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FASRI Office Hours Securitizations

This document explores the intricacies of securitization, particularly focusing on mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). It details how these financial instruments work, their structure—including various tranches like AAA and mezzanine—risks involved with cash flow dependencies, and the conceptual issues surrounding asset derecognition and valuation. By dissecting the essential components of securitization, we illuminate how these complex financial products can impact market behavior and investor strategies, emphasizing critical considerations for effective risk management.

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FASRI Office Hours Securitizations

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  1. FASRI Office HoursSecuritizations Catherine Shakespeare

  2. How does a securitization work? Mortgage-backed Securities Assets Account Receivables A AAA Tranche Pooled Account Receivables B Mezzanine A Account Receivables C Retained Interest

  3. What is a CDO? Mortgage-backed Securities Collateralized Debt Borrowing Assets Mezzanine B (From another securitization) AAA Tranche Account Receivables A AAA Tranche Mezzanine A Pooled ABC Account Receivables B Pooled Mezzanine D Account Receivables C Retained Interest Mezzanine C (From another securitization) Residual

  4. CDO2 Mortgage-backed Securities (MBS) Collateralized Debt Borrowing Collateralized Debt Borrowing Assets Mezzanine B (from another MBS) Mezzanine E (from another MBS) AAA Tranche AAA Tranche AAA Tranche AAA Tranche AAA Tranche Account Receivables A Pooled Pooled ABC Pooled DEF Mezzanine A Account Receivables B MezzanineA MezzanineD Mezzanine G Account Receivables C Retained Interest Residual Residual Mezzanine C (from another MBS) Mezzanine F (from another MBS)

  5. What happens on when the cash flows disappear? Mortgage-backed Securities Assets Account Receivables A AAA Tranche Pooled Account Receivables B Mezzanine A Account Receivables C Retained Interest Note: Indicates the default portion

  6. Extends into the CDO market Mortgage-backed Securities Collateralized Debt Borrowing Assets Mezzanine B (From another securitization) AAA Tranche AAA Tranche Account Receivables A Pooled ABC Account Receivables B Pooled Mezzanine A Mezzanine D Account Receivables C Retained Interest Mezzanine C (From another securitization) Residual Note: Indicates the default portion

  7. House of cards start to fall…. Mortgage-backed Securities (MBS) Collateralized Debt Borrowing Collateralized Debt Borrowing Assets Mezzanine E (from another MBS) Mezzanine B (from another MBS) AAA Tranche AAA Tranche AAA Tranche AAA Tranche Account Receivables A AAATranche Pooled Pooled ABC Pooled DEF Mezzanine A Account Receivables B MezzanineA MezzanineD Mezzanine G Account Receivables C RetainedInterest Residual Residual Mezzanine C (from another MBS) Mezzanine F (from another MBS) Note: Indicates the default portion

  8. Asset Derecognition • Asset sold for cash, seller has no further involvement • Asset sold for cash, seller has a call option to repurchase the asset, option way out of the money • Asset sold for cash, seller has a call option to repurchase the asset, option way in the money • Firm has a call option to purchase an option never owned

  9. Asset Securitization: Conceptual Issues • What are the basic conditions for removing an asset from the books? • Is failure to meet the definition of an asset sufficient? • If not, is there a flaw in the definition? • Implications of answer • Income statement – gain/loss • Balance sheet – don’t remove asset cash received is a loan

  10. Asset Securitization: Conceptual Issues • Does ownership history matter? • Can part of an asset be derecognized? • Modifications introduced as part of the transfer • Derivatives or guarantee • Derivative offsets risks but introduces a new source of risk (counterparty performance) • Cash flows may come from sources other than the asset • Should these differences affect the accounting treatment?

  11. Asset Securitization: Conceptual Issues • Is legal isolation required? • Does the order of the transactions matter? • Fixed price call option to repurchase a previously owned asset, versus the same option on an asset never owned • Can pieces of an asset be sold? • Strict control might say no, strict components would say yes • How would you divide the asset? • Cash flows, risk • How does derecognition interact with the choice of measurement attributes?

  12. Asset Securitization: Possible Approaches • Risk and Rewards • Compare transferor’s exposure before and after the transfer • Should we look at max exposure or expected exposure? • Control • Assets are placed beyond reach of the transferor and creditors • Transferee must be able to pledge/exchange assets • Should we really look to the transferee to determine the transferor’s accounting? • Components Approach • Focus on the contractual pieces • Every call put etc would be separately valued

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