Week 12

(Chapter 26)

Securitization
FINS3630

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Overview
This chapter discusses the concept of asset
securitization.
Why banks and other FIs are using this technology to transform
their balance sheets.
Different forms of securitization available to FIs.
The nature and significance of prepayment / interest rate risk
for different types of securitized assets.

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Introduction
Securitization: Packaging and selling of loans and other
assets-backed securities
The loans are transferred from the originating FI to an offbalance-sheet subsidiary, for example, Special Purpose Vehicle
(SPV ) or Structured Investment Vehicle (SIV).
The OBS subsidiary securitizes the loans and then sells the assetbacked securities (ABS) to investors.
The proceeds of the asset-backed security sale are paid to the
originating FI.
The ABS investors are paid from the cash flows from the
underlying loans used to back the ABS.

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Traditional Securitization Process using SPV

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Traditional Securitization Process using SIV

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Traditional Securitization Process

Special Purpose Vehicle
SPV earns fees from creation and servicing asset-backed
securities
All cash flows from the underlying assets pass through the SPV
according to terms of the ABS contract
SPV exists until cash flows from the assets are fully distributed

Structured Investment Vehicle

SIV issues commercial papers/bonds to purchase bank loans
SIV is responsible for payments on its asset-backed obligations
even if underlying assets do not generate sufficient cash flows
When the cash flows exceed costs, SIV keeps the spread
What if insufficient cash flows? - Usually has lines of credit or
loan commitments from sponsoring bank
Liquidity risk implications & exposure to runs for SIV
Risk implications for sponsoring FI
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Benefits of Securitization to FI
Example:
Bank originates 1000 new fixed-rate residential mortgage loans.
Average size per mortgage loan: $100,000.
Size of mortgage portfolio: $100 million.
Average mortgage rate: 12% p.a. with an average maturity of 30 years.
Capital requirement: $100 million 50% 8% = $4 million.
(assuming a risk weight of 50%)

We assume that the remaining $96 million needed to fund the

mortgages come from the issuance of demand deposits
Current regulations require that for every dollar of demand deposits
held by the bank, $0.10 in cash reserves be held at the Federal
Reserve Bank
Assuming that the bank funds the cash reserves with demand
deposits, the bank must issue $106.67 m. [$96 m/(1 .1)] in demand
deposits

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Benefits of Securitization to FI
Issues for bank:
Illiquidity,
Credit risk
Large positive duration gap,
Large regulatory burden: capital requirement, reserve
requirement and deposit insurance premium.

Solution: securitisation

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Benefits of Securitization to FI
Fee income
By removing assets (loans) from the balance sheet, FI gets rid of the
risks associated with the assets and the associated regulatory cost

Liquidity risk
Interest rate risk
Credit risk
Regulatory taxes such as capital requirement, reserve requirements, and
deposit insurance premiums

As of 2012, over 66% of all U.S. residential mortgages

were securitized.
The consequences of separating the risk of loans from the
lending?

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Why not directly sell the loans?

Similar benefits could be obtained if the originating
lender could successfully sell the loans to a third-party.
Problems
Lack of liquidity in the loan sale market (not many investors
available to buy the whole piece of loans).
The buyer will inherit all risks associated with the loans, and
thus there is no benefit of risk re-distribution.
Normally loans are sold with recourse if the borrowers default,
the buyer of loans could ask for the seller to compensate for the
loss due to default.

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Securitization in Australia
In Australia, between 2000 and 2004 one quarter of all housing
loans were securitised.

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Major Forms of Securitization

Pass through securities
Mortgage-backed bond (MBB)
Collateralized mortgage obligation (MBO)

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The Mechanism of Pass-Through Security

(For your knowledge only, not examinable)

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Securitization Programs
Government-sponsored programs
U.S.: GNMA (Ginnie Mae), FNMA (Fannie Mae), FHLMC
(Freddie Mac), to enhance the liquidity of the residential
mortgage market.
Australia: FANMAC Premier Trust (NSW), Keystart Bond
Program (WA), Victorian Housing Bond Program (VIC), to
facilitate low-cost finance to low-income borrowers.
Strong credit support from respective governments and resulting
high credit ratings.

Private securitisation program

The issuer or sponsor of the program is a private entity.

