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Asset Securitization Theory and Practice

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					The Originator and the Investor of the
    Asset Securitization Market


   The Originator and the Economics of
   Securitization
   Cultivating the Investor
                       The Originator and the Investor

      It is through decades of cooperation of various professions
      within the U.S. capital markets that the originator/lender, the
      borrower, and the investor can reap the benefits of securitization.

      The cooperation is actually directed by the invisible hand that
      the originator/lender and the investor each is motivated by
      different reasons to be involved in the asset securitization
      market.

      We now discuss the raison d'être of asset securitization: the
      originator’s needs to raise capital for loan originations and the
      investor’s needs to earn an attractive return for their capital.




Asset Securitization: Theory and Practice                                   2
Dr. Joseph Hu
    The Originator and the Economics of Securitization

      As mentioned at the outset of this class, one critical participant in
      the process of asset securitization is the originator/seller of loans
      (hereafter, simply the originator). This is obvious because the
      very reason for securitization is to enable the originator
      (which is the lender) to secure funding for the loan
      originations in the capital markets.

      The originator sets up a SPE and sells its newly originated (could
      also be existing) loans in the portfolio to the trust. This trust has
      only one specific purpose: purchasing the loans from the
      originator and funding the purchase by the proceeds from issuing
      an asset-backed security that is backed by the very loans that
      sold by the originator.

      The action of originating a loan followed by immediately selling
      the loan earns the expression of “the originator/seller” because
      the two are really the same entity. The SPE is the issuer of the
      asset-backed security.


Asset Securitization: Theory and Practice                                     3
Dr. Joseph Hu
    The Originator and the Economics of Securitization

      Securitization has two distinct advantages for the originator:
      securing funding and efficient management of balance sheet.

Let’s see how securitization enhances the efficient management
    of balance sheet.

      Consider for example that a newly established Bank XYZ that
      was not in the business of originating consumer loans in 2007,
      but plan to do so in 2008.

      As of December 31, 2007, it had a balance sheet as shown in
      Exhibit 3-1. For the purpose of illustration, the balance sheet is
      simplified to have only a few assets and liabilities.



Asset Securitization: Theory and Practice                                  4
Dr. Joseph Hu
   The Originator and the Economics of Securitization

   Among the few assets, it held “other assets” totaling $500,000 and
   a cash position of $25,000. To finance its $525,000 worth of total
   assets, the bank relies on the traditional sources of funding of
   deposits and debentures totaling $483,000. There is the additional
   funding source: the required capital of $42,000 (8% of the total
   assets).


           Exhibit 3-1. Balance Sheet of Bank XYZ, as of December 31, 2007
   Cash                                $25,000 Deposits                    $433,000
   Other assets                      $500,000 Debentures                    $50,000
                                                Capital                     $42,000

   Total Assets                             $525,000   Total Liabilities and   $525,000




Asset Securitization: Theory and Practice                                                 5
Dr. Joseph Hu
    The Originator and the Economics of Securitization

      If coming 2008, this bank decides to originate $1,000,000 worth of
      consumer loans and fund the origination strictly by the traditional
      sources of funds. That is, the bank will not rely on asset
      securitization to finance its loan originations.

      In this case, assumes that the bank does not engage in any other
      lending activities, the asset side of its balance sheet at the end of
      2008 will have an additional item of $1,000,000 consumer loans
      (Exhibit 3-2). With a substantial increase in the total assets, its
      liabilities will also expand along with an additional $80,000
      required capital.




Asset Securitization: Theory and Practice                                     6
Dr. Joseph Hu
   The Originator and the Economics of Securitization




           Exhibit 3-2. Balance Sheet of Bank XYZ, as of December 31, 2008
                                  No Securitization
  Cash                                $25,000 Deposits                    $1,353,000
  New consumer loans               $1,000,000 Debentures                     $50,000
  Other assets                       $500,000 Capital                       $122,000

  Total Assets                              $1,525,000 Total Liabilities and   $1,525,000




Asset Securitization: Theory and Practice                                                   7
Dr. Joseph Hu
   The Originator and the Economics of Securitization

   Without securitization, this bank’s income statement for 2008 is
   shown in Exhibit 3-3. It earns interest on the newly originated
   consumer loans (8% interest rate) and other assets along with a
   2% fee for originating the $1,000,000 consumer loans (assuming
   that the origination fee is 2% of the principal balance of the loan).
   After netting out expenses of interest paid on deposits and
   debentures, it has a net before-tax income of $59,320.




