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ASSET SECURITIZATION

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					ASSET SECURITIZATION




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Introduction
The purpose of this lecture is to introduce
- the asset-backed securities market;
- the evolution of asset securitization;
- asset-backed securities deal structures;
- the role of players;
- briefly presents pricing models; and
- real estate securitization




                                              2
Financial Intermediation
                 money                   money
         saver              commercial                 borrowers
                              bank
                 saving contract         lending contract


Traditionally, banks
1) originate a loan;
2) retain the loan in their portfolio of assets, thereby accepting
   the credit risk associated with the loan;
3) service the loan (collect payments and take legal action if
   payments were not made; and
4) obtain funds from the public with which to finance their
   assets.
                                                                   3
Problems
1. Asset/liability mismatching
2. liquidity mismatching
3. institutional mismatching




                                 4
Asset Securitization
Recently, banks
1) originate a loan;
2) sell the loan to an investment banking firm that creates a
   security backed by the pool of loans;
3) the investment bankers obtain credit risk insurance for the
   pool of loans from an insurance company;
4) the investment banker can sell the right to serve the loan to
   another bank or a company specializing in servicing loans;
   and
5) the investment banking firm can sell the securities to
   individual and institutional investors.
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   Asset Securitization
    lending                 money                   money                 money
               originator              trust                underwriter
                            lending            security              security
                            contract
borrowers                              credit                                   investors
                                       enhancement

    payments                                                         payments
                                       server




                                                                                            6
Defining Asset Securitization
• What is Securitization?
   - the sale of securities backed by the cash flows from a
      pool of financial assets, such as loans or leases
• Three basic requirements for any securitization:
  - a pool of self-liquidating assets that will serve as the
  source of payments on the asset-backed securities.
  - the payment performance of the assets (including the
  likelihood of delays and defaults) must be susceptible to
  evaluation, and
  - the cash flow from the assets and the payments made on
  the securities must be isolated from the risks of a      7
  bankruptcy or insolvency of the originator.
What sorts of assets are securitized?
 *residential mortgage loans *commercial mortgage loans
 *credit card receivables    *motor vehicle receivables
 *equipment and vehicle lease receivables
 *installment sale contracts *franchise loans
 * insurance loans           *student loans
 *high yield bonds.




                                                          8
The evolution of asset securitization
•   late 1970s and early 1980s
•   1982
•   1983, SEC
•   1984, Secondary Mortgage Market Enhancement Act
•   1986, Real Estate Mortgage Investment Conduits
•   1992
• 1993, Financial Asset Securitization Investment Trust



                                                          9
Real Estate Mortgage Investment
Conduits
• An alternative for pool owners who want to issue a multi-
  class security, but can't take on debt or need to sell the
  mortgages
  - Created in 1986 by Tax Reform Act
  - Separate legal entity for tax purposes
  - Tax-favored entity for issuing CMOs
  - Pool owners sell mortgages to the REMIC
  - Can take many forms - trust, corporation, partnership
  - Can use any type of security - pass-through, debt
  - Investors only pay tax on interest income
                                                          10
The asset-backed securities market




                                     11
The Secondary Mortgage Market
• Debt markets in U.S.A. in 1990
  mortgages      government securities corporate bond
  $3.5           $1.9                    $1.4 trillion
• Government National Mortgage Association (GNMA,
  Ginnie Mae)
• Federal National Mortgage Association (FNMA, Fannie
  Mae)
• Federal Home Loan Mortgage Corporation (FHLMC,
  Freddie Mac)


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The Secondary Mortgage Market
Origination of Passthrough by Agency
        (in million)
Year GNMA            FNMA       FHLMC     Private firms Total
 1984        28,097      18,684    13,546         6,273       68,584
 1985        45,980      38,829    23,649         6,916      117,359
 1986       101,433     100,198    60,566       13,163       277,346
 1987        94,929      75,018    63,229       18,576       253,739
 1988        55,248      39,777    54,878       20,699       172,590
 1989        57,190      73,518    69,764       12,010       214,471
 1990        64,651      73,815    96,695       14,341       251,492
Source: Freddie Mac, Secondary Mortgage
Markets, 1991




                                                                       13
 Holdings of Mortgage-Backed Securities
Percentage Distribution of Holdings of Mortgage-Backed Securities by
Institutions
Thrifts                                                       23.40%
Banks                                                          21.0%
Pension Funds                                                    9.7%
Life insurance companies                                       14.4%
Dealers, mutual funds, asset managers, etc.                    31.5%




