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securitization of mortgages

Page history last edited by Brian D Butler 11 years, 1 month ago









Boom leads to bust

see credit crisis of 2007




Securitization of Mortgages


Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment. It involves the selling of financial instruments which are backed by the cash flow or value of the underlying assets.  Securitization typically applies to assets that are illiquid (i.e. cannot easily be sold). It is common in the real estate industry, where it is applied to pools of leased property, and in the lending industry, where it is applied to lenders' claims on mortgages, home equity loans, student loans and other debts.


Any assets can be securitized so long as they are associated with a steady amount of cash flow. Investors "buy" these assets by making loans which are secured against the underlying pool of assets and its associated income stream. Securitization thus "converts illiquid assets into liquid assets" by pooling, underwriting and selling their ownership in the form of asset-backed securities (ABS).


Securitization has evolved from tentative beginnings in the late 1970s to a vital funding source with an estimated total aggregate outstanding of $8.06 trillion (as of the end of 2005, by the Bond Market Association) and new issuance of $3.07 trillion in 2005 in the U.S. markets alone.


Table of Contents





How it works?


Imagine getting the NPV of your future cash flows today.  This is what a bank / mortgage company does.  They know with high certainty that they will receive money from the mortgages, so, they sell those future cash flows to investors.  In essence, they get the money today, but loose the right to them in the future (giving up a fee in the process).


The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts.








Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are "credit enhanced," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).







Mortgage-backed securities, and Collateralized debt obligations

Mortgage banks began spreading their risk by issuing mortgage-backed securities (MBS) - bonds whose repayments are tied to a large pool of mortgages. By issuing these securities, lenders were able to free up additional capital on their balance sheets, thus allowing them to make more loans and increase the overall velocity of their lending business. This practice was further driven by significant growth in investor appetite as it effectively provided automatic loan diversification, spreading the damage done by a single default across a pool of thousands of loans.


Subsequently, MBSs were increasingly used as components in structured products sold by Wall Street. The key innovation of these structured products was that rather than spread the risk from these mortgage pools evenly across all bondholders, it would instead distribute losses hierarchically to investors, with status being dependent on expected yield. Because of these structures, the conventional wisdom ran that investment grade loans could be created out of low quality credit pools.


This mentality was given further credence by the national credit rating agencies, which began to see spectacular profits due to the boom in structured product issuances. Recent developments have suggested that the rating agencies may have applied a different scale to tranches of structured products, thus leading investors to believe that the probability of default on their investments was substantially lower than the reality.


Recommended reading:


From RGE Monitor:  In Those Who Really Saw the Crisis Coming also Know How it Ends, Joseph Mason looks at the lessons learned from this recession, which saw a very disruptive credit crisis having significant macroeconomic consequences. Mason argues for protecting the integrity of the securitization markets, which play an important role in financial markets, while realistically seeing their limitations.



Why Securitization is a GOOD thing...


From an issuer’s perspective, securitisation provides a vehicle for transforming relatively

illiquid, individual financial assets into liquid and tradable capital market instruments.

Through securitisation, an originator can replenish its sources of funds, which can then be

used for additional origination activities.


Securitisation also provides issuers with what is frequently a more efficient, and lower cost

source of financing in comparison with other bank and capital markets financing alternatives.

The principal reason for this greater efficiency and lower cost of financing is the ability of an

issuer, through securitisation, to issue securities that carry a higher rating (and thus a lower

interest rate) than the long-term credit rating of the originating institution. This affords issuers

cheaper financing than may be supported by their unsecured claims-paying ability.At the same

time, by offering an alternative to more traditional forms of debt and equity financing, securitisation

allows issuers to diversify their financing sources.


Another central objective and benefit of securitisation from an issuer’s standpoint is that

it facilitates the removal of assets from the organization’s balance sheet. This outcome can

help an issuer improve various financial ratios, utilize capital more efficiently and achieve

compliance with risk-based capital standards


Financial institutions in most European jurisdictions

are subject to the Basel Accords, which set forth an agreed framework for measuring

the capital adequacy of certain commercial banks and the minimum standards that must be

achieved. As many banks must either increase capital or dispose of financial assets to comply

with these guidelines, and as increasing capital may be quite expensive, disposing of assets

through a securitisation transaction has become an increasingly attractive means of assisting

commercial banks in complying with the Basel framework.


