EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 5: Securitisation; credit rating

2. 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

3. SECURITISATION • 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

4. 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

5. Examples • 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

6. 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

7. 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

8. 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’

9. 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

10. 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

11. 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

12. 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)

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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