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Securitization Markets and Mechanisms

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Regulating Securitized Products

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Abstract

In order to better understand my arguments, principles and recommenda-tions for a new regulatory regime, it is necessary to appreciate some of the less-well understood characteristics of the securitization markets and structures. One example of the need to understand the complexities of the asset class in order to design appropriate policies and regulations, is that an evaluation of the retention rule intended to align the interests of originators of loans and investors demands a detailed understanding of how arrangers and originators are compensated. This, in turn, requires an evaluation of some important characteristics of securitization such as ‘excess spread’ and ancillary income. A blind focus on the amount of principal risk taken, regardless of when and how the risks are taken will often miss the net risk and reward taken by an investor, as I shall show conceptually and mathematically in Chapter 5.

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Notes

  1. ‘Skin in the game’ refers to the concept that originators should retain some risk.

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  2. Loosely described as bank-like activities outside of the traditional and regulating banking sector, but often much more narrowly and sometimes more widely defined.

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  3. Trading and/or investing in securitizations for the profit of the firm. This is gen-erally contrasted with market-making (the business of maintaining buy (bid) and sell (offer) markets in securities for the purposes of profiting from facilitating client trades).

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  4. Giddy, I. (2001). ‘The securitization process’. NYU Stern School of Businss. Available at http://people.stern.nyu.edu/igiddy/ABS/absprocess.pdf.

  5. Many leveraged loan CLOs have the (albeit limited) ability to invest in other tranches of leveraged loan CLOs.

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  6. The most risky tranches of securitizations of loans and real estate assets as well as those securitizations of securitizations may be significantly less liquid than the underlying assets.

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  7. Segoviano et al., ‘Securitization’.

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  8. In leveraged loan CLOs, for example, it is possible to structure and sell a securi-tization to investors and then purchase the assets. This is often termed ‘print and sprint’.

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  9. Acharya, V. V., Schnabl, P. and Suarez, G. (2013) ‘Securitization without risk transfer’, Journal of Financial economics 107(3), 515–536.

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  11. In the GFC it became clear that many investors found the risks impossible to bear.

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  12. Covered bonds are obligations of a bank or other issuing entity, but are generally secured with an overcollateralized pool of (generally) retail mortgage loans.

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  13. Market risk exposure comes from any mark-to-market features. These include (1) a market pricing clause with respect to an investor’s obligation to the structure on default (that is, to measure loss given default (LGD)); (2) a mark-to-market unwind trigger in any of the assets (such as in leveraged super senior (LSS) swaps in conduits and, especially, SIVs)); and (3) payoffs based on the mark to market of the pool of assets (for example, market value CLOs). Market risk could also come from any facility used to fund securitization purchases, but that is another story. In general, highly leveraged market risks were, in my opinion, the main cause of the crisis.

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  14. Schwarcz, S. L. (2003) ‘Securitization post-Enron’, Cardozo Law Review 25, 1539.

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  15. Other credit enhancement is possible. Conduits have liquidity lines as their credit enhancement. Agency RMBS have the US government guarantees. Some securitiza-tions have combinations of subordination, overcollateralization, liquidity lines and (less often) guarantees.

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  16. ABS issuance in 2014 included issues backed by aircraft, timeshare properties, containers, small business loans, wireless spectrum, railcars, corporate stranded costs, tobacco settlements, and many other minor asset classes.

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  17. Likewise for originators.

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  18. For this reason (although also others), borrowings junior to those that are securitized often offer lower returns.

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  19. See, for example, the confrontation between CMBS debt holders and hedge funds: Bagli, C. (2010) ‘Hedge fund moves on Stuyvesant Town’, New York Times, 24 February.

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  20. One index of junior AAA tranches in the US, CMBX.AJ.3, has been trading around 75% of par recently, even in this currently benign environment.

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  21. SIFMA Agency MBS Market Practices Resource Center (available at http://www.sifma.org/issues/capital-markets/securitization/agency-mbs-market-practices/overview/).

  22. 2 USC 622 (2006).

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  23. For a good description of this market, see Hayre, L. (2001), Salomon Smith Barney guide to mortgage-backed and asset-backed securities, Wiley.

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  24. Acharya et al., Guaranteed to fail.

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  25. Acharya et al., Guaranteed to fail.

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  29. Acharya et al., Guaranteed to fail.

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  30. Also includes loans from the Office of Public and Indian Housing and the United States Department of Agriculture (USDA, through Rural Development loan assistance).

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  31. Thomson, J. and Koepke, M. (2010) ‘Federal Home Loan Banks: the housing GSE that didn’t bark in the night?’ Federal Reserve Bank of Cleveland Economic Trends. According to the FLHB’s Annual Reports, the FHLBs wrote down their investments in private-label RMBS by just under $4.4 billion (out of over $200 billion in investment securities held, $46 billion of which was in private-label RMBS) for the two years ended 31 December 2009.

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  32. Fannie Mae averaged mid-20s return on equity between 1998 and 2002.

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  33. Acharya et al., Guaranteed to fail.

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  34. Spanish government agency Instituto Credito Oficial (ICO) does guarantee tranches of mortgages.

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  35. Master trusts have the benefit of economies of scale, but also of targeting certain maturity profiles (along with the traditional credit risk profiles available through tranching) such as a hard bullet (legally obligated set maturity), soft bullet (non-legally binding) or controlled amortization (the setting of windows where the tranche will receive repayments from the mortgage pool).

