Asset securitization is the transformation of a mix of illiquid individual loans that are combined into relatively similar pools and transformed into highly liquid bonds traded in securities markets and usually, when securities are backed by non-mortgage loans, they are referred to as asset-backed securities (ABS). Securities issued exclusively against credit and loans with mortgage guarantees are referred to as mortgage-backed securities (MBS). Assets like ABS, MBS and it likes are now widely spread in fixed income portfolios at both the institutional and individual investor level. Although the largest and most well known example of asset securitization is the residential mortgage market. The dealings of asset securitization transactions vary, the typical transaction involves the sale by a bank or financial institution (who are called originator) of certain assets on its balance sheet to a trust, corporation or a separate entity, called special purpose vehicle (SPV). Thus, through the asset securitization process, SPV is funded by issuing securities whose payments are backed by the performance of the bought assets. Usually, the securities issued by the SPV to enhance the marketability are usually evaluated by bond-ratings agency, such as Moody’s, Fitch and Standard and Poor’s. The least risky tranches receive the highest credit rating and the most risky tranche receives no rating at all also, like in the event of a private placement, ratings are not always necessary since investors with technical know-how themselves can evaluate the securities. The credit rating received depends on the risk of the pool of assets as collateral.
Benefits of Asset Securitization to Banks
Asset securitization sometimes can lead to profitability as a result of the reduction in assets and through the reinvestment of the new received funds. Also, when the loans have been transferred to the SPV, the bank decides to monitor and service these loans on behalf of the entity for a fee. This effectively converts income that is based on a margin on assets into a fee collecting income. Then the liquidity created is used to fund new loans, which increases the business for the same or a similar level of assets and capital. Banks can create an asset securitization structure through which existing loans are channeled to investors and the cash proceeds are used to generate new loans in order to repeat the process. While under a non-agency structure, the lender will receive cash proceeds net of transaction costs from sale of the securities issued.
For banks, an additional benefit is that securitization reduces the level of regulatory capital required. For most mortgage loans, existing regulatory capital levels are too high, creating an incentive to securitize the least risky loans. By securitizing loans the bank is only required to hold capital and reserve requirements against the residual tranche of the SPV that it is forced to keep.
Asset securitization is also an alternative financing source to equity and debt financing and for financial institutions, in contrast to debt, the originator firm does not need to repay. Loan sales allow some banks to finance loans less expensively than by the traditional deposit or equity issue, because bank funds received via loan sales can avoid cost associated with required reserves and required capital.
Information Asymmetries in Asset Securitization
In addition to regulatory capital rules favoring securitization, the presence of information asymmetries may also encourage asset securitization. It is believed when the lender as a good information about the borrower’s credit quality than are the purchasers of the securitized debt, the purchasers would then set credit requirement that are higher than those of the lender. Informational asymmetries may therefore arise regarding the returns on the general assets of the firm when investors are equally informed about the possible returns on the assets. This means that issuing claims on the receivables avoids the problem that would be associated with an issue of claims on general assets.
Another understanding of securitized assets is the possibility of informational asymmetries among different classes of outside investors, and the asymmetry is about the securitized assets. Virtually all investors specialize to some degree in information about specific securities. Structured finance is sometimes associated with specialization by financial intermediaries in the valuation of the particular cash flows being offered by the originator. As earlier mentioned, private placement is made for some SPV, for securitization and technical know-how investors that are fully informed about the value of the securities that the services of rating agencies are not purchased.
Asset Securitization and Mortgage Market
Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation popularly known as Fannie Mae and Freddie Mac respectively are government sponsored enterprises (GSE) that have being very important in the development of securitization of mortgages. A brief history of both organisations can give a better understanding; Fannie Mae was created by the U.S. Congress. In its early years, Fannie Mae functioned as a government agency that purchased mainly mortgages insured by the Federal Housing Authority (FHA). Later in the sixties, Fannie Mae became a public corporation and its functions changed. Freddie Mac was chartered by Congress in 1970 to provide stability and liquidity to the market for residential mortgages, whose major function was to focus on mortgages that originated from savings institutions. By the nineties, both Fannie Mae and Freddie Mac were dealing in the purchase of mortgages, for either securitization purposes and mortgage-backed securities (MBS) (large pools of loans are swapped with a single lender) would be issued or just to keep them in their books to sell credit protection to the original lender and this usually enhances liquidity. In the first case, the originating bank retains no stake in the mortgage. In the second case, the bank continues to fund the mortgage and bear the interest rate risk, but obtains the option to sell it off as an MBS (because of the credit protection).