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The Present Value of Pass-Through Securities

The full amortization structure of mortgages (assuming fixed
mortgage rate)
Constant payment over the life of the mortgage (if no prepayment)
1

mn
1
r

1 +
m

Size of pool = PV ( all _ future _ payments ) =

PMT

where r is annual mortgage rate, m is the number of payments per year, and n is
the number of years to maturity.
The formula is not required for assessment.

Each payment includes both interest payments and principal

payoffs, for example, for a monthly payment bond, its payment in
month t, PMT, consists of:
Interest payment = principal at the beginning of month*r/12
Principal payment = PMT interest payment

Cash flows to pass-through security holders

The payments, minus the servicing fee and insurance fee, are passed
through to securities holders.
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Prepayment Risk on Pass-Through Securities

Mortgagees may decide to pay back loans before the maturity
which affects the pattern of cash flows.
Refinancing:
In case of decreasing coupon rates on new mortgages, existing
borrowers have an incentive to refinance at lower rates.
Costs associated with refinancing: transaction costs, recontracting costs,
and penalty fees.

Housing Turnover:
Decision to move houses.
It does not always cause prepayment.
Assumable mortgage: automatic transfer of the same mortgage contract
from the seller to the buyer
Transferable mortgage: allows a change of asset to be mortgaged

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Prepayment Risk on Pass-Through Securities

The relationship between the mortgage rate difference
(Y: current mortgage rate, r: old mortgage rate) and the
prepayment frequency

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Prepayment Risk on Pass-Through Securities

Effects of lower current mortgage interest rates and faster
prepayments:
Good News Effects
Increase in PV of cash flow streams,
Faster prepayment of mortgage pools principal,

Bad News Effects

Fewer interest payments in absolute terms,
Cash flows can only be reinvested at lower rate.

Ex-ante, the possibility of prepayment decreases the value of a

fixed-income security.
A simple way to understand it: An embedded option to prepay by
borrowers, which should be deducted from the security price
A subtle way to understand it: Asymmetric value effect of interest
rate increase versus decrease
a) When interest rate increases and there is no prepayment, the security value
decreases like a normal fixed-income security;
b) When interest rate decreases and there is prepayment, the security value is
supposed to increase, but prepayment cuts duration short and the value
increases less compared to a regular fixed-income security.

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Prepayment Models (For Interests only, not examinable)

PSA (originally Public Securities Association, now
Securities Industry and Financial Markets Association)
model
Based on the average rate of prepayment of FHA-insured
mortgages.
Starts at 0.2% (per annum) in the 1st month
Increases by 0.2% per month for the 1st 30 month
Levels off at 6% per annum thereafter
The prepayment rate differs across mortgage pools due to
different features of the pool. Practitioners typically adjust PSA
rates by a factor.

Other empirical models

FIs make own estimates of monthly prepayment patterns based
on past experience or similar mortgage portfolios.

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Prepayment Models (For Interests only, not examinable)

Option Models:
Basic idea:
Ppass-through = PT-bond Pprepayment option
In yield dimension: Ypass-through = YT-bond + Yoption
Option-adjusted spread between pass-throughs and Tbonds should reflect value of option.
Estimate interest rate dynamics in the future (levels and
probability period by period)
Estimate the borrowers prepayment probability under different
interest rate dynamics
Estimate the cash flows for future periods under different
interest rate dynamics
Derivation of option-adjusted spread:
P=

E (CF1 )
E (CF2 )
E (CFn )
+
+
...
+
(1 + d1 + OS ) (1 + d 2 + OS )2
(1 + d n + OS )n
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The Mortgage-Backed Bond (MBB)

MBBs are bonds collateralised by a pool of mortgage
assets.
Special features:
On-balance sheet transactions,
Relationship between cash flows on underlying assets and those
on bonds is one of collateralisation, but not a direct link.

MBB bondholders have first claim on FIs mortgage

assets in case of financial distress.
Most MBB issues are backed with excess collateral.
Problems:

Illiquidity of MBB,
Need for over-collateralisation,
On balance sheet, regulatory tax implications.
As such, MBB is the least used securitization form (in the U.S.),
but extensively used in Germany and some European countries.
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The Collateralized Mortgage Obligation (CMO)

CMO is a mortgage-backed bond issued in multiple
classes or tranches.
In a typical pass-through securization program, security holders
receive payments proportionately (in an equal manner).
In CMO, investors in different classes have different seniorities
in receiving cash flows.

