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History and overview of securitization

by sugeladi on Aug 10, 2010

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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/

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