Asset Securitization: Theory and Practice                                  8
Dr. Joseph Hu
   The Originator and the Economics of Securitization


  Exhibit 3-3. Income Statement for Bank XYZ, December 31, 2001
                            No Securitization
 Interest on consumer loans           $80,000 (8% interest on $1,000,000)
 Interest on other assets             $45,000 (9% interest on $500,000)
 Origination fees                     $20,000 (2-point origination fee on $1,000,000)
      Gross Income                  $145,000

 Less: Interest costs on deposits           $81,180   (6% interest on $1,353,000)
 Less: Interest costs on debentures          $4,500   (9% interest on $50,000)
     Net income before tax                  $59,320




Asset Securitization: Theory and Practice                                           9
Dr. Joseph Hu
    The Originator and the Economics of Securitization

      Alternatively, suppose that the bank relies on securitization
      to fund its origination of consumer loans. Suppose further
      that during a year the bank has the capacity of originating
      $1,000,000 worth of loans every three months. That is, the bank
      can originate and securitize the newly originated loans (turnover
      the origination/securitization process) four times a year to earn
      substantially more origination fees.

      To facilitate the origination of loans, the bank secures a
      “warehousing line of credit” from another financial institution.
      This line of credit is revolving. The bank draws down the line to
      originate loans. Once the loans are originated and sold (through
      securitization), the line will be replenished with the proceeds of
      loan sale. But the bank will draw down the line again to originate
      still more loans, only to replenish it again by the proceeds of
      selling the newly originated loans.
Asset Securitization: Theory and Practice                                  10
Dr. Joseph Hu
    The Originator and the Economics of Securitization

      As shown in Exhibit 3-4, since the funding is through
      securitization, this operation will not alter the balance sheet of the
      bank at the end of 2008. Its total assets remain to be $525,000
      with an unchanged capital of $42,000. This unchanged size of
      balance sheet is markedly smaller than the “no
      securitization” balance sheet of $1,525,000 at the yearend
      2008.

      However, its income statement under securitization during 2008
      changes significantly (Exhibit 3-5). First and foremost, by
      originating $4,000,000 worth of loans, it would earn an
      origination fee of $80,000. This fee income is four times as
      large as that of funding through deposits (no securitization). As
      the bank warehouses the newly originated loans before they are
      sold, it still earns interest on the loans. On average, by holding
      the loans for a three-month period, it would earn on average one
      and half months of interest.

Asset Securitization: Theory and Practice                                      11
Dr. Joseph Hu
    The Originator and the Economics of Securitization

      To do it four times a year, the total interest income would be
      equivalent to six months of interest, or $40,000, on a principal of
      $1,000,000. On the cost side, while the bank no longer relies on
      deposits for funding loan originations, it has to pay interest on the
      warehousing line of credit (at a 6% annual interest rate, assuming
      the cost of credit line is the same as the interest paid in deposits.)
      The bottom line is that for 2008, the bank would have a before-tax
      net income of $74,484. This earning is more than 25% more
      than the amount earned through “no securitization.”

      The simplified example demonstrates two remarkable advantages
      of securitization: less capital requirement and more earnings.
      In fact, the two mutually re-enforce each other. By relying on
      securitization, Bank XYZ can free up precious capital for
      other lending and investment activities. These activities
      enable the bank to increase earnings. The greater earnings in
      turn will enable the bank to strengthen its capital position.

