SIC 12 An accounting interpretation by the International Accounting Standards Board whereby SPVs which are supported or credit-enhanced
8. Makes profit accounting volatile
Securitization accounting, as per current accounting standards, leads to upfront booking of profits. These profits represent not only the profits encashed while making the sale, but even estimated profits based on future profitability of the transaction. In other words, the originator accelerates future profits on the securitized portfolio and puts the same on books upfront.
Unless a continued growth in volume of securitization is maintained, this impacts future profitability. That is why aggressive securitization is compared to tiger riding: To stay safe, you have to continue to ride!
Yet another drawback of securitization accounting is volatility, introduced by the need to regularly review and revise profit estimates made on past transactions. Thus, the quality and predictability of financial information is depleted by securitization transactions.
Notes
1 A good way to understand the process of securitization may be the series of steps listed below (p. 59), in conjunction with the numerical examples in Chapter 8.
2 See Chapter 1 for more on asset-based financing.
3 See Chapter 23 on Legal Issues
106 Securitization: The Financial Instrument of the Future
4 Rating agency Moody’s issued a Special Report on March 22, 2001, titled Non-Bankruptcy-Remote Issuers In Asset Securitization suggesting that it was possible for an operating company, without involving a bankruptcy remote special purpose vehicle, to issue notes that could serve the same purpose as securitization – achieve higher ratings than that of the issuer. The Moody’s report said that this was relevant for the insolvency laws of England & Wales, and coun- tries with similar insolvency legal systems, such as the Cayman Islands, Hong Kong, Singapore, Australia, Malaysia and Bermuda. Legal experts were not in agreement and the market also did not take it very seriously.
5 Pfandbriefe and traditional mortgage funding instruments in Germany are discussed in detail in Chapter 3 under Germany, and also in Chapter 6 on RMBS.
6 ABCP is commonly issued by ABCP conduits – discussed in Chapter 18. Also, see Chapter 4 for more on expected and legal maturity of asset-backed securities.
7 Also discussed in Chapter 22.
8 See the section on secured loan structures in Chapter 23 on Legal Issues. Also pfandbriefsin Germany in Chapter 12 on Residential Mortgage-backed Transactions.
9 In the case studies taken up in Chapter 6 on Residential Mortgage-backed Securities, the Abbey National’s Holmes transaction uses a master trust structure.
Master trust structures have almost become the rule in credit card transactions.
10 See Chapter 4 on Liquidity Enhancements.
11 The term “pass-through” is covered in IAS 39 – see Chapter 27 under IAS 39.
12 We will return to asset liability mismatches later under Advantages of Securitization.
13 Over-collateralization is a form of credit enhancement discussed in Chapter 4.
14 For CDOs, the revolving structure is used, and the assets are corporate loans or bonds. If the bonds or loans do not amortize during the amortization period, they are sold, usually by way of an auction, called auction call.
15 Steven Todd: The Effects of Securitization on Consumer Mortgage Costs, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=223585, last visited December 19, 2005.
16 http://www.federalreserve.gov/Pubs/FEDS/2000/200044/200044pap.pdf, last visited December 19, 2005.
17 http://www.federalreserve.gov/pubs/feds/2001/200126/200126pap.pdf, last visited December 19, 2005.
18 The new capital standard Basle II seeks to relate capital requirements not just to the value of assets, but the risk-weighted value, while the risks will be calculated based on external or internal rating of the asset. See Chapter 29.
19 Frederick Feldkamp in Securitization: The Alchemist’s Dream; International Financial Law Review; London; 2000.
20 We shall take up investors’ experience, including performance and returns, in Chapter 30.
21 For example, Regulation AB requires several disclosures – see Chapter 28.
Chapter
The World of Securitization 1
T he market for securitization has grown dramatically since its onset about three decades ago, with the total outstanding issuance of securi- tized assets soon expected to reach US$9 trillion.2Notably, new issuers from new geographical territories are coming into the market, and at the same time, new applications of securitization beyond the traditional mainstream areas are keeping the markets vibrant. Synthetic securitization has given a totally new dimension to securitization methodology and has registered dra- matic growth in recent years.
The purpose of this chapter is to take a quick look at the market develop- ments, generally in regions and specific countries.
