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Homeequityloanmorgages Z Home Szh Html Association Home Equity Loan Morgages History and overview of securitization
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p Home incip Home l Home Html nvsearchst Home rsearch 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,
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manufactured housing loans, student loans and even future entertainment royalties.
Credit card receivables, auto and home-equity loans make up about 60 percent of all
ABS. Manufactured housing loans, student loans and equipment leases comprise most
of the other ABS. And the industry continues to look for new assets to securitize such as
auto leases, small-business loans and "stranded cost recovery" ABS. (The latter refers to
bonds backed by fees some newly deregulated utilities have won authority to include in
future billings as an offset of previous investment.)
How Securitization Works
ABS and MBS represent an interest in the underlying pools of loans or other financial
assets securitized by issuers who often also originate the assets. The fundamental goal of
all securitization transactions is to isolate the financial assets supporting payments on the
ABS and MBS. Isolation ensures payments associated with the securities are derived
solely from the segregated pool of assets and not from the originator of the assets. By
contrast, interest and principal payments on unsecuritized debt are often backed by the
ability of the issuing company to generate sufficient cash to make the payments.
Origination and Servicing
The assets used in securitizations are created—or originated—in a number of ways.
When a lender extends a loan or acquires another revenue-producing asset such as a
lease, they are creating assets that can be securitized. Other assets, such as the balances
due on credit card accounts or a corporation's accounts receivable can also be securitized.
Because they initiate the securitization chain, the lenders, credit card companies and
others are also called originators. Originators often retain a connection to their assets
following a securitization by acting as a servicer—the agent collecting regular loan or
lease payments and forwarding them to the SPV. Servicers are paid a fee for their work.
Some originators contract with other organizations to perform the servicing function, or
sell the servicing rights.
Asset Transfer or the "True Sale"
In the vast majority of securitizations, it is critical that the transfer of assets from the
originator to the SPV is legally viewed as a sale, or "true sale." The proceeds of the
securities are remitted to the originator as the purchase price for the assets. If the asset
transfer is not a "true sale," investors are vulnerable to claims against the originator of the
assets. The cash flows backing the securities or the assets themselves could be ruled a
part of the originator's estate and used to satisfy creditors' claims if a true sale did not
occur. Legally separating the assets also protects the originator.
Investors can turn only to the SPV for payments due on the ABS and MBS, not to the
general revenues of the originator.
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Special Purpose Vehicle and the Trust
The SPV can either be a trust, corporation or form of partnership set up specifically to
purchase the originator's assets and act as a conduit for the payment flows. Payments
advanced by the originators are forwarded to investors according to the terms of the
specific securities. In some securitizations, the SPV serves only to collect the assets
which are then transferred to another entity—usually a trust—and repackaged into
securities. Individuals are appointed to oversee the issuing SPV or trust and protect the
investors' interests. The originator, however, is still considered the sponsor of the pool.
Underwriter
Underwriters—usually investment banks— serve as intermediaries between the issuer
(the SPV or the trust) and investors. Typically, the underwriter will consult on how to
structure the ABS and MBS based on the perception of investor demand. The
underwriter may, for example, advise the SPV to issue different tranches each with
specific characteristics attractive to different segments of the market. Underwriters also
help determine whether to use their sales network to offer the securities to the public or to
place them privately. Perhaps most importantly, underwriters assume the risk associated
with buying an issue of bonds in its entirety and reselling it to investors.
Credit Enhancement
Credit enhancement is common in securitization transactions. Depending on the nature
of the transaction and the type of assets, the securitization pool may need such support to
attract investors. Enhancement or support can come from the assets themselves or from
an external source. Examples of internal enhancements include subordinating one or
more tranche, or portion, of the securities issued. This practice places the claims of one
tranche over another. Any defaults affecting the securities must be absorbed by a
subordinate tranche before the senior tranche is affected. Over-collateralization of asset
pools is also used to enhance credit. This occurs when the amount of assets placed in a
securitization pool exceeds the principal amount of bonds issued.
External credit enhancements can include a surety bond or a letter of credit from a
financial institution. Both options serve as guarantees that investors will receive the
payments associated with the securities. GSEs enhance the credit of the MBS they issue
by guaranteeing the timely repayment of principal and interest.
Credit Rating
Virtually all ABS and MBS are rated by independent rating agencies whose analyses is
watched closely by investors as a guide to the credit quality of the securities. In almost
all cases, rating agencies monitor the performance of the securities on an ongoing basis.
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Dealers
Just as in other bond markets, dealers play an important role once an issue is initially
distributed. For most bond investors, liquidity—the ability to easily buy or sell a
security—is an important characteristic. By offering prices at which they will buy or sell
bonds to the investment community, dealers provide this service. Bonds typically trade
more actively closer to their date of issue. Because bond investors—usually institutional
investors such as pension funds and insurance companies—hold most bonds to maturity,
trading in bonds declines as they draw nearer to their stated maturity date. The issuance
volume of a certain bond, a bond's credit rating and whether it was issued publicly or
privately can also affect liquidity. All ABS and MBS are traded on the dealer-based,
over-the-counter markets so liquidity depends in part on the ability and willingness of
dealers to maintain an inventory, or make a market, in a certain bond.
Benefits of Securitization
Less Expensive, More Broadly Available Credit
The public benefits of securitization are evident in a number of ways. Chief among these
is the contribution of securitization to lower borrowing costs both for individuals and
corporations. The existence of a liquid secondary market for home mortgages increases
the availability of capital to make new home loans. Financial institutions that realize the
full value of their loans immediately can turn around and re-deploy that capital in the
form of a new loan. This is often the most efficient way to raise new funds in the capital
markets and the savings are passed on to the borrower.
Consumers other than homebuyers also benefit from lower borrowing costs.
Securitization can lower a firm's financing costs as well. MBS and ABS are often
designed to carry a higher credit rating than the originating firm would otherwise realize
for other types of bonds. Higher credit ratings mean the security is less risky and
translates into a lower interest rate for the originator as investors do not demand the same
risk premium. The originator passes the savings on to the consumer in the form of lower
lending rates.
Securitization also aids in the geographic dispersion of capital to areas that may
otherwise be deprived of credit options. Traditionally, depository institutions have
provided credit in the areas where they accepted deposits. By securitizing loans,
however, the lender generates capital for new loans that may come from a different
location. This linkage to the capital markets broadens the range of regions where
depository institutions obtain capital to provide credit.
By subjecting the lending decisions of financial institutions to valuation by the capital
markets, securitization also encourages an efficient allocation of capital. Financial
institutions and others who securitize assets depend, of course, on investors. Investors
seek an appropriate return based on a level of risk. If the asset pools are not of a
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