Asset Securitization: Theory and Practice                                      12
Dr. Joseph Hu
   The Originator and the Economics of Securitization

         Exhibit 3-4. Balance Sheet of Bank XYZ, as of December 31, 2008
                                  Securitization
 Cash                                $25,000 Deposits                    $433,000
 Other assets                      $500,000 Debentures                    $50,000
                                               Capital                    $42,000

 Total Assets                               $525,000   Total Liabilities and   $525,000

           Exhibit 3-5. Income Statement for Bank XYZ, December 31, 2001
                             Securitization
 Origination fees                     $80,000    (2-point origination fee on $4,000,000)
 Interest on consumer loans           $40,000    (8% on $1,000,000 for 6 months)
 Interest on other assets             $45,000    (9% on $500,000)
      Gross Income                   $165,000

 Less: Cost of bank credit lines            $60,000      (6% on $1,000,000)
 Less: Interest costs on deposits           $26,016      (6% on $433,000)
 Less: Interest costs on debentures          $4,500      (9% on $50,000)
     Net income before tax                  $74,484

Asset Securitization: Theory and Practice                                            13
Dr. Joseph Hu
                          Cultivating the Investors
      One important contributor to the success of the U.S. asset
      securitization market over the past two decades has been the
      rapid expansion of its investor base.

      This base comprises a great variety of investors, ranging from
      short-term money market investors, to commercial bank portfolio
      managers, to long-term pension fund managers.

      It is important to note here that investors in asset-backed
      securities comprise primarily “institutional investors” with very
      few “individual investors.” To the extent that individual
      investors are involved, they basically do so through mutual fund
      managers.)

      Nowadays, virtually all types of fixed-income investors own, to
      a varying degree, asset-backed securities with underlying
      assets in the form of various consumer loans, commercial loans,
      residential mortgages, and commercial mortgages.

Asset Securitization: Theory and Practice                                 14
Dr. Joseph Hu
                          Cultivating the Investors
      The rapid expansion of asset-backed securities investors is not
      incidental. It took a great deal of research and marketing efforts
      on the part of issuers, investment bankers, and rating agencies
      to cultivate and educate investors on the investment and credit
      performances of the asset-backed securities.

Knowledge on the Underlying Assets
      One of the most important goals of investing is to achieve the
      highest possible return given the risks of the investment.
      Since the cash flows of structured securities are derived solely
      from the underlying collateral, it is critical that investors
      understand the investment characteristics of the underlying
      assets.




Asset Securitization: Theory and Practice                                15
Dr. Joseph Hu
                          Cultivating the Investors

Knowledge on the Underlying Assets
      One example of this is RMBS. As will be discussed later in
      details in the RMBS discussions, residential mortgages are
      prepayable at par. Thus, RMBS have a unique “prepayment
      risk.”

      When mortgage rates decline, mortgagors (homeowners who
      borrow money from lenders to purchase homes) tend to
      refinance their existing mortgages with new mortgages that carry
      lower rates. As mortgagors refinance, the proceeds of
      prepayment would be returned at par to RMBS investors.




Asset Securitization: Theory and Practice                                16
Dr. Joseph Hu
                          Cultivating the Investors

      This prepayment hurts the return of the investment because the
      proceeds now would have to be reinvested in a low interest
      rate environment that would entail a lower rate of return for the
      RMBS.

      Because of this prepayment risk, RMBS have been yielding
      significantly greater than other securities with comparable
      maturities and credit risk. Investors who do not appreciate the
      inherent prepayment risk of RMBS would mistakenly view the
      higher yield as an excellent investment opportunity, not a
      necessarily extra return compensating for the extra risk.

      During the 1980s, when RMBS were in the early stage of
      development, investment bankers had spent a great deal of
      their resources educating investors on the prepayment risk.

Asset Securitization: Theory and Practice                                 17
Dr. Joseph Hu
                          Cultivating the Investors
Ability to Analyze the Cash Flow
To appreciate the unique features of the underlying assets is
    actually the prerequisite toward the ultimate understanding of the
    investment performance of the asset-backed securities. Once
    investors have the required knowledge of the underlying
    assets, they can then have the ability to analyze the cash flow
    of asset-backed securities.

      Again, from the RMBS example, investors need to be able to
      analyze the potential cash flow of the securities under various
      interest rate scenarios. This ability is vitally important because
      they need to be sure that the securities are the right investment for
      them.




Asset Securitization: Theory and Practice                                 18
Dr. Joseph Hu
                          Cultivating the Investors
Ability to Analyze the Cash Flow
      Certain basic and unique measurements of the cash flow
      characteristics of asset-backed securities are critical for
      investors to fully comprehend. They include the annual
      prepayment rate, the average life (calculated on the basis of the
      assumed prepayment rate), duration, and convexity of RMBS.

