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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

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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

    • 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


  • 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
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


  • 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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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