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    Asset Securitization: Theory and Practice
    Asset Securitization: Theory and Practice
    Asset Securitization: Theory and Practice
    Ebook428 pages4 hours

    Asset Securitization: Theory and Practice

    By Joseph C. Hu

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    About this ebook

    Asset Securitization is intended for beginners and market professionals alike who are interested in learning about asset securitization—its concepts and practices. It is designed so that the readers will come away with a fundamental but comprehensive understanding of the asset securitization market. As such, the book aims to provide a review of the market's development, necessary framework, potential benefits, and detailed descriptions of major asset securitization products.

    Part I of the book, which consists of four chapters, will discuss the fundamental concepts, the funding efficiency, the market participants, and the potential benefits of asset securitization. An analysis of mortgage finance will be provided in Part II, which consists of six chapters that cover a variety of topics from the description of many different types of residential mortgages to the securitization of different types of residential mortgages, including the now infamous sub-prime mortgages. Also included are important topics, such as prepayments, cash flow structure, maturity and credit tranching, and the trading and relative value of the various mortgage-backed securities. The three chapters in Part III will explain the other major asset securitization products, such as commercial mortgage-backed securities, credit card receivable-backed securities, auto loan-backed securities, and collateralized bond obligations. Part IV has two chapters: one reviews the collapse and the potential recovery of the asset securitization market, and the other describes the asset securitization efforts in Japan, Australia, Taiwan, and China.

    Extensive tables and charts are presented to help illustrate a concept or describe a product. Neither analytical discussions nor investment strategies of the various asset-backed securities are included as they are not the focus of this book.

    LanguageEnglish
    PublisherWiley
    Release dateJun 1, 2011
    ISBN9780470828991
    Asset Securitization: Theory and Practice

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      Book preview

      Asset Securitization - Joseph C. Hu

      Preface

      This book, Asset Securitization: Theory and Practice, is based on my 30 years of observations and work experience in the U.S. asset securitization market. It is a celebration of this efficient financing method that has, over the last four decades, benefited lenders, borrowers, and investors alike. As a capstone for a career spent in some of the major investment banking firms and a leading credit rating agency, this book is also written with an unavoidable tinge of sadness. Powerhouses such as Salomon Brothers, Bear Stearns, and Lehman Brothers, and venerable investment firms like E. F. Hutton—places I admired or worked and honed my analytical skills at as a young man—have been swept away by the change of times or mismanagement. And the asset securitization market was almost destroyed by greed, abuse, and complacency. As a market practitioner who believes in the power of asset securitization, and contributed in a small way to its success, the events of the last three years have been painful to witness. However, ever the optimist, I am hopeful that the market will storm back bigger, better, and stronger, to once again provide financing to consumers and businesses, creating wealth for our society.

      This book could not have been published without the help of many of my colleagues and friends. I would like to thank Rocco Sta. Maria, Head of Sales and Client Services for Standard & Poor's in Asia-Pacific, for putting me in touch with John Wiley & Sons. I am grateful for the assistance extended to me by my colleagues at Standard & Poor's offices in Tokyo (Yu-Tsung Chang), Melbourne (Vera Chaplin), Beijing (Li Jian), Hong Kong (Frank Lu), and Taipei (Aaron Lai), who provided insights into the development of the Japanese, Australian, Chinese, and Taiwanese asset securitization markets. I would also like to express my gratitude to K. C. Yu, Deputy CEO of SinoPac Holdings and Nick Ding of Standard & Poor's Beijing office, for providing me access to up-to-date market information. Over the years, the excellent market commentaries of Citigroup Global Markets, J. P. Morgan Securities, Merrill Lynch, Morgan Stanley, and UBS Securities kept me abreast of the asset securitization market. I would also like to thank many of my friends who helped me clarify and improve the content of this book. Additionally, I greatly appreciate the assistance of Nick Melchior, Senior Publishing Editor, John Wiley & Sons, without whose encouragement and enthusiasm this book would not have been completed so expeditiously. Though I am solely responsible for the content of this book, the skills and professionalism of my copy editor, Michael Hanrahan, made the text eminently more readable. Finally, I wish to thank my wife, Linda, and my children, Justin and Brian. Their love and support made the writing of this book and, in fact, my whole professional journey all the more rewarding and enjoyable.