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  36. Also sometimes high yield CLOs.

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  37. The Volcker Rule prevents banks from investing in securitizations that consist of other securities.

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  38. The risk in a BDC is amply revealed in a paper by Paul Einhorn’s Greenlight Capital (2002), An analysis of Allied Capital. Availabe at http://foolingsomepeople.com/main/Greenlight%20Paper.pdf

  39. Other methods of risk transfer are also possible, including designing a credit hedge as an insurance contract, or using loan participations that allow for risk taking without altering the legal holder of the asset.

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  40. In some cases almost the entire underlying pool had liquid single name CDS equiva-lents, indicating that arbitrage (or near arbitrage) was the likely deal driver.

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  41. For example, Volkswagen Financial Services (VFS) had the equivalent of EUR 17 billion in ABS outstanding as of 31 December 2013, funding leases and car loans through standalone ABS but also master trusts.

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  42. In declining order letter ratings are AAA/Aaa, AA+/Aa1, AA/Aa2, AA-/Aa3, A+/A1, A/A2, A-/A3, BBB+/Baa1, BBB/Baa2, BBB-/Baa3, BB+/Ba1, BB/Ba2, BB-/Ba3, B+/B1, B/B2, B-/B3, CCC+/Caa1, CCC/Caa2, CCC-/Caa3, CC/Ca, C/D.

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  43. We have found multiple instances, especially in Europe, where deals were modeled incorrectly by third party analytical tools, or by investors, themselves. Investors have been able to arbitrage others’ views of the models. However, in my opinion, this does not make deals complex, but it does indicate that generally not enough due diligence is done by investors. We go further than ‘trust but verify’ in that we are totally paranoid as investors.

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  44. This is because most securitized bonds do not default until they have not paid a legally required amount of interest or principal, even if the pool performance implies that they will default with 100% likelihood at a later date.

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  45. The reason for LSS was to get investors to provide mark-to-market (correlation and spread widening) protection to ‘complete the capital structure’ and therefore allow the dealers to take the model reserves as immediate profit. Trading books had already entered into CSOs that referenced the junior risks of a pool of CDS, but risk managers that allowed the traders to mark to model forced them to reserve much of the profit in case the model was wrong. By entering into a senior swap (with leverage), the model risk was eliminated. However, as it turned out, LSS did not fully hedge such risks — another lesson in risk management learned the hard way.

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  46. Northern Rock was able to securitize its mortgage loans using a master trust structure (Granite), but also sell off the first loss in synthetic form (Whinstone).

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  47. A recent example of this was a manager who worked hard to have the equity risk of their CLO transferred to a sophisticated enough investor to understand the hidden value in the deal’s portfolio so that they would call the deal before it hit an event of default (EOD). And call they did, and the firm’s reputation was saved. Holders of the mezzanine notes, who received par back when they might have, in a fire sale on EOD, received less than par and much later, benefited from this action.

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  48. For completeness, it is not unheard of for arranging banks to approach a manager for a deal to be executed given a lead order, generally in the equity for all CLO, or in any single tranche (for a managed synthetic).

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  49. Giddy, I. (2001) ‘The securitization process’ (available at people.stern.nyu.edu/igiddy/ABS/absprocess.pdf).

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  50. Acharya et al., ‘Securitization without risk transfer’.

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  51. A German bank could (theoretically) diversify some risks by investing in US loans, for example.

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  53. Banks, E. (2006) Synthetic and structured assets, John Wiley & Sons.

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  55. George Akerlof’s lemon problem asserts that high-quality used cars can never trade at prices higher than the worst examples on the market because buyers cannot measure quality, while sellers can (and buyers know this). This is similar to the problem of cherry picking assets for sale, also known as adverse selection. Akerlof, G. A. (1970) ‘The market for “lemons”: quality uncertainty and the market mechanism’, Quarterly Journal of Economics 84(3), 488–500.

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  56. Goodhart, ‘A ferment of regulatory proposals’. See also Frame, W. S. and White, L. J. (2014) ‘Reexamining financial innovation after the Global Financial Crisis’, in Acharya et al., The social value of the financial sector.

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  57. Fitch Ratings (2001) ‘Asset-Backed Commercial Paper explained’. Structured Finance.

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  59. O’Leary, C. (undated) ‘Move over CDOs, SIVs are coming of age’, American Securitization Forum. Available at http://www.americansecuritization.com/uploaded-Files/SIVs.pdf.

  60. Mollenkamp, C., McDonald, I. and Bauerlein, V. (2007) ‘SIV situation: will rescuers arrive in time?’ Wall Street Journal, 24 October.

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  62. The uniform net capital rule of the 1934 Securities Exchange Act.

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  63. A re-remic, or resecuritization of real-estate mortgage conduits, is a technique to turn a bad bond into two tranches — one ‘better’ than the old one and one ‘worse’.

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  64. Notes secured by one or more properties, yet junior to the loan that is purchased by the CMBS vehicle.

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Authors and Affiliations

  1. West Face Capital Inc., France

    Rasheed Saleuddin

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© 2015 Rasheed Saleuddin

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Saleuddin, R. (2015). Securitization Markets and Mechanisms. In: Regulating Securitized Products. Palgrave Macmillan, London. https://doi.org/10.1057/9781137497956_2

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