#16810 - Assset Securitisation - Banking Law Notes

How to reduce risk:

• Sharing amongst many through loan syndication and bond issue.

• Getting security

• Transferring to others through securitisation (to be covered now)

• Hedging

• Monitoring and influencing the borrower’s behaviour

• Getting a better ranking than other creditors through subordination.

Overview:

• What is asset securitisation?

  • Asset-backed securities

  • Collateralised debt obligations

• Policy considerations

What is securitisation?

• Definition:
  Illiquid loan obligations (e.g. residential and commercial mortgages credit card receivables, commercial loans, et cetera) are pooled and repackaged as highly liquid and tradable debt securities that are supported by the underlying loan portfolio.

• Purposes:

  • Risky loans are removed from the originator's balance sheet;

  • Reduced regulatory capital requirements;

  • Debt securities are more highly rated;

  • Lower cost of capital due to bankruptcy remoteness;

  • Spreading of risk;

  • Structured finance: Tranches with optimum risk attributes; and

  • Capital can be raised more widely.

• Originate-and-distribute:
  

  • Originator has granted loans to B1 and B2 of 1000 each.

  • Assume that each loan carries a 10% risk of total default.

  • What is the expected value of each loan? How much would a risk-averse buyer be willing to pay?

    • Expected value = 900 each

    • Price that the risk-averse buyer will pay = Less than 900, because the risk-averse will “price in” the risk.

    • This give the originator an incentive to securitise rather than selling the loans directly on the markets.

  • B1 and B2 loans are sold (through an assignment of debt receivables) to an SPV.

    • This has to be a true sale.

    • This means that the SPV must be entirely separate from the originator (and definitely cannot be a subsidiary of the originator); if there is such a link, the loans will not disappear from the originator’s balance sheets because the balance sheets will still have to be consolidated in the end.

  • The loans are combined into a single pool.

    • The equity in the SPV is held by a charitable or purpose trust.

  • The SPV issues two tranches of debt securities.

    • Tranche 1: Receives the first 1000 coming in.

    • Tranche 2: Receives whatever else comes in.

  • The SPV pays the sale price of the loans to the originator through the proceeds of the issue of debt securities.

• Financial Alchemy (1):

  • B1 and B2: 10% of default each

  • Tranche 1: 1% probability of default

    • Default only if both B1 and B2 default, and 10% x 10% = 1%

    • AAA credit rating (which is higher than the rating for B1 and B2 loans)

    • Higher yield than that for other AAA-rated instruments

  • Tranche 2: 19% probability of default

    • Fully paid only if B1 and B2 do not default (90% x 90% = 81%)

    • 19% probability of default

    • This gives it high-yield (i.e. “junk”) status

  • But the market premium on T1 is large enough to offset the discount on T2.

Financial Alchemy (2): Collateralised Debt Obligations

• T2 bonds of different securitisations are pooled

• Special Investment Vehicle (“SIV”) issues two tranches

  • Senior: The first 1000 coming in

  • Junior: Whatever else comes in

• Tranche 2: Bonds A and B have a 19% probability of default each

• Senior tranche: A 3.6% probability of default

  • Default only if T2Aand T2B both default (19% x 19% = 3.6%)

  • AAB credit rating (higher than the rating of T2A or T2B)

  • Yield higher than that for other AAB rated instruments

• Junior tranche: 34.4 probability of default

  • Fully paid only if T2A and T2B both do not default (81% x 81% = 65.6%)

  • 34.4% probability of default

  • This gives it high-yield (i.e. “junk”) status

• Two risky assets have been transformed into a safe asset and a very risky asset

Repeating the above: CDO-squared

• Junior notes of different CDOs are pooled.

• The SIV issues two tranches again.

• Senior tranche: A 11.8% probability of default.

• Junior tranche: A 57% probability of default.

• Next step: CDO-cubed

Synthetic CDO

• The swap counterparty does not have any real exposure to the reference portfolio or the different reference entities.

• Nothing of any real value is being created here.

  • Fees are charged on all sides, and this is therefore an inefficient form of risk transfer between the parties.

Policy considerations

• Advantages:

  • Lower cost of capital through risk reduction:

    • Risk transfer can be used to limit the lender’s exposure to particular borrowers, asset classes, or regions.

  • Diversification of funding sources:
    Through financial alchemy (see above), the originator can reduce the riskiness of (certain tranches of) the bonds, and the AAA tranches can then be used to access investors that the originator would not otherwise be able to reach.

    • These investors include regulated financial institutions such as pension funds, trusts, and insurance companies.

    • These financial institutions also need not maintain as much capital (as against the bonds that they have invested in).

    • This is because capital adequacy requirements are measured against the riskiness of the assets (such that financial institutions have enough capital to absorb losses on the bonds) , and the AAA tranches are very safe.

  • Reducing the maturity mismatch:

    • Maturity mismatch = Banks may lend long and borrow short.

    • Through securitisation, bank can reduce illiquid securities into immediate cash.

  • Economies of scale through enhanced utilisation facilities.

    • This is because securitisation bundles thousands of loans and moves out of the bank’s balance sheets.

    • The bank’s back office need not be maintaining so many loans at the same time (as they have been sold to the SPV and hence relieved from the bank’s balance sheet).

  • Third party discipline and enhanced market pricing.

  • Market completion:

    • Investors that could not buy securities with lower ratings can now buy the highly-rated tranches.

    • Higher ratings also mean lower capital charges.

    • Synthetic CDOs create new instruments that did not exist before.

    • More parties can participate in bond markets.

• Dangers:

  • Flawed credit ratings:

    • Conflict of interest (under the “issuer pays” model): The issuer pays the rating agencies, and, in order to keep getting business from the issuers, the rating agencies must continue giving favourable ratings.

    • Easy for originators to manipulate inputs and assumptions.

    • Incomplete risk modelling.

  • Misaligned incentives:

    • Deterioration of underwriting standards. This is because originators know that they can move even toxic loans from their books through securitisation and hence shift the risk onwards to investors.

    • Incentivised to maximise loans granted regardless of creditworthiness (if you can continue finding gullible investors to continue buying bonds from the SPV).

    • Reduced monitoring of borrowers. This is, once again, due to moving the risk from the originator, and then spreading the risk amongst so many bondholders.

  • Systemic risk:

    • Opaque risk spreading within the system. This is because of multiple layers of securitisation + spreading the risk throughout bondholders all over the world.

    • Opaque risk spreading = Fuelling animal spirits and fears = Turning the deterioration in subprime assets into a run on repo and a global crisis.

    • Valuation of assets and appreciation of risk is difficult.

  • Regulatory efforts at addressing the aforementioned issues:

    • Higher capital requirements (for investors that invest in the bonds of the SPV) for “complex securitisation” (however “complex might be defined in the relevant statutory instruments).

    • “...