Ec247 financial instruments and capital markets dr helen weeds 2013 14 spring term
Download
1 / 24

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term - PowerPoint PPT Presentation


  • 96 Views
  • Uploaded on
  • Presentation posted in: General

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term. Lecture 5: Securitisation; credit rating. LEARNING OUTCOMES. At the end of the topic the student should understand: Securitisation What asset-backed securities (ABS) are

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha

Download Presentation

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term

Lecture 5: Securitisation; credit rating


LEARNING OUTCOMES

At the end of the topic the student should understand:

  • Securitisation

    • What asset-backed securities (ABS) are

    • The process of securitisation

    • Structured finance: CDOs and CMOs

    • Structured investment vehicles (SIV)

    • The role of securitisation and structured securities in the financial crisis of 2007-09

  • Credit rating agencies

    • Historical development

    • Role in regulation of financial institutions

    • Conflict of interest

    • Criticisms


SECURITISATION

  • What is securitisation?

    • Packaging of assets, e.g. mortgages or credit card debt, into securities that can be sold to third parties

    • These are asset-backed securities (ABS)

  • Underlying assets are typically difficult to trade (illiquid)

  • ABS that are created are easily traded (liquid)

  • Thus, asset-backed securitisation involves pooling and repackaging of small, homogeneous and illiquid financial assets into liquid securities


How asset securitisation works

  • Originator(e.g. mortgage lender) collects together many (mortgage) claims – i.e. rights to receive interest and capital from borrowers

  • Sets up a special purpose vehicle (SPV) or special purpose entity (SPE), giving this entity the right to collect these cashflows

  • Sells bonds secured against assets of the SPV (i.e. mortgage claims): these are asset-backed securities (ABS)

  • Funds raised from bond sales are used to originate more loans

  • Bonds may be non-recourse or recourse

    • Bondholder may bear risk of non-payment, or may have recourse to the mortgage lender


Examples

  • Mortgage-backed securities

    • Around 80% of asset-backed securities (ABS) world-wide in 2008 were mortgage-backed securities

  • Credit card debt

  • Auto loans

  • Student loans

  • Other examples

    • Pop bands have securitised future royalties on album sales

    • Movie studios have securitised revenues on groups of films

    • Football clubs and museums have securitised future ticket sales

    • Universities have securitised future rental income on student accommodation


Comparing bonds and ABS

  • Bond

    • Guaranteed payments, with specified amounts and dates

    • Redemption date(s) fixed at issue; specified conditions under which the bond may be called prior to maturity

  • ABS

    • Payments are income streams from specific assets

    • Assets may be liquidated earlier than expected (e.g. mortgage redemption), reducing income

    • Higher risk, higher return than on govt or corporate bonds

    • Easier to buy & sell (greater liquidity) than the underlying assets


Why securitise?

  • Specialisation

    • Issuer can focus on making loans, e.g. to a specific group, raising funds from elsewhere

  • Risk profile and risk-spreading

    • Bank reduces its exposure to the housing market

    • Artist protects against risk that changing tastes might reduce sales

  • Reduces issuer’s need for capital reserves

    • Bank loan (an asset in bank’s balance sheet) requires appropriate amount of capital to be set aside to meet regulatory rules

    • Securitisation removes loans from the bank’s balance sheet

  • Liquidity

    • ABS are easier to trade than the underlying assets

    • Sale of ABS creates publicly available prices: assists valuation


Changes mortgage lending

  • ‘Originate and hold’

    • Issuing banks hold loans until they are repaid

    • Traditional model of banking

    • Risk remains with the originator

  • ‘Originate and distribute’

    • Loans are pooled and resold via securitisation

    • Risk is spread to other investors

  • Incentive problem: moral hazard

    • If default risk is passed on to other investors, why take steps to minimise risk?