      Joseph Hu

      November 2010

      Introduction

      In A Tale of Two Cities, Charles Dickens described the chaotic and brutal period of the French Revolution as the best of times and the worst of times. For the asset securitization market, one might similarly regard the period after the subprime mortgage debacle that caused panic and tremendous financial loss worldwide as the worst of times—the winter of hindsight and reflection. Yet this period can also be viewed as the spring of hope and rebirth, and as the best time to study the concept and practice of asset securitization, to once again make it a powerful financial engine that creates wealth and prosperity.

      Over the last 40 years, the asset securitization market has grown and flourished to become the largest sector of the U.S. fixed-income securities market. In the initial development of the asset securitization market in 1970, residential mortgages were the only type of securitized assets. Remarkably, however, since the mid-1980s, many other types of financial assets with a predictable future receivable cash flow began to be utilized as the underlying asset for the issuance of asset-backed securities. These assets include, but are not limited to, commercial mortgages, credit card receivables, auto loans, student loans, equipment leases, and small business loans. By facilitating the funding of consumption and business activities, asset securitization has contributed substantially to the steady growth of the U.S. economy and the increase in the American standard of living. Asset securitization has been the living proof of the adage, finance creates value.

      Alas, asset securitization became the victim of its own success. With the abundance of funds available to be invested, market participants became overly creative with the underlying assets of their originations and created a variety of new asset-backed securities. Throwing caution to the wind, originations of residential mortgages—the securitization market's most prominent and best performing underlying assets—began to grossly deviate from prudent underwriting guidelines. Driven by greed, more and more of the low-credit-quality (subprime) mortgages were originated and their inherent credit risks were consistently underestimated. When incidences of delinquencies and defaults of these mortgages became abnormally frequent, investors were alarmed and began to shy away from subprime mortgage-backed securities. Like dominos, fear and panic quickly spread to the mortgage-backed securities market and eventually put a strangle hold on other sectors of the capital market as well.

      A credit risk problem created a liquidity problem so severe that funding became unavailable to consumption and business activities. Since late 2007, the U.S. economy has experienced the worst contraction both in depth and duration since the Great Depression. The rest of the world has been similarly impacted with their economies languishing in a severe downturn. In the initial panic, asset securitization became one of the most vilified and demonized financial terms in the world. Critics questioned the justification of such a market and there were doubts aplenty about whether the asset securitization market would ever recover. It would seem that this is indeed the worst time for asset securitization. Yet, the bottom of the market is the perfect place and time to examine asset securitization anew—its successes and failures—and plan for a future asset securitization market that is transparent, self-disciplined, and rigorous in its regulation and supervision.

      This book is intended for students and entry-level market professionals alike who are interested in learning about asset securitization—its concepts and practices. It is designed so that the readers will come away with a fundamental but comprehensive understanding of the asset securitization market. As such, the book aims to provide a review of the market's development, necessary framework, potential benefits, and detailed descriptions of major asset securitization products.

      1Part 1 of the book, which consists of four chapters, will discuss the fundamental concepts, the funding efficiency, the market participants, and the potential benefits of asset securitization. An analysis of mortgage finance will be provided in 5Part 2, which consists of six chapters. They cover a variety of topics from the description of many different types of residential mortgages to the securitization of these mortgages, including the now infamous subprime mortgages. Also included are important topics, such as prepayments, cash-flow structure, maturity and credit tranching, and the trading and relative value of the various mortgage-backed securities. The three chapters in 11Part 3 will explain the other major asset securitization products, such as commercial mortgage-backed securities, credit card receivable-backed securities, auto loan-backed securities, and collateralized bond obligations. 14Part 4 has two chapters: one reviews the collapse and the potential recovery of the asset securitization market, and the other describes the asset securitization efforts in Japan, Australia, Taiwan, and China.

      Extensive tables and charts are presented to help illustrate a concept or describe a product. Neither analytical discussions nor investment strategies of the various asset-backed securities are included as they are not the focus of this book.

      It is hoped that, after reading this book, students of asset securitization will gain new insight into and appreciation for the creative financial instruments that make up this market. And be mindful of the critical lesson learned that not all good things need come to an end, if prudence is always the guiding principle of our behavior in the financial market.

      Part One

      Basics of Asset Securitization

      Chapter 1

      Asset Securitization: Concept and Market Development

      The concept and market practice of asset securitization started in 1970, when mortgage bankers pooled their newly originated residential mortgages and issued residential mortgage-backed securities. By issuing residential mortgage-backed securities, mortgage bankers were able to raise funds more efficiently in the capital market to finance their originations of residential mortgages.¹ It took only 20 years for the asset securitization market to become the largest sector in the U.S. capital market, with the outstanding balance exceeding one trillion dollars. In the early development of the asset securitization market, residential mortgages were the only type of underlying assets that were being securitized. Since the mid-1980s, a great variety of financial assets that had predictable and steady future receivable cash flows have been utilized as the underlying assets for securitization.

