Securitization
Securitization
is a technique whereby assets are
pooled and security interests in the pool are sold. These operations are made
typically to institutional investors.
Assets
created in this manner include mortgage-backed securities wich are backed by
residential mortgages, and asset-backed securities which are backed by credit
card receivables or consumer installment loans.
In
a typical arrangement, the assets are transferred to a trust [ and security
interests are sold to investors. While various arrangements are used, typically,
principal and interest cash flows are paid directly to investors. In this way,
the investors incur the prepayment risk of the underlying assets.
Most
deals entail some sort of credit
enhancement. This may include over-collateralisation, a third party guarantee,
or other enhancements. For this reason, the securities tend to have excellent
credit ratings.
The
originator of the underlying assets may continue to process the assets—communicating
with borrowers and collecting their payments. They subtract a fee for doing so.
Alternatively, the originator may sell these "processing rights" to a
third party.
For
loan originators securitization is a means of removing risky assets from their
balance sheet, freeing up capital to support further loan writing.
For
investors, the securities offer yields that exceed those on comparable corporate
bonds. Because the deals are usually large and have high credit ratings, the
securities tend to be liquid—most are actively traded on secondary markets.
Mortgage-backed
security (MBS) is a bond which represents a securitized interest
in
a pool of (typically residential) mortgages.
The simplest form of MBS is a
mortgage pass-through. With that structure, all principal and interest payments
(less a processing fee) from the pool of mortgages are passed directly to
investors each month.
A
typical 30-year fixed-rate residential mortgage makes a fixed payment each month
until its maturity. Each payment represents a partial repayment of principal
along with interest on the outstanding principal. Over time, as more and more of
the principal is paid off, the size of the interest payment declines.
Accordingly, the proportion of each payment representing principal repayment
increases over the life of the mortgage.
Although
the scheduled payments on a mortgage are fixed from one month to the next, the
cash flows to the holder of a mortgage pass-through are not fixed. This is
because mortgage holders have the option of prepaying
their mortgages. When a mortgage holder exercises that option, their principal
prepayment is passed to the holder of the pass-through. This accelerates the
cash-flows to the holder of the pass-through who receives the principal payments
early, but never receives the future interest payments that would have been made
on that principal.
Prepayments
introduce uncertainty into the cash flows of a mortgage pass-through. The rate
at which mortgage holders prepay their mortgages is influenced by many factors,
not least of these being the level of interest rates. If interest rates decline
following the issuance of a mortgage, the mortgage holder is more likely to
prepay—refinancing the mortgage to take advantage of the lower rate. On the
other hand, if interest rates rise, the mortgage holder is more likely to not
prepay because the mortgage's rate is now low relative to rates otherwise
available in the market.
By
acting in their own best interest, mortgage holders act to the detriment of the
investor holding the mortgage pass-through. The duration of the pass-through
extends as interest rates rise, and contracts as interest rates fall. For this
reason, mortgage pass-throughs entail significant convexity risk. To compensate
investors for that convexity risk, pass-throughs typically offer higher yields
than comparable corporate bonds.
Despite
their market risk, mortgage pass-throughs were considered as entailing little credit risk.
This is because they are usually insured by a US federal agency or quasi-federal
agency such as FHLMC (the Federal Home Loan Mortgage Corporation, or "Freddie
Mac"), FNMA (the Federal National Mortgage Association, or "Fannie Mae")
or GNMA (the Government National Mortgage Association, or "Ginnie Mae")
Asset-backed
securities represent securitized interests in a pool of assets. Issues have been
backed by credit card receivables, auto loans and other forms of consumer installment loans.
Investors
receive monthly payments of principal and interest. Securities backed by
installment loans operate much like a mortgage pass-through.
All principal and interest payments flow directly to investors.
Securities
backed by revolving credit lines, such as credit cards, may delay distributing
principal during a lockout period. During that period, principal cash flows are
reinvested in additional receivables. Once the lockout period is over, principal
flows to the investors.
The
rate at which asset-backed securities pay down principal, as well as their
ultimate maturity date, is uncertain. This is because principal cash flows
depend upon the rate at which individual consumers decide to prepay their
indebtedness. However, because deals are large, and diversified across many
loans, this uncertainty is minimal. Unlike mortgage-backed securities, whose
prepayment rates are affected by changes in interest rates, asset-backed
security prepayments show little sensitivity to interest rates.