    • ‘No doc’ and ‘low doc’ loans: ‘liar loans’


Securitisation is not new…

  • USA: mortgage securities have a long history

    • Federal National Mortgage Association (FNMA, ‘Fannie Mae’): set up in 1938, originally a government agency

    • It created a secondary market in mortgages by purchasing mortgage loans from originators, using government money

    • Expanded mortgage lending and supported the housing market, at a time of bank failures

  • Federal Housing Administration (FHA), a government agency, was set up in 1934 to insure mortgage loans

    • Initially most loans bought by Fannie Mae were FHA-backed

  • Fannie Mae established standard procedures for

    • Valuing property, assessing credit-worthiness of borrowers and relating eligibility to income

    • Collection of interest and principal payments


Fannie Mae & Freddie Mac

  • Privatisation and competition

    • In 1968 Fannie Mae became a private-sector corporation

    • Government National Mortgage Association (GNMA, ‘Ginnie Mae’) was split from Fannie Mae, remained government-owned

    • In 1970 Federal Home Loan Mortgage Corporation (FHLMC, ‘Freddie Mac’) was set up to provide competition

  • Government-sponsored enterprises (GSEs)

    • Fannie Mae and Freddie Mac became private-sector corporations but implicitly guaranteed by the federal government

    • In 2008 they had to be bailed out (nationalised) because of huge losses on US home loans


Growth of securitisation

  • Pass-through

    • Fannie Mae originally used government money to buy mortgages; mortgage interest payments repaid the government

    • 1970: first ‘pass-through certificates’ issued, passing mortgage interest and principal payments to private investors: the first ABS

  • Since around 2000

    • Development of mortgage-backed securities in other countries (Europe, Asia)

    • Growth in non-mortgage securities: credit-card loans, auto loans, student loans

  • Mostly private-sector transactions

    • ABS became very popular up to 2007

    • Government guarantees for (some) mortgage-backed securities exist in some but not all countries


STRUCTURED FINANCE

What are structured securities?

  • Consider a pool of assets (e.g. mortgages) to be securitised

  • Divide up the income stream from the pool of assets to create different ‘tranches’ or classes with different characteristics

    • E.g. one tranche might receive all interest and principal payments in the first 3 years, another the payments in years 4-7, etc.

      • These are differently affected by early redemption of mortgages

    • Or different degrees of exposure to defaults

      • Lower tranches absorb losses, making senior tranches less risky

  • Usually 3-5 separate securities created from each asset pool

    • Shortest-term / senior / A tranche has the most stable payments

    • Higher/lower risk for higher/lower expected return

  • Examples

    • Collateralised debt obligation(CDO)

    • Collateralised mortgage obligation(CMO)


Reasons for structured finance

  • Structured finance creates relatively safe securities from securitised assets

    • Senior tranches are lower risk than the underlying assets

  • This is important to certain investors (banks, pension funds)

    • Required by regulation to invest only in ‘investment grade’ bonds

    • Senior tranche of structured securities was created so as to gain high credit rating (AAA)

  • Other tranches are more risky

    • Junior tranche (‘toxic waste’)

    • Mezzanine tranches are between these extremes


Structured investment vehicles (SIV)

  • An SIV (or ‘conduit’) is a non-bank financial institution (i.e. does not take deposits)

    • Usually created by investment banks

    • Off-shore and off-balance sheet: avoid regulation (costly capital requirements) and tax

  • Carries out fixed income maturity transformation

    • Invests in long-term fixed income assets (bonds)

      • Prior to the 2007-09 financial crisis, SIVs invested heavily in asset-backed securities (ABS) and structured products (CMOs)

    • Issues shorter-term liabilities to finance these investments

      • Asset-backed commercial paper (ABCP)

    • Profits from difference between short-term borrowing rates and longer-term returns from investments

  • Many SIVs failed in the financial crisis as lenders withdrew funding: would not buy ABCP


Securitisation and the financial crisis

  • Risks associated with these securities were not well understood or not fully appreciated

  • Riskiness of underlying assets may have been underestimated

    • Sub-prime lending practices

    • Possibility of falling rather than rising house prices

  • Correlation between individual assets in the pool

    • (Low) correlation of defaults is important

    • Pooling and prioritisation can manage idiosyncratic risk

    • But if defaults are highly correlated, even senior tranches become risky

  • House price falls increased defaults across the board


Readings on securitisation

  • Levinson chapter 5 – basic information

  • Brunnermeier (JEP 2009): Deciphering the Liquidity and Credit Crunch 2007–2008

    • Securitised lending and the financial crisis

  • Foote, Gerardi & Willen (BLS chapter 6): Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis

    • Highlights role of overly optimistic expectations of future house prices

    • This made credit-worthiness of borrower seem unimportant, as value of collateral (=house) would cover any credit losses from default


CREDIT RATINGS

  • Credit ratings

    • Indicate risk of default and recoverability of debt

    • Used for gilts, corporate bonds, structured securities, money market instruments, etc.