      This chapter will first discuss the basic concept of asset securitization. It will then present the development history of the asset securitization market in the United States over the past 40 years.

      Basic Concept of Asset Securitization

      Asset securitization is an innovative way for lenders to raise funds in the capital market by selling the future receivable cash flows of their assets.² The cash flows are sold in the form of securities that are backed by the cash flows of the very assets sold. The securities are therefore called asset-backed securities. This method of financing differs from the traditional means of raising funds by attracting deposits or borrowing in the form of loans. It is also different from issuing debt or equity securities (bonds or stocks) to obtain funds in the capital market.

      Issuers of asset-backed securities are mostly originators of the assets backing the securities. These assets can be a wide variety of residential or commercial mortgages, consumer loans, commercial leases, or any financial instruments that have predictable and stable receivable cash flows. In recent years, there have been new and popular asset-backed securities that are supported by assets that are corporate bonds, commercial and industrial loans, or even asset-backed securities themselves.

      Since asset-backed securities are issued by lenders through the mechanism of structuring future receivable cash flows of the underlying assets to finance their funding needs, the securities are also called structured finance securities. From an accounting point of view, the issuance of asset-backed securities is considered an asset sale. This differs from the issuance of bonds, which is debt financing by corporations, the various levels of government, or authorities.

      Specifically, by issuing an asset-backed security to raise funds to finance the origination of loans, the financing has the following five salient features:

      The asset-backed security is issued through a special purpose entity.

      The accounting treatment of issuing an asset-backed security is asset sale rather than debt financing.

      An asset-backed security requires the servicing of the underlying assets for the investor.

      The credit of the asset-backed security is derived primarily from the credit of the underlying assets (the collateral).

      There is invariably a need of credit enhancement for the asset-backed security.

      At the outset, it is critical that several basic terms of asset securitization are clarified to avoid possible confusion in future discussions. Throughout this book, the presentation and the analysis, unless specifically noted, are from the viewpoint of the lender, who is a loan originator. The originator is the one who originates the loans that are pooled as the underlying assets for the issuance of asset-backed securities in the asset securitization transaction. Therefore, the term originator is synonymous with the term lender. The two terms are used in the book interchangeably. Further, since asset securitization is primarily enabling those originators to use their newly originated or existing loans to obtain funds, the loans are really their assets (although from the point of view of the borrowers, they are debts). Thus, the terms loans and assets in the context of structured finance are also synonymous. They are interchangeable terms. The issuer of asset-backed securities is mostly an entity that is set up by the originator of the underlying assets. So, while the originator and the issuer are legally two different entities, they are economically the same or very closely related business entities.

      Special Purpose Entity

      A special purpose entity (SPE) is a unique feature of asset securitization.³ Alternatively, an SPE is also referred to as a special purpose vehicle (SPV) or a special purpose trust (SPT). Basically, an SPE is a trust that is set up by the originator for the purpose of purchasing the loans it originates and issuing in the capital market a certificate of beneficial interest, for which the cash flows are backed solely by the cash flow of loans purchased from the originator (see Figure 1.1). Actually, the purchase of loans and the issuance of the certificate of beneficial interest take place simultaneously. They are two parts of a transaction. The SPE, on the one hand, raises the funds in the capital market by issuing the asset-backed security; and on the other hand, it uses the very issuance proceeds to pay for the purchase of the underlying assets. The holder of the certificate of beneficial interest is generically called the investor of the asset-backed security.

      Figure 1.1 Asset Securitization Cash-Flow Scheme

      From a balance-sheet point of view, the SPE has no assets other than those purchased from the originator, and no liabilities other than those of the asset-backed security it issues. With this special and strict asset–liability structure, the cash flows of the assets are matched by those of the liabilities. From the accounting and legal points of view, the SPE is considered bankruptcy-remote. Asset securitization is also called structured finance, because it is done through a special legal structure of the SPE and the interest and principal payment of the security it issues is through the structuring of the projected future receivable cash flows from the underlying assets. Structured finance is a formal and generic term for asset securitization. The term structured finance is often used to differentiate from corporate finance. Colloquially, however, the term asset securitization is more often used to describe precisely the process of pooling assets for the issuance of an asset-backed security. To further simplify the description of asset securitization, it sometimes is just called securitization.