A final set of issuer benefits associated with securitisation relate to the more flexible

and adaptable nature of this form of financing in comparison with more traditional alternatives.

For example, the ability of an issuer to subdivide and redirect cash flows from

underlying financial assets often provides it with a better ability to manage its balance sheet,

and to achieve a more precise and efficient matching of the duration of its assets and liabilities.

Similarly, many issuers have found that securitisation permits a greater degree of

specialization and corresponding efficiency, by allowing a financial institution to segregate

and unbundle its loan origination, funding and servicing functions in a manner that best

responds to that institution’s competitive advantages and desired strategic focus



From the standpoint of investors, securitised instruments offer significant yield premiums over

sovereign government issues of comparable maturities. The magnitude of this premium

depends on a number of factors, but is most directly related to the credit quality of the particular



Securitised instruments typically are traded on the basis of a spread above a benchmark

rate — such as the London Interbank Offered Rate (LIBOR), in the case of floating rate

instruments. As such, they can help meet investors’ demands for alternative spread-based

investment product, while simultaneously serving basic investment goals of diversification and

the risk reduction that may result.

Investors pursue varying strategies involving the ABS sector. For example, a large percentage

of LIBOR-based floating-rate product tends to be absorbed by commercial paper

conduits or leveraged LIBOR funds.Utilizing this strategy, investors can take advantage of the

spread between their low funding costs and the wider margins available in the ABS market.


On the fixed-rate side, pension funds constitute a large investor segment for certain types of

ABS due to their relatively high credit ratings and predictable cash flow. Given their constituency,

pension funds tend to be conservative in their investment strategy, and ABS provide

a wide variety of product choices at attractive spreads. On the other hand, insurance companies

and money managers tend to focus on total return. The ABS market offers generous

spreads in comparison to the corporate debt markets, allowing total return accounts to focus

on incremental spread characteristics. Accordingly, the bulk of low investment-grade rated

ABS products tend to be purchased by insurance company and money manager accounts


NOTE:  this search for extra return is exactly at the root of the current crisis!


The significant and virtually limitless variety and flexibility of credit, maturity and payment

structures and terms made possible via securitisation techniques allows investment

products to be tailored in a manner that responds to specific, and sometimes unique,

investor needs. This variety and flexibility are the hallmarks of securitisation structures and

instruments, and is a key investor consideration. And, as the secondary market for broad

categories of European securitised instruments matures, and adds greater breadth and

depth, investors are also likely to benefit from increasing levels of liquidity and a corresponding

tightening of spreads.



existence of liquid and efficient secondary securitisation markets has had the effect of increasing the availability,

and reducing the cost, of financing in the primary lending markets.


For all of these reasons, the widespread use and encouragement of securitisation as a

matter of governmental policy can help to achieve desirable social and economic goals, such

as stimulating the growth of affordable housing; increasing the availability and lowering the

cost of consumer credit; promoting efficient market structures and institutions; facilitating

the efficient use and rational allocation of capital; and facilitating the achievement of

governmental fiscal, economic and regulatory policy goals.








Think of the various less-than-transparent actors that have set up shop in London

– Many sovereign wealth funds.

– A lot of the SIVs set up by US (and European) banks were legally domiciled in the UK

– Some credit hedge funds

- And most importantly, a host of European banks with large dollar books (think of them as badly regulated credit hedge funds) ran a large part of the dollar exposure through London.


There was a reason, after all, why residents in the UK were the largest purchaser of US corporate debt over the past few years. Corporate debt – in the US balance of payments data – includes asset-backed securities. Foreign purchases of such debt soared – especially from 2004 to 2007 – before falling off a cliff during the crisis.


see  shadow banking market



Impact on the Developing  world


One of the most important financial innovations has been the securitization of mortgages.  This simple Innovation has had a massive impact on Latin America where it allowed large pools of money to invest in Latin America for the first time.  Before then, the only option for  pension funds, for example, was to invest in the limited number of corporate bonds in Latin America.  But with the innnovation of mortgage backed securities, we saw the mobilization of capital in Latin America for the first time.  Not since the Brady Bonds has there been such an important financial innovation for the financial industry in Lat. AM. 





HOw the Credit crisis happened:


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for more info, visit: http://en.wikipedia.org/wiki/Securitization





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