                                                                        14
Asset-Backed Securities Issuance
                         Issuance amount by collateral (in billion)
           Collateral type
    Year Autos           Credit cards Home Others Total
                                        equity
      1985        898.6               0        0    338.3        1236.9
      1986         9473               0        0    617.6       10090.6
      1987       6372.2          2410          0 1208.7          9990.9
      1988       5497.8          7420          0 2276.1         15193.9
      1989       7823.6         11112 2700.2 2912.5             24548.3
      1990      11632.6         22731 5499.9 1963.9             41827.4
                   28%            54%        13%      5%
     *1991      11240.5         16342 8820.5 2928.4             39331.4
    Total       52938.3         60015 17020.6 12245.5 142219.4
    * Through September 1991
    Source: Data supplied by the first Boston Corporation




                                                                          15
Benefits to lenders
1) Obtaining a lower cost of funds
2) More efficient use of capital
3) Better asset/liability management
4) Enhancing financial performance
5) Diversification of sources




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Benefits to investors and borrowers
• To investors:
   – reduced credit risk.
   a) it is backed by a diversified pools of loans, and
   b) there is credit enhancement.
   – returns are also improved.
• To borrowers: reduce the lending rates.




                                                          17
Mortgage-backed securities
- Mortgage passthrough securities, or simply,
  passthrough
- Collateralized mortgage obligations (CMOs)
- Stripped mortgage-backed securities




                                           18
Mortgage Passthrough Securities
- Most popular form of mortgage-backed security
- Represents sale of mortgages
- Taxed only at investor level
- Commits to pay P,I, and prepayments each month as
   received
- "Modified" pass through guarantees timely payment
- Greatest volume issued by FNMA, FHLMC and GNMA
   surrogates
- Private entities also issue
- Swap program provided more options to originators
                                                  19
Collateralized Mortgage Obligations
- Debt instrument secured by pool of mortgages
- Appeals to investors who can't tolerate prepayment
- A Derivative: different from the underlying mortgages even
    though CMO distributions are derived from the mortgages
- Issued in multiple maturities or tranches
- Cash flow is distributed in sequential order (A,B,C,Z
    tranches)
- A method for issue debt, reduce prepayment risk and shift
    remaining prepayment risk to the investor
- Quoted with a stated maturity within a range
- Overcollateralized                                       20
Stripped mortgage-backed securities

- Issuer retains ownership
- I is paid based on a coupon rate of interest (IO), P is passed
    through as it is received from normal amortization and
    prepayments (PO)
- Some overcollateralization is required
- Prepayment potential important to investor




                                                              21
Features of passthroughs
1) Type of guarantee: fully modified, modified
2) Number of lenders permitted in the pool.
3) Mortgage design of the loans
4) Characteristics of the mortgage loans in the pool
5) Payment procedure
6) Minimum pool size




                                                       22
Cash flows of mortgage-backed
securities
1) interest
2) scheduled principal repayment
3) payments in excess of the regularly scheduled principal
   repayment




                                                        23
Asset-backed securities market - Cards




                                     24
Asset-backed securities market - Cards




                                     25
Role of players
a. collateral/borrower
b. origination
c. servicing: often by originator
d. credit-enhancement:
e. Special Purpose Trust:
f. investors
g. underwriters
h. rating agency
i. government

                                    26
Role of an investment bank
• An investment bank provides consultants to a broad
  spectrum of issues, including corporate, bankruptcy,
  regulatory, securities, and security-interest questions.
• An investment bank serves as an representative of issuers
  and underwriters in the public and private sale of securities
  secured by a variety of nonmortgage assets.




                                                             27
Evaluation of mortgage-backed
securities
Pricing is a function of:
   - interest rate risk
   - default
   - risk of delayed payment
   - prepayment possibilities
       - PSA model
       - FHA prepayment experience
       - empirical models


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Measuring price volatility:
  Effective duration
                       price if yield decreases price if yield increases
                                                 
  effective duration     by x basis po int s         by x basis po int s
                                        initial price ( 2x )


  Effective convexity
                        price if yield decreases price if yield increases
                                                                           2 ( initial price )
  effective convexity     by x basis po int s         by x basis po int s
                                                2 ( initial price )( x 2 )




                                                                                                   29
Price/Yield Relationship for a Callable
bond - negative convexity

        price




                          yield


                                      30
The Option pricing methodology

callable bond price
= noncallable bond price -call option rice




                                             31
Option-adjusted spread methodology


           S    360                  s
       1                    CFt
p0      
       S s t           t
           1   1
                       (1  r
                      i1
                                 s
                                     i    oas )


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Total return framework

                               1
    (    total future dollars ) no . of months in horizon  1
      price of the passthrough


    Then the effective annual yield is

    (1  total monthly return )12  1




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