      Asset Sale versus Debt Financing

      One great advantage of asset securitization is that it is an effective way of managing the balance sheet by the originator through the selling of its newly originated or existing loans to raise funds. This way of financing enables the originator to collect the present value, at the prevailing market price, of the stream of the future receivable cash flows of their assets. Asset securitization, therefore, is not a debt financing and the funding has no consequence of expanding the issuer's balance sheet. Further, by selling assets, the originator does not rely on attracting deposits or borrowing from other financial institutions to fund the origination of the assets, both of which will expand the liability side of the balance sheet. Actually, it can be said that when a lender raises funds through asset securitization, the financing could even have the effect of shrinking the lender's balance sheet if it elects to use the issuance proceeds to pay down liabilities (this being the case when the lender sells existing loans on its portfolio). By contrast, a lender raising funds through deposits, borrowing, issuing debt or equity securities to fund the origination of loans would have the consequence of expanding its balance sheet.

      The Requirement of Servicing

      The function of servicing is unique for asset-backed securities because the sole source of the interest and principal payments of the securities is supported entirely by the future cash flows of the underlying assets. The servicing function is performed by a servicer, who often is the originator and also the seller who sells the very assets to the SPE. Primarily, the servicer performs the servicing function by collecting the interest and principal cash flows generated from the underlying assets and then passing them, through the SPE, to the investor (holder of certificate of beneficial interest). Other important elements of the servicing function include working with delinquent borrowers, disposing of defaulted assets, and providing timely and accurate cash-flow reports to investors.

      In the early days of the legal structure of the SPE, which was a grantor trust, the servicing function was passive in that the servicer was required not to touch the cash flow generated from the underlying assets other than just passing them on to the investor. This requirement was made necessary so that the Internal Revenue Service would see through the SPE, not levying an income tax at the SPE level on the interest cash flow generated from the underlying assets. The income tax liability will fall on the investor, who is the ultimate owner of the assets underlying the asset-backed securities. It stands to reason that if the tax on interest income to the SPE were to be levied while the interest income to the investor is also taxed, there would be income taxes on two levels of the transaction. This double taxation would completely nullify the economic benefits intended for securitization.

      Under this passive management requirement, all the servicer was required to do was simply pass the cash flows onto the investor. The servicer could not manage the cash flows to earn incremental yield for the trust by reinvesting the interim cash flow (the cash flow the SPE owns temporarily between the time it was collected by the servicer and the time it was distributed to the certificate holder). Nor was the servicer permitted to allocate the principal cash flow of the underlying assets to satisfy the varying maturity preferences of the different types of investors. Later on, new legislation permitted active management of the cash flow of the underlying assets. It allowed the servicer to allocate the cash flow, without encountering tax consequences, by prioritizing the principal payment of the underlying assets to investors according to maturity and credit-risk preferences. Also, the servicer was allowed to manage the interim cash flow to enhance the income of the trust by purchasing short-term money market instruments with the interim cash flow.

      As will be explained in later chapters, the ability of the servicer to allocate cash flows is critically important in the development of new types of asset-backed securities. It allowed the innovative creation of maturity tranching and credit tranching of the cash flows of the underlying assets. Issuers were allowed to issue asset securitization securities in various maturity classes and credit-risk classes.

      In comparison with asset-backed securities, corporate or government bonds do not need servicers. This is because the interest and principal payment of these obligations are paid out of the issuers' earnings or tax revenues. The cash flows of the liabilities are not matched by the cash flows of any of their assets.

      Credit of the Underlying Assets

      Since the interest and principal cash flow of an asset-backed security come solely from its underlying assets, the credit risk of the security is derived primarily from the credit risk of the underlying assets. (As will be explained in later chapters, the credit risk, or simply the credit, of a borrowing entity or a debt instrument refers to the likelihood of the borrower defaulting on its debt. The likelihood of default is assessed publicly by credit rating agencies. According to credit rating agencies, the incidence of default is defined as the borrower failing to make timely payment of interest and/or the repayment of principal of the debt. A high credit rating, or a strong credit, would mean a low probability of default. Conversely, a low credit rating, or a weak credit, suggests a high probability of default.) More important, the credit of the assets is highly dependent on economic conditions. In a prosperous economy, the underlying assets would perform strongly with less frequent incidences of default. In a depressed economy, however, the underlying asset would have a weak credit performance and the incidences of default would become more frequent.

