • Commercial and Industrial Loans: CLOs (Collateralized Loan Obligations) • Can all assets be securitized?

27. Costs and Benefits of Securitization for Banks & Risks Faced by Investors

28. Banks’ Main Cost of Securitization • Main Coast: Increase off-balance sheet risk exposure • SIV: • The sponsoring bank guarantees the issue. • Bank can issue a Standby letter of credit • Bank can sell the loans with recourse • In either case, the guarantee increases the banks’ off-balance sheet risk • If the SIV defaults, the bank assumes responsibility for the issue or takes possession of the bad loans • SPV: • Pass-through payments are based on the cash flows of the pool • If mortgages go bad the investors receive lower payments. The SPV is not in danger of defaulting on its obligated payments – Issues commercial paper (high or low quality?) How does an SIV raise funding? How? How can the SIV issue high-quality CP? How would this affect a bank’s capital adequacy? There is really no risk to the bank with an SPV SIV seems more risky why not just use the SPV?

29. Banks’ Main Benefit of Securitization • Reduces Regulatory tax • Banks face substantial regulatory costs for holding risky assets on their balance sheet • Banks can avoid these regulatory costs by securitizing risky assets • Reduces Gap exposure (refinancing risk) • Mortgages are financing using short-term debt which must be refinanced. That rate will change but the mortgage interest rate will remain constant • Illiquidity Risk • Mortgages are illiquid and will likely need to be sold at a large discount • Securitizations are more liquid so they can usually be sold at less of a discount.

30. Risks Faced by Investors • Default Risk • If the mortgage pool is not insured, bond holders will loose principal and interest if mortgagees default on their loans. • If the SPV/SIV payments are not insured, then bond holders may loose principal and interest if the SPV defaults. • GNMA bonds are not exposed to default risk ! • Prepayment risk (discussed in next section) • Bond holders will likely lose interest income on prepaid principal • Interest rate risk • Just like a treasury bond, the price of bonds generated through securitization are sensitive to changes in interest rates.

31. Is Securitization Bad? • Bank Creates SPV/SIV • Bank Sells Assets to SPV/SIV • SPV/SIV creates securities and sells them to investors Bank SPV/SIV

32. Example Benefits of Securitization

33. Example – Reduction of Regulatory Tax Bank issues 1,000 loans with $100,000 principal Bank • Size of mortgages are small so they need insurance • The average maturity is 30 years • The aggregate mortgage coupon is 12% 100 Mill Capital Requirements: • Why capital requirements? What do they have to do with regulatory tax? • If we add risky mortgages to the balance sheet, then we need to hold capital against these mortgages • The question is: how much capital do we need to raise so your cap ratio does not change? ↑ mortgages = ↑ risk adjusted asset value = ↓ risk-based capital ratio raise capital to restore risk-based capital ratio

34. Example – Reduction of Regulatory Tax Bank issues 1,000 loans with $100,000 principal Bank • Size of mortgages are small so they need insurance • The average maturity is 30 years • The aggregate mortgage coupon is 12% 100 Mill Capital Requirements: • 50% risk weight in risk-based capital If we increase RAAV by $100, then we need to increase capital by (0.08)($100) = $8 to maintain the RBC ratio • Current capital ratio is 8% 8% capital requirement 50% risk weight $100M in mortgages

35. Example – Reduction of Regulatory Tax Assume the remaining $96M needs to be funded by raising demand deposits Reserve Requirements: • For every $1 of demand deposits $0.10 needs to be held in reserves $96M to fund mortgages $10.67M to meet reserve requirements Excess Reserves FDIC: bank needs to pay a 40 basis point insurance premium

36. Example – Reduction of Regulatory Tax • Cost of holding mortgages on balance sheet: • Securitizing mortgages removes them from the balance sheet and frees up all the regulatory capital associated with holding mortgages Why do banks want to securitize mortgages?

37. Example: Atlantic National Bank purchased a pool of 300 mortgages with an average principal of 250,000 each. They finance the purchase with deposits and equity. Currently, their total risk-based capital ratio of 9.3%. The FDIC charges 0.24% of deposits for insurance and the Fed requires 10% of deposits to be held in reserves. Calculate the total regulatory tax that Atlantic Nation is exposed to from holding mortgage on its balance sheet. Assume mortgages have a 50% risk weight

38. Lecture Summary • Securitization through and SPV or SIV • Pass-through security • Who securitizes assets – which assets • Costs, Benefits and risks associated with Securitization • Regulatory tax