      Further, investors need to understand that the underlying cash
      flows of the securities have often been “credit tranched” and
      “maturity tranched.” This means that the issuer of asset-
      backed securities have often segmented the entire cash flow of
      the underlying assets into many maturities and credit classes.
      These maturities and credit classes perform very differently in
      various interest rate and economic environments.

      Investment bankers and rating agencies have spent a significant
      amount of time and effort to research and provide information
      on the historical performance of these maturities and credit
      classes as a service to the investors.

Asset Securitization: Theory and Practice                                 19
Dr. Joseph Hu
                          Cultivating the Investors
Total-Return Oriented Investors
      As the asset securitization market expanded and became more
      sophisticated, so did the types of investors. In the early stage of
      the market development, the most important investors in asset-
      backed securities have been yield-oriented investors, such as
      saving and loan associations and commercial banks. These
      investors are also known as the spread bankers that they focus
      on the spreads between the costs of their money versus the
      yields from their investments.

      It should be noted here, however, that yield-investors are not the
      “junk-bond” investor as sometimes notorious known the yield-
      oriented investors. They were naturally attracted to the
      securitization market because they had been first to securitize
      their assets. They understood very well that asset-backed
      securities offered significantly higher yields than corporate bonds
      with comparable maturities and credit ratings. Another way of
      saying this is that asset-backed securities offered
      substantially greater “yield spreads” to investors.

Asset Securitization: Theory and Practice                                   20
Dr. Joseph Hu
                          Cultivating the Investors
Total-Return Oriented Investors
      In the fixed-income market, the yields of all securities are
      measured against the comparable maturity Treasury securities
      (Treasurys) that are considered to be free of credit risk, or
      technically referred to as “credit risk free.” The yield differential
      between a fixed-income security and its comparable-maturity
      Treasury is called the “yield spread.”

      In the early market development when their investment
      characteristics were new and not well understood, asset
      securitization securities offered significantly large yield
      spreads as enticement for investors. Even to this day, yield
      spreads of asset-backed securities are still markedly greater than
      corporate bonds with comparable maturity and credit ratings. The
      rapid growth and increased popularity of the asset securitization
      market is attributable significantly to the attractive yield spreads to
      yield oriented investors.

Asset Securitization: Theory and Practice                                       21
Dr. Joseph Hu
                          Cultivating the Investors
Credit Oriented Investors
      It is well established in investment theory that risk and return go
      hand in hand with an inverse relationship: the high the risk is,
      the high the return will be, and vice versa.

      Since asset-backed securities are backed by mainly consumer
      loans that are perceived by investors as of high credit risk. For
      this reason, credit ratings are a very important consideration
      in the minds of investors.




Asset Securitization: Theory and Practice                                   22
Dr. Joseph Hu
                          Cultivating the Investors
Credit Oriented Investors
      This is particularly so for institutional investors, who for fiduciary
      reasons are limited to investments with only “investment-
      grade” credit ratings. (These are credit ratings above ‘BBB-’ or
      ‘Baa3’.) In other words, these investors were prohibited from
      investing in any securities with non-investment grade credit
      ratings (‘BB+’ or ‘Ba1’). Therefore, credit-oriented investors are
      just the opposite of yield-oriented investors.

      The primary concern of credit-oriented investors is to comply with
      the fiduciary requirements. Only within the framework of
      investment grades, do credit-oriented investors start looking
      for greater yields.




Asset Securitization: Theory and Practice                                      23
Dr. Joseph Hu
                          Cultivating the Investors
Maturity-Oriented Investors
      Just as there are investors who are restricted to investments of
      certain credit ratings, there are investors who are confined to
      certain maturity ranges. As mentioned earlier, through maturity
      tranching, asset-backed securities have the advantage of offering
      investors with multiple maturity choices within a given transaction.
      For example, one residential mortgage-backed transaction may
      offer maturities ranging between 1-, 3-, 5-, 7-, 10-, and 30-year
      maturity.

      Money market mutual fund managers or commercial banks may
      therefore purchase a RMBS with a 1- or 3-year maturity.

      An insurance company portfolio manager may purchase a 5- to
      10-year maturity RMBS.

      A pension fund manager may purchase a RMBS with 10- or 30-
      year maturities.


Asset Securitization: Theory and Practice                                    24
Dr. Joseph Hu

				
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