Asset securitization in the mortgage market works like this, large pools of loans are exchanged with a single lender in return for a MBS collateralized by the same pool of loans. Interest on the pool of loans covers servicing costs, and its paid to the originator, a guarantee fee is then paid to the agency, and the balance of the available interest payments are available for the coupon on the security. Also as for the loans held, the agencies purchase smaller pools of loans and combine them into larger multi-lender pools and issue securities backed by them. In either case, the originator can realize all loan fees collected in excess of costs as current period profits and can continue to earn ongoing fees for loan servicing with limited balance-sheet exposure and without any credit risk. Also to note, is another market that developed at about this period, known as the non-agency mortgage-backed securities. Loans that are regarded as too large to meet conforming size limits or do not meet agency underwriting guidelines (Alt-A or subprime)may be securitized in these private label issues, though alternative credit enhancement structures are required, since guarantees are not available from the agencies.
Sub-prime mortgages was setup in other to service a great proportion of low-income and higher-risk households which could be granted access to financial markets and the opportunity to become home owners. The marketing of the sub-prime, alt-A, and home equity loans was reliant on independent mortgage originators who were part of a financial network that developed in parallel to the issuance and securitization of conventional mortgages by the government sponsored enterprises (GSEs) and agencies. As earlier noted the standards of the GSEs were too high for conforming mortgages, and full documentation of the borrower’s financial condition and the valuation of the property was required. While, the sub-prime market operated with less difficulty. The originators wrote the mortgage loans, provided a short-term guarantee (usually 90 days), and sold the loans to private arrangers who pooled the mortgages and MBS.
Asset Securitization and Risk Exposure
The sub-prime market was not properly regulated and issues or loan quality were not priority for the originators, its was just sales of the loans that was on there mind.
The costs of entry and exit from the industry were pretty low, as long as firms meet the minimum capital requirements they were allowed to operate. Sub-prime mortgages often incorporated low down payment requirements and a significant prepayment penalty. Underwriting standards declined as loan originators focused on collecting fees on loans that they quickly resold. The subprime market lacked transparency and had an undue complexity about its operations and this made purchasers of MBS in the secondary market fail to evaluate the quality of the assets and to take-note of the risks involved. Due to the absence of regulators, the only institutions used as a source of information on the risks of the mortgage-backed securities were the credit rating agencies e.g Standard & Poor’s, Fitch, and Moody’s. These agencies also failed to provide a true assessment of risk. The credit rating agencies received payment for their ratings directly from the issuers of the Financial products being rated, thereby creating a clear conflict of interest and a subsequent tendency for issuers to seek the agency willing to give them the favourable rating. This resulted to an underestimation of the degree of risk associated with these new securities, and the sheer complexity of their design prevented anyone from taking a closer look.
Sub-prime mortgages expanded rapidly in 2000, especially the period between 2001- 2007. Without the large role played by sub-prime mortgages, the increase in home prices would have peaked earlier: Potential buyers would not have been able to purchase mortgages at such high levels which was inconsistent to there means of livelihood. A few other financial innovated products that covered-up the risk accompanied the growth of the sub-prime mortgage market. Collateralized debt obligations (CDOs), backed by the cash flow from a portfolio of mortgage-backed securities (MBS), were issued in a series of tranches, where the losses were borne by the equity and junior tranches, giving higher tranches the appearance of greater protection. The transaction appeared to give low-risk senior tranches access to the high returns of the underlying sub-prime mortgages. The rapid growth of these securities occurred in off-balance sheet entities called Structured Investment Vehicles (SIVs), which also led to increases in the size of the issuing institutions without a matching increase in capital.