LO 35.9: Explain the decline in dem and in the new-issue securitized finance products following the 2007 financial crisis.
The financial crisis of 20072009 was a direct result of the subprime mortgage problems that led to an asset-backed commercial paper standstill. The liquidity crisis faced by large financial institutions led to a worldwide recession. U.S. mortgage defaults quickly rippled worldwide through the globally integrated banking system and global investments in structured credit products backed by U.S. mortgages. Collateralized debt obligations (CDOs) and other ABS were key contributors in poor lending decisions in the U.S. mortgage market.
Key factors that led to the loss in market confidence and the 20072009 financial crisis were the impact of the credit crunch, shadow banking system, leverage, lack of transparency, credit rating agencies practices, accounting rules, and liquidity. These factors led to negative sentiment among investors and a sharp decline in the new-issue securitization market.
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Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
The widespread use of securitization to remove assets from the balance sheet of financial institutions eventually led to the credit crunch. Subprime lenders made excessive amounts of low quality loans and then removed these loans from their balance sheets through ABS. Investors were overconfident in buying these ABS and unaware of the risks in this market.
The securitization structure is designed to break the link between loan originators and borrowers. Loans are carefully grouped and packaged into tranches and sold to investors who have no knowledge of the credit quality of the original borrowers. A shadow banking system was created where entities are not bound by the same regulatory requirements of normal banks. These entities in the shadow banking system were referred to as special investment vehicles (SIVs). SIVs funded loans through commercial paper and did not rely on the central banks discount window as a backup source of funding. This worked until the shadow bank was no longer able to find investors in this market. The inability to refinance the securitized products led to a liquidity crisis.
SIVs were highly leveraged just prior to the market collapse in 2007. Leverage ratios of 1:15 were common at this time. Some SIVs had leverage ratios as high as 1:50 as they increased their borrowing in an attempt to compensate for the shrinking credit spreads during the bull market. The use of leverage was even more problematic for CDOs that invested in other CDOs.
The lack of transparency resulted in increasingly complex products. Valuing products with no transparency is extremely difficult. As the credit crisis progressed, the wide variety of ABS tranches that existed in the market became very difficult to mark-to-market due to the widening of credit spreads for tranches and the changing correlation risk for ABS portfolios. To complicate matters even further, the changes in correlations had different impacts for different seniority levels of tranches.
Credit rating agencies (CRAs) were overly optimistic in their ratings due to poor credit quality models and a lack of understanding of the degree of correlation risk for ABSs. High ratings were justified for lenders on the assumption that the residential real estate market would continue to increase in value. The models used by rating agencies did not correctly incorporate the impact of correlations or sharp declines in real estate values.
Investors viewed securitized products as AAA rated with high liquidity. Unfortunately, the liquidity of ABS was overestimated. As the first losses were realized in the subprime lending market, SPVs needed to unwind or sell off investments in securitized paper. The SPVs mispriced the securities initially by failing to include a liquidity premium.
The impact of the liquidity crisis was even greater due to mark-to-market accounting rules. As investments were marked-to-market, it created a downward spiral effect in asset prices of securitized products. In the flight-to-quality environment of a liquidity crisis, financial institutions were required to mark down asset values based on highly stressed prices in the secondary market. To complicate things further, securitized products were more negatively impacted than plain vanilla commercial paper, which is characteristic of markets where participants are attempting to shed risky assets for safer ones.
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Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
K e y C o n c e p t s
LO 35.1
Securitization is the process of issuing securities against an asset pool. The proceeds of the security sale collateralize the purchase of the assets from the originator, thereby removing the liability and involvement of the originator. A special purpose vehicle (SPV) is used to separate the assets from the originator and customize the products for investors.
LO 35.2
A common credit enhancement of securitized assets is overcollateralization where the principal value of the notes issued by the SPV are valued less than the principal value of the original underlying assets. The first-loss piece or equity piece absorbs initial losses. This non-rated junior tranche is often held by the originator.
LO 35.3
The master trust is a special type of structure that is used for frequent issuers. The difference in how payments are received from the underlying collateral over the asset-backed securitys life determines whether the ABS is better suited to the amortizing or revolving structure.
LO 35.4
Financial institutions benefit from securitization by funding assets, balance sheet management, and risk management. Securitization benefits investors by providing access to liquid assets that were previously not available to them.
LO 35.5
Credit enhancements such as overcollateralization, pool insurance, subordinating note classes, margin step-up, and excess spread enable originators to lower costs while providing investors customized products that meet their needs.
LO 35.6
The portfolio performance of ABS and MBS products is largely dependent on the ability of individuals to pay off their obligations in the form of consumer debt and mortgages. Performance measures serve as trigger methods to accelerate amortization.
The loss curve shows the expected cumulative loss for the life of the collateral pool. The absolute prepayment speed (APS) measures prepayment by comparing the actual period payments as a percentage of the total collateral pool balance.
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LO 35.7
The delinquency ratio is computed by dividing the value of credit card receivables more than 90 days past due by the total credit card receivables pool. The default ratio is calculated by dividing the amount of written off credit card receivables by the total credit card receivables pool. The monthly payment rate (MPR) is calculated as the percentage of monthly principal and interest payments divided by the total credit card receivables pool.