Arguably, mortgage financiers in the U.S. were the first securitizers, trans- forming themselves from portfolio lenders to mortgage originators. Constrained by regulatory growth restrictions, credit card (or non-bank entities) soon fol- lowed by securitizing excess production and adding upward of 30% a year to their portfolio. Specialty finance companies later emerged as increased market efficiency, advanced technology, structural improvements, and investor demand expanded the securitization market to include automobile, home equity, and other asset classes. These lenders used securitization aggressively as a low-cost funding source that effectively eliminated balance sheet constraints to growth.
Most recently, as investors became increasingly comfortable with newer asset classes and innovative structures, the securitization of commercial assets emerged. This market has also migrated from the U.S. to Europe and now Asia and other parts of the world. Motivated by regulatory capital relief and efficient capital allocation, commercial banks’ issuance of collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs) are adding new excitement in the market. Synthetic technology has taken securitization to arbitraging desks where extremely interesting combinations of synthetic assets are taken to market mimicking traditional credit assets.
History of securitization
The history of securitization depends on the meaning of securitization adopted. One could take a broad meaning as to include securitized loans or
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Securitization: The Financial Instrument of the Future by Vinod Kothari Copyright © 2006 Vinod Kothari
every securitized instrument, in which case, securitization goes as deep in history as the very concept of a corporate body.
However, in the sense it is understood presently – as a tool of structured finance-securitization developed in the U.S. real estate financing market—it spread not only all over the world but to diverse applications.
However, in Europe a form of mortgage funding has existed for many years that has remarkable similarities to the present form of securitization, although the two are not the same. This instrument has existed in Denmark for more than 200 years. Likewise, the German pfandbrief instrument has a long history.
For more details, see the country profiles for Germany and Denmark later in this chapter.
Deeper in history
It remains interesting that securitization in Denmark has a history of 200 years, much longer than the U.S. mortgage-backed securities (see the country profile for Denmark). Similarly, Germany has a traditional mortgage financing instru- ment called pfandbriefthat too has a very long history and is alive even today (see the country profile for Germany).
A form of transfer of interest in land seems to have an even deeper history than pfandbrief. In a paper titled The Capital Market Before 1600,3it says that sale of rentals out of land emanated in Northern France in the 12th Century, as an escape from increasing assaults on mortgage loans on account of usuri- ous lending. “For example, rather than selling land for cash, it could be sold in exchange for a rent constituted on it – a bail à rente or rent-sale. Or, rents could be made the basis for a loan: a lord could assign rents due to him from his vessels to a third party in exchange for a capital sum, or he could consti- tute a rent on his land and sell this in exchange for a capital sum.” The author says this was not viewed as a sale. “Because it was considered a sale rather than a loan, the creditor had less difficulty in seizing the property on which the annuity was drawn in case of default.”
The U.S. mortgage market
The first efforts towards securitizing financial assets were made in the U.S., originating in the mortgage financing markets of the country. The instrument was developed with a need to create a secondary market in mortgage financ- ing. In the process the catalysts were government agencies formed for buying and selling federally insured mortgages.
The history of U.S. government efforts to introduce a secondary market in mortgages goes back to the 1930s. Originally, mortgages in the U.S. were originated by savings and loans associations that financed their operations through retail deposits. During the Depression, deposit markets collapsed.
To allow originators to fund mortgages, the Congress enacted the National Housing Act to create a secondary market in mortgages. Subsequently, it created the Federal Housing Administration (FHA). The FHA insured housing loans made by private lenders and thus absorbed the inherent
risks in housing finance. In 1938, the Federal National Mortgage Association was created to buy and sell federally-insured mortgages. In 1968, the erstwhile Federal National Mortgage Association (FNMA) was split into two parts – a new FNMA and the Government National Mortgage Association (GNMA).
It was these agencies, FNMA (colloquially called Fannie Mae) and GNMA (colloquially called Ginnie Mae), which were responsible for the present-day development of securitization markets.
Ginnie Mae’s first securitization initiative
In 1970, GNMA did its first securitization transaction on a “pass-through”
structure. GNMA’s pass-throughs were securities backed by mortgages insured by FHA. These pass-throughs had the full credit and the backing of the U.S. government, as GNMA guaranteed both the repayment of principal and timely payment of interest.
The 1970 program (GNMA-I) is still in operation. In 1983, GNMA launched another pass-through program called GNMA-II. GNMA II had a range of interest rates and sellers, while GNMA-I was designed for a single seller and a single rate of interest. These programs are further classified based on the type of mortgages pooled therein, such as single family (SF) loans and multi- family (MF) loans.