Creation (normally by investment banks):

Packaging and securitising whole mortgage loans, or placing
existing pass-throughs in a trust (off-balance sheet).
Each class has a fixed coupon.
However, each class has different priority of receiving principal
payments, for example, first Class A , then Class B and finally
Class C.

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Example of CMO
An investment bank has $150 million issue of passthrough securities placed as collateral to issue a CMO
with
Class A: annual fixed coupon 7%, class size $50M
Class B: annual fixed coupon 8%, class size $50M
Class C: annual fixed coupon 9%, class size $50M

Suppose in month 1 the bank receives $1 million monthly

promised payment and $1.5 million prepayment.
Cash flow distribution:
Class C: 50M * 9% / 12 = $375000 coupon payment
Class B: 50M * 8% / 12 = $333333 coupon payment
Class A: 50M * 7% / 12 = $291667 coupon payment, plus the
remaining cash flows ($1.5 M) as principal payment
After class A is fully paid, then class B investors will receive the
principal payments, and finally class C investors (after the
retirement of both classes A and B).
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Risk redistribution in CMO

Mortgage prepayment protection for different classes
(A, B and C):
Class C: high degree,
Class B: average degree,
Class A: low degree/none.

Default risk by class:

Class C: high,
Class B: average,
Class A: low.

Value creation due to risk redistribution:

n

i,CMO

> PMBS

i =1
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Class A, B and C Bond Buyers

Class A:
Shortest average life and minimum prepayment protection
Potential buyers: savings banks & commercial banks.

Class B:
Expected medium duration, and average prepayment protection,
Potential buyers: superannuation funds & life insurance
companies.

Class C:
Longest average life and maximum prepayment protection,
Potential buyers: superannuation funds & insurance companies.

The use of three classes enables FIs to attract a wider

range of investors.
In practice, up to 17 classes have been issued.

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Other CMO Classes

Class Z:

Accrual class,
Stated coupon, but interests accrue
Payment only occurs if preceding classes have been retired,
Has characteristics of zero-coupon bonds and regular bonds.

Class R:
Residual CMO class,
Owner has right to residual collateral plus reinvestment income
once all other classes have been retired.
Value increases, if interest rate increases and thus there are less
prepayments and higher reinvestment income.
negative duration

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Mortgage Pass-Through Strips

A special type of CMO divides the cash flows of the underlying pool of
mortgage loans or pass-through securities into only two classes
IO strip and PO strip.
IO (Interest Only) Strips:
Investors receive only interest payments of the underlying
mortgage pool.
P IO =

IO

1 +

IO

1 +

+ ... +

IO

n*m

1 +

n*m

Effect of interest rate decrease and prepayment

Discount effect : positive - value increases if interest rate decreases.
Prepayment effect: negative - less interest payment due to more prepayment.
Overall: negative because prepayment effect dominates.
So the price of IO strips typically increases with interest rate when the current
interest rate is below the coupon rate on the underlying mortgage loans, and
hence IO strips have negative duration.
when the current interest rate is above the coupon rate, price will decrease with
interest rate (due to rare or no prepayments)

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Mortgage Pass-Through Strips-IO strips

The priceyield curve slopes upward in the interest rate range below 10
percent (refer to the graph below).
This means that as current interest rates rise or fall, IO values or prices rise
or fall. (for the interest rates below the coupon rate)
The IO is a rare example of a negative duration asset

Is very valuable as a portfolio-hedging device for an FI manager when included with regular
bonds whose priceyield curves show the normal inverse relationship.
Thrifts have been major purchasers of IOs to hedge the interest rate risk on the mortgages
and other bonds held as assets in their portfolios

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Mortgage Pass-Through Strips-PO strips

PO (Principal Only) Strips:
Investors receive only principal payments of the underlying
PO
PO
PO
mortgage pool.
=
+
+ ... +
P
1

PO

1 +

1 +

n*m
n*m

1 +

Effect of interest rate decrease and prepayment

Discount effect : positive - value increases if interest rate decreases.
Prepayment effect: positive early payments of principals due to more
prepayment.
So the price of PO strips decreases with interest rate increases, much more than
a typical coupon bond, when the current interest rate is below the coupon rate
on the underlying mortgage loans.
When the current interest rate is above the coupon rate and there is rare or no
prepayment, price will decrease with interest rate increase, similarly as a regular
coupon bond.
The PO is attractive to FIs that wish to increase the interest rate sensitivity of
their portfolios and to investors who wish to take speculative position regarding
the future course of interest rates.

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