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Chapter 27 Securitization.docx

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FIN 701
Patricia Mc Graw

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FIN701 Financial Institutions Management CHAPTER 27 Securitization INTRODUCTION  Asset securitization – packaging and selling of loans and other assets as securities o Used to hedge interest rate exposure gaps, allows FI asset portfolios to become more liquid, provides source of fee income, and reduces effects of regulatory “taxes” such as capital requirements and deposit insurance premiums THE CANADIAN MARKET FOR ASSET-BAKED SECURITIES (ABS)  Asset-backed commercial paper (ABCP) – short-term debt issued by commercial firms that is backed by collateral such as inventory and accounts receivables o Canadian markets and their FIs were stable during the credit crisis, with the exception of ABCP  Capital markets – market for all short-term and long-term financial securities  Money market – market for short-term financial securities with maturities of less than one year ABCP Market Freeze: August 2007  Bank-sponsored ABCP supported by backup lines of credit that issuers were able to draw down  Under market disruption clause of contracts, non-bank issuers of ABCP were unable to draw down on backup credit lines  Conduits – trust created to purchase assets from FIs and corporations and issue asset-backed securities to investors The Securitization Market: 2008-2009  Asset-backed securities outstanding divided into two types: term asset-backed securities for longer maturities, and asset- backed commercial paper for shorter maturities  Assets securitized in Canadian ABCP market dominated by credit cards, commercial mortgages and auto leases  Banks manage securitizations of trade receivables, credit cards, and mortgages of other firms via special-purpose entities (SPEs) or variable-interest entities (VIEs) and receive a fee to administer them THE PASS-THROUGH SECURITY  FIs pool mortgages and other assets they originate and offer investors an interest in the pool in the form of pass-through securities o Pass-through mortgage securities “pass through” promised payments by households of principal and interest on pools of mortgages created by financial institutions to secondary investors (mortgage-backed security bondholders) holding an interest on these pools  Original use of securitization is a result of government sponsored programs to enhance the liquidity of residential mortgage market and indirectly subsidizes growth of home ownership  Four government agencies or government-sponsored enterprises directly involved in creation of mortgage-backed, pass- through securities: CHMC, GNMA, FNMA, FHLMC CHMC  Canadian Mortgage and Housing Corporation (CHMC) are fully insured, guarantees all payments to the security holders under the National Housing Act (NHA), and an NHA MBS is equivalent to Government of Canada bond o These securities are default free and serve as a substitute for fixed-income securities o Issuers of NHA MBS are FIs who are approved lenders of NHA-insured mortgages GNMA  Government National Mortgage Association (GNMA) or “Ginnie Mae” is a government-owned agency with two functions 1. Sponsoring mortgage-backed securities programs by FIs such as banks, thrifts (savings and loans), and mortgage bankers 2. Acting as guarantor to investors in mortgage-backed securities regarding timely pass-through of principal and interest payments on sponsored bonds  Timing insurance – service provided by sponsor of pass-through securities guaranteeing bondholder interest and principal payments at the calendar date promised FNMA  Federal National Mortgage Association or “Fannie Mae” creates mortgage-backed securities by purchasing packages of mortgage loans from banks and thrifts; it finances such purchase by selling MBSs to outside investors such as life insurers and pension funds FIN701 Financial Institutions Management  Engages in swap transactions whereby it swaps MBSs with an FI for original mortgage o FNMA guarantees securities as to full and timely payment of interest and principal, FI receiving MBSs can resell them on capital market or hold them in its portfolio FHLMC  Federal Home Loan Mortgage Corporation (FHLMC) or “Freddie Mac” are similar to FNMA except that its major securitization role has involved savings institutions  Sponsors conventional loan pools as well as pools of government-sponsored mortgage loans, and guarantees timely payment of interest and ultimate payment of principal on securities it issues The Incentives and Mechanics of Pass-Through Security Creation  Focus of FI in creating ABS is to forecast projected cash flow that determines yield and depends on prepayment model assumed  For MBS security, contraction risk arises when mortgage rates decline and borrowers speed up their prepayments; extension risk arises when mortgage rates rise and prepayments slow down, leading to decline in market price of security  Mortgage portfolio faces two levels of regulatory costs: 1. Capital requirements 2. CDIC insurance premiums  Mortgage portfolio faces two risk exposure problems: 1. Gap exposure or D A kD –Lduration mismatch 2. Illiquidity exposure – exposed to potential liquidity shortages including risk of having to conduct mortgage asset fire sales to meet large unexpected demand deposit withdrawals  Possible solution to reduce risk exposure (but does not resolve regulatory cost) is lengthen bank’s on-balance-sheet liabilities by issuing longer-term deposits or engage in interest rate swaps to transform the bank’s liabilities into those of long-term, fixed-rate nature  Possible solution to reduce risk exposure and regulatory cost by creating NHA pass-through securities o Packaging mortgage loans and removing them from balance sheet by placing them with a third party trustee in a special-purpose vehicle (SPV) off the balance sheet o Bank determines that (1) CMHC will guarantee, for a fee, timing of interest and principal payments on securities issued to back mortgage pool and (2) bank itself will continue to service pool of mortgage for a fee, even after they are placed in trust o NHA CHMC mortgage-based securities are sold to outside investors in capital market and proceeds go to originating bank  Investors are protected against two types of default risk 1. Default risk by the mortgagees – through CMHC housing insurance, government agencies bare the risk of default, thereby protecting NHA MBS holders against losses 2. Default risk by bank/trustee – because of guaranteed prompt timing of interest and principal payments on HNA CHMC securities, CHMC would bear cost of making the promised payments in full and on time to MBS holders  Cash proceeds from mortgage/NHA MBS sale can be reduced to create or originate new mortgages; FI acting more of asset broker than asset transformer o FI profits from mortgage pool servicing fees plus up-front fees from mortgage origination and no longer bare illiquidity, duration mismatch risk, and regulatory costs Prepayment Risk on Pass-Through Securities  Cash flows on pass-through directly reflect interest and principal cash flows on underlying mortgages minus service fees o Over time, mortgage rates change where if interest decreases, the market value of pool will be greater than its original value; if interest increases, the market value will decrease in value  Prepayment risk has two principal sources: 1. Refinancing – as coupon rates fall, increasing incentive for individuals to pay off old high-cost mortgages and refinance at lower rates  Refinancing involves transaction costs and recontracting costs, new mortgages involve cost of appraisal a
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