Fannie Mae’s securitization deals
Though the FNMA was the oldest of all the U.S. government agencies, it was the last to enter the securitization market. In 1968, the original FNMA was split into a new FNMA and GNMA, with FNMA privately owned and its shares quoted on the New York Stock Exchange. However, due to implicit support from and historical affiliation with, the U.S. government, the credit standing of FNMA is seen as better than private corporations, although slightly inferior to government agencies like GNMA.
The first FNMA mortgage-backed security (MBS) was issued in 1981. The agency played a crucial role in promoting securitization of adjustable-rate mortgages (ARMs) and variable rate mortgages (VRMs).
The Freddie Mac
The FHLMC was created in 1970 to promote an active national secondary market in residential mortgages and has been issuing mortgage-backed secu- rities since 1971.
Spreads over to non-mortgage assets
Securitization spread to non-mortgage assets in 1985. The first non-mortgage securitization deal was in March 1985, when Sperry Corporation issued $192.5 million in securities backed by computer lease receivables.
110 Securitization: The Financial Instrument of the Future
Securitization through recession
Since September 11, 2001, the U.S. economy was seen as passing through a recessionary phase. However, this did not affect securitization volumes.
On the contrary, it is felt that securitization is helping maintain the growth in consumer spending by supplying capital to the credit card industry through securitization of credit cards. The percentage of securitization in the credit card segment has recorded a sharp increase.
Like the U.S., Japan and a number of Asian and European countries are equally concerned about recession.
That securitization is resilient through recession was noticed in 1991 and proven beyond a doubt in 2001. A December 1991 article in the Institutional Inves- torsaid: “The asset-backed securities market is roaring its way through the reces- sion with record issuance and reliable performance that prove it has come of age.”
Securitization volumes continued to grow, unimpeded by the economic slowdown in the early years of the decade. Rather than being identified as a cause of financial catastrophe, securitization has played a major role in improv- ing the financial condition of distressed economies. Another striking feature is the growing number of securitization issues by sovereigns. Synthetic deals are also becoming increasingly popular. There can be no doubt that securitization has matured from being a complicated transaction veiled in complications and viewed with scepticism to an instrument used across the globe.
The life cycle of securitization
The life cycle of the development of securitization is shown in Figure 3.1:
• Unrated, Bilateral transfers
• Full originator backing
• Purpose: off-balance sheet; exploiting excess spread, etc Quasi-financial deals
• Transfers through SPV route
• High degree of credit enhancement/cash participation by originators
• Purpose: off balance sheet; better ratings Early-stage securitization
• Credit enhancements dwindle; lower classes take risk
• Synthetics; arbitrage activity enter the stage
• Purpose: economic capital; better capital/risk management Advanced-stage securitization
• Separation of funding and risk tranfers
• Synthetics answer regulatory concerns more easily
• In traditional cash structures, transaction models are built around securitisation mechanics: orignation/servicing split Synthetics stage
• More stress on risk tranfers
• risks of operating businesses: retail credits, performance- oriented businesses are transferred
• Distinction bet. banking and insurance becomes less clear Operating Risk transfers/
Index risk transfers
? (possibly, reinvention stage)
Figure 3.1 Life cycle of asset-backed securitization
112 Securitization: The Financial Instrument of the Future
Present state of securitization
North America U.S.
The United States of America is the largest securitization market in the world.
In terms of depth, it is the only market in the world where securitization draws participation from both institutional as well as individual investors. In terms of width, the U.S. market has far more applications of securitization than any other market.
Approximately 75% or more of the global volume in securitization have originated from the U.S. This by itself indicates the tremendous significance of the U.S. in the global securitization market. Also, securitization issues orig- inating from Japan, Europe and a few other emerging markets, draw investors from the U.S.
The historical beginning of the securitization pass-through market in U.S.
mortgages has already been noted. Needless to say, mortgage markets might have existed in Europe for years, but the concept of securitization has matured in the U.S. and even developments such as securitization of insur- ance risk and public utility stranded costs, have taken place in the U.S.
We have noted the early beginning of securitization in 1970s, as well as the role of the government in promoting the concept through its agencies.
In the 1980s, securitization deals also received legislative support from the government. In 1983, the Securities and Exchange Commission made the ben- efits of shelf registration available for mortgage-related securities. In 1984, Congress adopted the Secondary Mortgage Market Enhancement Act (SMMEA), which provided for the exemption of highly rated mortgage- backed securities from the registration requirements of most state securities laws and made them eligible for investment by certain regulated entities.
