Www Homeequityloanmorgages T Equity Equity Home It 1 Home Equity Loan Morgages History and overview ofecuritization

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History and overview of securitization — Document Transcript

• zycnzj.com/ www.zycnzj.com Statement of Cameron L. Cowan Partner Orrick, Herrington, and Sutcliffe, LLP On behalf of the American Securitization Forum Before the Subcommittee on Housing and Community Opportunity Subcommittee on Financial Institutions and Consumer Credit United States House of Representatives Hearing on Protecting Homeowners: Preventing Abusive Lending While Preserving Access to Credit November 5, 2003 Thank you Chairman Ney and Chairman Bachus for holding this hearing and the opportunity to testify today on the role and importance of securitization in the mortgage industry. My name is Cameron Cowan. I am a partner at the law firm of Orrick, Herrington, and Sutcliffe. Within Orrick, I serve as the managing director of financial practice and as a member of the firm’s executive committee. I am also a member of the American Securitization Forum’s (ASF) executive committee and I chair the ASF’s Legislative and Judicial Subcommittee. The ASF, an affiliate of The Bond Market Association, is a broadly-based professional forum of participants in the U.S. securitization market. Among other roles, the ASF members act as investors, issuers, underwriters, dealers, rating agencies, insurers, trustees, servicers and professional advisors working on transactions involving securitizations. For the last 16 years, my law practice has focused on structured finance—also known as securitization. My knowledge of subprime and predatory lending generally comes from the perspective of the secondary market. In my testimony today, I will focus on the securitization process, the growth of the industry and the many benefits securitization brings to consumers (including subprime borrowers), investors and issuers. History and Overview of Securitization Securitization is the creation and issuance of debt securities, or bonds, whose payments of principal and interest derive from cash flows generated by separate pools of assets. It has grown from a non-existent industry in 1970 to $6.6 trillion as of the second quarter of 2003. Financial institutions and businesses of all kinds use securitization to immediately realize the value of a cash-producing asset. These are typically financial assets such as loans, but can also be trade receivables or leases. In most cases, the originator of the asset anticipates a regular stream of payments. By pooling the assets together, the payment streams can be used to support interest and principal payments on debt zycnzj.com/ 360 MADISON AVENUE NEW YORK, NY 10017-7111 Telephone 646.637.9200 Fax 646.637.9126 americansecuritization.com 1399 NEW YORK AVENUE, NW WASHINGTON, DC 20005-4711 Telephone 202.434.8400 Fax 202.434.8456
• zycnzj.com/ www.zycnzj.com securities. When assets are securitized, the originator receives the payment stream as a lump sum rather than spread out over time. Securitized mortgages are known as mortgage-backed securities (MBS), while securitized assets—non-mortgage loans or assets with expected payment streams—are known as asset-backed securities (ABS). To initiate a securitization, a company must first create what is called a special purpose vehicle (SPV) in the parlance of securitization. The SPV is legally separate from the company, or the holder of the assets. Typically a company sells its assets to the SPV. The payment streams generated by the assets can then be repackaged to back an issue of bonds. Or, the SPV can transfer the assets to a trust, which becomes the nominal issuer. In both cases, the bonds are exchanged with an underwriter for cash. The underwriter then sells the securities to investors. Unlike other bonds, securities backed by mortgages usually pay both interest and a portion of the investor's principal on a monthly basis. Mortgage-Backed Securities The first mortgage-backed securities arose from the secondary mortgage market in 1970. Investors had traded whole loans, or unsecuritized mortgages, for some time before the Government National Mortgage Association (GNMA), also called Ginnie Mae, guaranteed the first mortgage pass-through securities that pass the principal and interest payments on mortgages through to investors. (Ginnie Mae is a government agency that guarantees securities backed by HUD- and Veterans Administration-guaranteed mortgages.) Ginnie Mae was soon followed by Fannie Mae, a private corporation chartered by the federal government—along with Freddie Mac—to promote homeownership by fostering a secondary market in home mortgages. Pass-throughs were a dramatic innovation in the secondary mortgage market. The whole- loan market, the buying and selling of mortgages, was relatively illiquid. This presented a risk to mortgage lenders who could find themselves unable to find buyers if they wanted to sell their loan portfolios both quickly and at an acceptable price. Holding the loans also meant exposure to the risk that rising interest rates could drive a lender's interest cost higher than its interest income. But trading whole loans meant a raft of details and paperwork that made the business relatively costly. MBS changed that. By combining similar loans into pools, the government agencies are able to pass the mortgage payments through to the certificate holders or investors. This change made the secondary mortgage market more attractive to investors and lenders alike. Investors now had a liquid instrument and lenders had the option to move any interest rate risk associated with mortgages off of their balance sheet. Growth in the pass-through market inevitably led to innovations especially as originators sought a broader MBS investor base. In response, Fannie Mae issued the first collateralized mortgage obligations (CMO) in 1983. A more complicated twist on pass- throughs, CMOs redirect the cash flows of trusts to create securities with several different payment features. The central goal with CMOs was to address prepayment risk—the main obstacle to expanding demand for pass-throughs. Prepayment risk for MBS 2 zycnzj.com/
• zycnzj.com/ www.zycnzj.com investors is the unexpected return of principal stemming from consumers who refinance the mortgages that back the securities. Homeowners are more likely to refinance mortgages when interest rates are falling. As this translates into prepayment of MBS principal, investors are often forced to reinvest the returned principal at a lower return. CMOs accommodate the preference of investors to lower prepayment risk with classes of securities that offer principal repayment at varying speeds. The different bond classes are also called tranches (a French word meaning slice). Some tranches—CMOs can include 50 or more—can also be subordinate to other tranches. In the event loans in the underlying securitization pool default, investors in the subordinate tranche would have to absorb the loss first. As part of the Tax Reform Act of 1986, Congress created the Real Estate Mortgage Investment Conduit (REMIC) to facilitate the issuance of CMOs. Today almost all CMOs are issued in the form of REMICs. In addition to varying maturities, REMICs can be issued with different risk characteristics. REMIC investors—in exchange for a higher coupon payment—can choose to take on greater credit risk. Along with a simplified tax treatment, these changes made the REMIC structure an indispensable feature of the MBS market. Fannie Mae and Freddie Mac are the largest issuers of this security. Asset-Backed Securities The first asset-backed securities (ABS) date to 1985 when the Sperry Lease Finance Corporation created securities backed by its computer equipment leases. Leases, similar to loans, involve predictable cash flows. In the case of Sperry, the cash flow comes from payments made by the lessee. Sperry sold its rights to the lease payments to an SPV. Interests in the SPV were, in turn, sold to investors through an underwriter. ABS Outstanding (billions) $4,000 $3,000 $2,000 $1,000 $0 1995 1996 1997 1998 1999 2000 2001 2002 2003:Q2 Outstanding Automobile Credit Card Home Equity Manufactured Housing Student Loans Equipment Leases CBO/CDO Other Source: The Bond Market Association Since then, the market has grown and evolved to include the securitization of a variety of asset types, including auto loans, credit card receivables, home equity loans, 3 zycnzj.com/
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