ec247 financial instruments and capital markets dr helen weeds 2013 14 spring term n.
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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