Then, as part of the Tax Reform Act of 1986, Congress enacted new tax legis- lation permitting the creation of real estate mortgage investment conduits —
”REMICs” — facilitating the issuance of multi-class, pass-through securities.
These early legislative actions benefited only mortgage-backed transactions.
During the time when these laws were being debated and adopted, however, the first non mortgage-backed asset securitization transactions occurred, and the next round of legal changes was not limited to transactions involving mortgage loans.
In October 1992, the SEC amended its rules to permit specifically the shelf registration of investment grade “asset-backed securities.”
In 1994, Congress amended SMMEA to provide an exemption from state securities laws for highly rated securities backed by certain lease receivables and small business loans, similar to the exemption already enjoyed by mortgage-backed securities.
Later, tax-efficient vehicles for non-mortgage securitization were permitted in 1996 (regulations were framed in 2000) called FASITs. However, FASITs came under a lot of criticism after the Enron debacle, and ultimately, the FASIT legislation was repealed in 2005.4
There is no doubt that the success of securitization in the U.S. has been helped by successive government support.
In recent years, particularly after the collapse of Enron, securitization earned a vicarious bad name due to special purpose entities run by Enron.
Soon afterwards, there was an academic debate about whether to allow a bankruptcy safe-harbor to securitization transactions. This debate blew up into whether securitization is good for the country or not. Possibly for the first time, people had to write whether and why securitization is good. However, as stated above and evident from the data quoted elsewhere in this chapter, there has been no decline in securitization activity in the post-Enron years.
It is customary in the U.S. to classify securitization markets into mortgage- backed and asset-backed (other than mortgage) market. The issue of mortgage-backed securities in 2002 was a record high, which scaled a peak in 2003. Figure 3.2 shows the MBS (new issuance) until early 2003.
2500
$ Billions
Jan–Jun 2000
1500
1000
500
'96 '97 '98 '99 '00 '01 '02 '02 '03
0
Private-Label MBS Agency MBS/CMO
However, in 2004 the issuance of agency paper declined. The volume of agency paper in 2003 was US$2.13 trillion. However, the agency volume declined to US$1.01 trillion in 2004, and the volume until September 2005 was US$715 billion. U.S. mortgage financing activity moved from traditional mortgage funding products to innovative products such as ARMs and inter- est only mortgages, the private label sector. The growth of the private label MBS has also been dramatic. According to the Bond Association, issuance by private label issuers totalled US$415.4 billion by the first half of 2005, a hike of 52.7% from US$272.1 billion during the same period the previous year.
Likewise, the ABS segment activity has been scaling new heights as shown in Figure 3.3:
Figure 3.2 Issuance of mortgage-related securities, 1996–2003:Q2 Source: Bond Market Association
The securitization market has continued to grow. According to the Bond Market Association, total volumes of securitization in the first three quarters of 2005 totaled US$831.9 billion and the total volume for 2005 was US$1,103.4 billion, substantially higher than US$902.6 billion registered in 2004. Amongst asset classes, the Home Equity Loan Sector accounted for US$329.3 billion and the Bond Association feels that this class contributed 40% of the total volume of asset-backed securities. The other major asset classes were Auto Loan (US$66.4 billion), Student Loan (US$45.7 billion) and Credit Cards (US$41.8 billion).
Canada
Canadian financial markets were quick to capture U.S. financial innovations.
However, securitization had a slow start in Canada primarily due to the absence, for a long time, of agencies comparable to the GNMA that promoted the secondary market in mortgages.
Following the U.S. example, Canada formed a crown corporation called Canada Mortgage and Housing Corporation, essentially on the lines of Fannie Mae. This corporation is engaged in acquiring and securitizing housing mortgages.
In its report Canadian Securitization — State of the Marketof March 2001, the credit agency Fitch said: “Fitch expects to see continued growth within asset classes already securitized, with particularly high growth rates expected in CMBS. Other asset classes with potential for growth include collateralized debt obligations (CDOs) and whole business transactions.” In its April 2001 issue of Global Securitization Quarterly, Fitch further remarked that the term 114 Securitization: The Financial Instrument of the Future
500
$ Billions
Jan–Jun 400
300
200
100
0
'96 '97 '98 '99 '00 '01 '02 '02 '03
Private Public
Figure 3.3 Issuance of asset-backed securities, 1996–2003:Q2 Source: Bond Market Association