  • Credit rating agencies (CRA)

    • Evaluate borrowers and individual securities

    • Big 3: Moody’s, Standard & Poor’s (S&P), Fitch

  • CRAs have been much criticised for giving high (AAA) ratings to financial instruments that were later revealed to be very risky in the financial crisis of 2007-09


Role of CRAs

  • CRAs came to hold a crucial position in the financial system

  • History

    • 1909: first publicly available bond ratings (of railroad bonds) issued by Moody’s

    • Other agencies: Poor’s (1916), Standard (1922), Fitch (1924); merger to create S&P (1941)

  • Initially, credit ratings were a private matter

    • Investors (lenders) value credit ratings to reduce asymmetry of information between them and issuers (borrowers)

    • But no requirement to have these


Regulatory ‘outsourcing’

  • 1930s: CRAs took on a regulatory function

    • US bank regulators required banks to invest only in ‘safe’ assets

    • Restricted banks to holding ‘investment grade’ bonds (in today’s terms, rated BBB- or higher on S&P’s scale)

    • As given by ‘recognized ratings manuals’ – which were only Moody’s, Poor’s, Standard and Fitch

  • Hence, judgements of these agencies gained the force of law

    • Delegation of regulatory oversight

    • Banks no longer free to use any source of information

  • Other financial institutions: credit ratings of investments were used to set regulatory capital requirements

    • Insurance companies

    • Pension funds

    • Broker-dealers (investment banks & securities firms): SEC, 1975


Who pays for credit ratings?

  • Credit rating agencies charge for their service

    • Initially, CRAs sold their assessments to investors for a fee

    • 1970s: ‘investor pays’ business model replaced by ‘issuer pays’

  • Possible reasons

    • Photocopying of ratings manuals

    • Greater concerns of bond issuers to have credit ratings, especially given the financial regulations

    • ‘Two-sided’ market: any split of payments is possible in principal

  • Problem: conflict of interests

    • Incentive to raise the rating to keep the customer (issuer) happy

  • Worsened by competition

    • ‘Shopping around’: issuer goes to CRA that gives it the highest rating

    • Raise rating to prevent the issuer going to another CRA

  • Reputation concerns of CRAs may limit this incentive


Criticisms of CRAs

CRAs failed to spot major financial failures and/or were slow to adjust ratings

  • Enron (energy co.) bankruptcy Nov 2001

    • Bonds rated ‘investment grade’ until 5 days before bankruptcy was declared

  • WorldCom (telecoms co.) bankruptcy July 2002

    • CRAs slow to downgrade despite indications of deteriorating finances

  • Lehman Brothers (investment bank) bankruptcy Sept 2008

    • Commercial paper still rated ‘investment grade’ the morning it declared bankruptcy


CRAs and securitisation

  • Securitisation played a major role in financing of subprime mortgage lending

  • High credit ratings were given to senior tranches of mortgage-backed securities (CMOs)

    • High ratings were necessary for regulated financial institutions to invest in these

    • Structured products were designed so as to achieve high ratings, often with the help of the CRAs

  • Problems

    • Complexity of mortgage-related securities

    • Small number of issuers with high volumes: worsened incentive problem for CRAs

  • Many CDO tranches initially rated AAA were subsequently downgraded to below investment grade


Policy responses

Tweaks to try to improve CRA performance

  • Increase entry

    • SEC designated more ‘nationally recognized statistical rating organizations’ (NRSRO)

  • Limit conflicts of interest

    • E.g. CRA must not rate a CDO that it has helped to design

  • Increase transparency

    • Publish details on methodologies, assumptions, track records

  • Not clear how effective these measures will be

  • Meanwhile, CRAs retain their central role in financial regulation


Readings on CRAs (incl. term paper)

  • White (JEP 2010): Markets: The Credit Rating Agencies

    • Discussion summarised in this lecture

  • Hull & White (BLS chapter 7): Ratings, Mortgage Securitizations, and the Apparent Creation of Value

    • More detail on how ratings are (and should be) assessed

  • Bolton, Freixas & Shapiro (JF 2012), The Credit Ratings Game

    • Conflicts of interest among CRAs in a competitive model

  • White (2010): Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs Is a Better Response

    • Argues that regulation of financial institutions’ bond portfolios should reduce reliance on ratings from CRAs

    • And reduce regulation of CRAs to increase entry and innovation in provision of creditworthiness information


ad
  • Login