The debt service coverage ratio (DSCR) is calculated by dividing net operating income (NOI) by the total amount of debt payments. The weighted average coupon (WAC) is calculated by multiplying the mortgage rate for each pool of loans by its loan balance and then dividing by the total outstanding loan balance for all pools. The weighted average maturity (WAM) is the weighted average months remaining to maturity for the pool of mortgages in the MBS. The weighted average life (WAL) of the mortgage notes issued is calculated by summing the time to maturity multiplied by a pool factor, which is the outstanding notional value adjusted by the repayment weighting.
LO 35.8
Common methodologies used to estimate prepayments for securitized products collateralized by mortgages or student loans are the constant prepayment rate (CPR) and the Public Securities Association (PSA) method.
The CPR is calculated as: CPR = 1 (1-SMM)12
The PSA typically assumes that prepayments will increase as a pool approaches maturity. The MBS pool of mortgages has a 100% PSA if its CPR begins at 0 and increases 0.2% each month for the first 30 months.
LO 35.9
Key factors that led to the loss in market confidence and the financial crisis of 20072009 include: the impact of the credit crunch, shadow banking system, leverage, lack of transparency, credit rating agencies practices, accounting rules, and liquidity.
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Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
C o n c e p t C h e c k e r s
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A major benefit of securitization for a financial institution is the ability to remove assets from the balance sheet, which lowers risk and the required regulatory capital. While a large portion of the risk is removed from the balance sheet the originating financial institution often maintains a portion of the risk. Which of the following terms best identify the risk that is maintained by the originator? A. Correlation. B. Excess spread. C. First-loss piece. D. Guarantor of collateral value.
Securitized products are often customized to meet the needs of the investor as well as the originator. What type of asset-backed securities (ABSs) typically uses a revolving structure? A. Residential mortgage. B. Credit card debt. C. Commercial mortgage. D. Commercial paper.
Which of the following statements regarding credit enhancements in the process of structuring a securitization through a special purpose vehicle (SPV) is correct? A. The securitization process is structured such that the asset side of the SPV has a
lower cost than the liability side of the SPV.
B. Credit enhancements are typically only associated with mortgage-backed
securities (MBS) and are not used in other types of asset-backed securities (ABS). C. The most senior class of notes is often overcollateralized in order to reduce the
risk of the asset-backed security (ABS).
D. A margin step-up is sometimes used by an asset-backed securities (ABS) where
the coupon structure increases after a call date.
Which of the following measures are most likely to be used by a securitized product backed by student loans? A. Single monthly mortality (SMM), constant prepayment rate (CPR), and Public
Securities Association (PSA).
B. Loss curves and absolute prepayment speed (APS). C. Weighted average life (WAL), weighted average maturity (WAM), and weighted
average coupon (WAC).
D. Debt service coverage ratio (DSCR) and monthly payment rate (MPR).
Assume an MBS is composed of the following four different pools of mortgages:
$2 million of mortgages that have a maturity of 90 days. $3 million of mortgages that have a maturity of 180 days. $5 million of mortgages that have a maturity of 270 days. $10 million of mortgages that have a maturity of 360 days.
What is the weighted average maturity (WAM) of these mortgage pools? A. 167 days. B. 225 days. C. 252 days. D. 284 days.
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C o n c e p t C h e c k e r An s w e r s
1. C The originator often maintains ownership of the first-loss piece, which is the class of assets with the lowest credit quality and is the most junior level where losses are first absorbed in the event of a default.
2. B Revolving structures are used with products that are paid back on a revolving basis, such as credit card debt or auto loans. Credit card debt does not have a pre-specified amortization schedule; therefore the principal paid back to investors is in large lump sums rather than amortizing schedules.
3. D ABS issues may use a margin step-up that increases the coupon structure after a call date.
Credit enhancements play an important role in the securitization process for both the asset- backed security (ABS) and mortgage-backed security (MBS) issues. The liability side of the SPV has a lower cost than the asset side of the SPV to create an excess spread prior to administration costs. The lowest class of notes are often overcollateralized where the principal value of the notes issued are valued less than the principal value of the original underlying assets.
4. A The constant prepayment rate (CPR) and the Public Securities Association (PSA) method are
common methodologies used to estimate prepayments for student loans and mortgages.
5. D The WAM is calculated as follows:
WAC = [90(2 million) + 180(3 million) + 270(5 million) + 360(10 million)] /
(2 million + 3 million + 5 million +10 million)
= (180 million + 540 million + 1,350 million + 3,600 million) / 20 million
= 5,670 million / 20 million
= 284 days
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
U n d e r s t a n d i n g t h e Se c u r i t i z a t i o n o f S u b p r i m e M o r t g a g e C r e d i t
Topic 36
E x a m F o c u s
This topic describes many important aspects of the subprime markets. Seven frictions between market participants are discussed involving mortgagors, originators, arrangers, rating agencies, asset managers, and investors. You should understand the information problem (moral hazard or adverse selection) for each friction. Characteristics of subprime mortgages are also discussed including loan terms, performance, and subordination. For the exam, be familiar with subprime mortgage securitization, the frictions in the subprime market, and the process of rating subprime securities.
T h e S u b p r i m e S e c u r i t i z a t i o n P r o c e s s