      This feature contrasts sharply with the credit determinant of a debt obligation of a corporation or a government entity. The credit strength of a corporate debt is first and foremost dependent on the management of the corporation. A well-managed corporation is likely to have a stronger credit because it is more likely to be financially healthy with a greater earning potential. This would enable the corporation to service its debt in various economic environments. Conversely, the credit of a poorly managed corporation is likely to be weaker. With the exception of the U.S. government, whose debts are risk free, the credit of a state or local government is also dependent on its ability to manage various expenditures in relation to tax revenues under all economic conditions.

      Need for Credit Enhancement

      Credit risk of a security is an important investment consideration for investors. In order for an asset-backed security to attract certain investors, it has to have a desirable credit rating. If the underlying assets cannot provide the security with a desirable credit rating, then the security would require credit enhancement as defined by the credit rating agencies. In this case, four major sources of credit enhancement are available to strengthen the credit of an asset-backed security. They are: (1) self-insurance, (2) corporate-parent credit guarantee, (3) surety bond, and (4) letter of credit (detailed analysis of credit enhancement will be provided in various later chapters when the cash-flow structure of products is explained).

      Credit enhancement through self-insurance can be in the form of senior/subordination, over-collateralization, or interest spread. In senior/subordination, the cash flow of an asset-backed security is subdivided into two classes: senior and subordinated classes. The principal cash flow of the subordinated class is structured to support (enhance) the credit of the principal of the senior class. Under the senior/subordination structure, the investor of the senior class of the security will be repaid before the investor of the subordinated class.

      One simple example may be appropriate to explain the senior/subordinate cash-flow credit enhancement. Consider a pool of assets that is expected to experience a lifetime cumulative default rate (default frequency) of 30 percent. After the default, the underlying assets may be liquidated to recover 60 percent of the original loan amount. That is, the loss on the defaulted assets is 40 percent (loss severity). For the life of the pool, the cumulative loss therefore would be the product of default frequency and loss severity; that is, 12 percent (30% × 40% = 12%). Based on these cash-flow assumptions, it is possible to structure a senior/subordinate credit enhancement with the senior class security being supported by the 88 percent (1 – 12%) of the pool's cash flow and the subordinate (junior) class being supported by the first loss of 12 percent of the pool's cash flow.

      In an over-collateralization structure, the principal amount of the underlying assets is greater than the principal amount of the asset-backed security so that more principal protection can be provided by the excess principal. For example, the underlying principal cash flow can be 110 percent of that of the security. Thus, the additional 10 percent of over-collateralization is behaving like a subordinate class that supports the principal of the senior class. In addition to the principal, the interest can also be used in credit enhancement. This is under the structure where the interest on the asset-backed securities is set to be significantly less than that of the underlying assets and the excess spread is used to support the credit of the asset-backed securities. All these are viewed as self-insurance because the principal and/or the interest of the underlying assets are the sources of credit enhancement.

      Sometimes, it may be more economical to issue an asset-backed security with the corporate-parent of the issuer providing the credit enhancement. In this case, the credit strength of the security is equivalent to that of the corporate parent. An alternative to a corporate-parent guarantee can be a credit guarantee provided by a bond insurance company in the form of surety bond. The bond insurance companies often have a very strong credit so that the bond-insured structured security would also be highly rated. The fourth alternative is credit enhancement via letter of credit from a commercial bank with a strong credit. In this case, the credit of the asset-backed security is the same as the credit of the commercial bank.

      Development of the Asset Securitization Market in the United States

      Asset securitization began in the United States in 1970, when residential mortgages were securitized by mortgage bankers with the issuance of mortgage-backed securities. Over the last 40 years (1970 to 2009), more than $23 trillion worth of principal amount of asset-backed securities has been issued with a wide variety of underlying assets, ranging from residential mortgages to airplane leases to corporate bonds. As of year-end 2009, outstanding principal of asset-backed securities approached $11 trillion.

      Three major factors contributed to the rapid growth of the asset securitization market. First, during the thrift crisis of the 1980s asset securitization enabled thrifts to convert their holdings of residential and commercial mortgages to mortgage-backed securities. It greatly increased the marketability of mortgages and expedited the resolution of failed thrifts. Second, the coming of home-buying age in the late 1970s of the post–World War II baby boomers created a strong demand for housing for nearly 20 years. Securitization of residential mortgages facilitated the funding for

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