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Overview

Overview.

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Overview

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  1. Overview • Securitization is another mechanism that may be employed by FIs to manage their risk exposure and improve liquidity. This chapter explores the role of securitization in improving the risk-return trade-off. The three major forms of asset securitization, and its mortgage lending origins, are also explained.

  2. Introduction • Securitization: Packaging and selling of loans and other assets backed by securities • Many types of loans and assets are being repackaged in this fashion • Original use was to enhance the liquidity of the residential mortgage market • Separates the risk of assets from lending • Perverse incentive effects instrumental in creating the financial crisis

  3. Conversion of On-Balance-Sheet Assets to Securities • Creation of special purpose vehicle, or SPV, to facilitate the removal of assets from the balance sheet • SPV earns fees from creation and servicing • All cash flows pass through the SPV according to terms of the ABS contract • SPV exists until cash flows from the assets are fully distributed • Structured investment vehicle, or SIV, issues commercial paper to purchase bank loans • SIV essentially an asset-backed security

  4. Traditional Process using SPV

  5. Structured Investment Vehicles • SIV responsible for payments on its ABCP obligations even if underlying assets do not generate sufficient cash flows • When the cash flows exceed costs, the SIV keeps the spread • Usually has lines of credit or loan commitments from sponsoring bank • Liquidity risk implications & exposure to runs

  6. Traditional Process using SIV

  7. Special Purpose Entities • Profitability of SPVs and SIVs hinges on maintaining high credit rating • Prominent role in the 2008-2009 financial crisis • Subprime market • Misperceptions of the credit risk • Complexity encouraged regulator reliance on the banks’ complex models • Abdication of responsibility

  8. The Pass-Through Security • Government National Mortgage Association (GNMA) • Sponsors MBS programs and acts as a guarantor • Timing insurance • FNMA actually creates MBSs by purchasing packages of mortgage loans • Fully guarantees the securities

  9. Freddie Mac • Federal Home Loan Mortgage Corporation • Similar function to FNMA except major role has involved savings institutions • Stockholder owned with line of credit from the Treasury • In conservatorship with the FHFA • Sponsors conventional loan pools as well as FHA/VA mortgage pools

  10. Web Resources • For more information on mortgage loans, visit: GNMA www.ginniemae.gov FNMA www.fanniemae.com FHLMC www.freddiemac.com

  11. Incentives & Mechanics of Pass-Through Security Creation • Example: Create a mortgage pool from one-thousand $100,000 mortgages (results in $100 million) • Each mortgage receives credit risk protection from FHA • Capital requirement: $4 million • Must issue more than $96 million in liabilities due to reserve requirements (+ FDIC premia) • Reduces regulatory tax burden

  12. Further Incentives • Gap exposure • Illiquidity exposure • Default risk by mortgagees • FHA/VA bears the default risk • Default risk by bank/trustee • GNMA responsible for payments to bondholders

  13. Present Value of the Pass-through • Because of the servicing fees, the present value of the payments to the holder of the pass-through will be less than the present value of the underlying mortgage payments, assuming zero prepayments

  14. Present Value of a Mortgage • For monthly payments (PMT), the monthly interest rate equals r/m, where r is the APR and m = 12 months • For a mortgage with a remaining time to maturity of n years, the present value is calculated as: • Recognizable as the product of PMT and PVAF

  15. Prepayment Effects • Prepayments result of: • Refinancing • Prepayment penalties and points • Housing turnover • Most GNMA pools allow assumable mortgages • Not the case for FNMA or FHLMC pass-throughs

  16. Prepayment Effects • Good news effects • Lower market yields increase present value of cash flows • Principal received sooner • Bad news effects • Fewer interest payments in total • Reinvestment at lower rates

  17. Prepayment Models • Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates • Weighted-average life WAL = [ Time × Expected Principal received] Total principal outstanding

  18. Prepayment Models • Methods: • Public Securities Association (PSA) approach • Other empirical approaches • Option pricing approach

  19. PSA Model • Assumes 0.2 percent per annum in first month, increasing by 0.2 percent per month for first 30 months, until annualized prepayment rate equals 6 percent • Actual outcomes affected by relative coupon level, age of mortgage pool, amortization, assumability, size of pool, conventional/non-conventional, location, and demographics of mortgagees

  20. Other Empirical Models • Generally proprietary variants of PSA model • Incorporate: • Economic variables • Burn-out factor variables • Idiosyncratic factors

  21. Option Model Approach • Use option pricing theory to figure fair yield spread of pass-throughs over Treasuries • Fair price on pass-through, decomposable into two parts: • PGNMA = PTBOND - PPREPAYMENT OPTION

  22. Option Adjusted Spread • Within the binary tree structure, the option adjusted spread can be calculated as the spread over the Treasury security term structure needed to equate the present value of the cash flows with the observed price of the security • Value of the prepayment option: • Option-adjusted spread between GNMAs and T-bonds reflects value of a call option

  23. FNMA and FHLMC Concerns • Gained too much market share and pose a serious risk to financial system • Credit losses and high debt to equity • Excessive interest rate risk exposure FNMA • Overcharging lenders • Freddie Mac misstatement of earnings • FNMA $1.1 billion restatement of equity • Perception of complete federal backing • Threat to the financial system during the crisis • Delisting of Fannie and Freddie

  24. Collateralized Mortgage Obligation (CMO) • CMO structure • Prepayment effects differ across tranches (classes) • Z-Class CMO • R Class • Improves marketability of the bonds

  25. Mortgage-Backed Bonds (MBBs) • Normally remain on the balance sheet • Regulatory concerns • Other drawbacks to MBBs

  26. Innovations in Securitization • Pass-through strips • IO strips • Negative duration • PO strips • Effect of prepayments • Highly sensitive to interest rate changes

  27. Securitization of Other Assets • Securitization of other assets • CARDs • Various receivables, loans, junk bonds, ARMs • Bounds on securitization: • Degree of homogeneity of underlying assets • Credit quality of underlying assets • If difficult to value, costs of securitizing are higher

  28. Bounds on Securitization • Serious damage to SIVs, the FIs that owned them, and to financial markets delivered by CDOs backed by subprime and alt-A CMO tranches • Most investors did no analysis • Homogeneous assets are better assets for the purpose of securitization

  29. Pertinent Websites Federal Reserve www.federalreserve.gov FHLMC www.freddiemac.com FNMA www.fanniemae.com GNMA www.ginniemae.gov Securities Industry and www.sifma.org Financial Markets Assoc.

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