Securitization

Securitization is the process of pooling and repackaging homogeneous FINANCIAL INSTRUMENTS in the form of marketable securities. In each pool of LOANS, the financial instruments are similar with regard to maturity and type of loan (MORTGAGE, automobile, consumer, etc.). The pools of loans are transferred to a TRUST, which then, with the assistance of an underwriter, sells securities (usually called certificates and backed by the pool of loans) to ultimate investors. Often the financial institution instituting the securitization will enhance the credit rating of the securities by insuring the payments against DEFAULT. In the United States, securitization began in the early 1970s with the sale of bundles of mortgage loans by the GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (Ginnie Mae). These were followed in the 1980s by similar mortgage securitizations by the FEDERAL NATIONAL MORTGAGE ASSOCIATION (Fannie Mae), and FEDERAL HOME LOAN MORTGAGE CORPORATION (Freddie Mac). Because these securities were backed by a government agency (Ginnie Mae) or by GOVERNMENT-SPONSORED ENTERPRISES (Fannie Mae and Freddie Mac), they received high credit ratings. Private CAPITAL MARKET participants quickly jumped into the securitization market and began offering collateralized mortgage obligations (CMOs), mortgage-backed securities (MBSs), and asset-backed securities (ABSs). By insuring the repayment of principal, the government-sponsored obligations retain the credit or default risk, while privatelabel securitizations transfer the credit risk to investors. By 1998 securitized loans amounted to over $2 trillion. Securitization has been applied to automobiles, CREDIT CARDS, leases, and other classes of loans. Securitized obligations are fixed-INCOME and DERIVATIVE SECURITIES. They are fixed income in that they pay a set amount to holders but are also derivatives in that the payments are derived from the underlying pool of ASSETS. For lenders, the benefits of securitization are that it releases CAPITAL that can be loaned out to others and, since the lender usually services the loan, generates fees. Lenders PROFIT from loan origination, servicing, and UNDERWRITING fees. For investors, securitized assets are much more liquid than loans and can be adapted to meet the investor’s maturity needs. Most loans are repaid before they mature. While Americans frequently take out 15- and 30-year mortgage loans, the average homeowner stays about seven years in a home. This usually results in repayment of the loan well before maturity. Some investors want earlier return of their money, while others are willing to invest for a longer period of time. INSURANCE companies, using actuarial tables, can accurately predict when they will have to pay off life-insurance obligations and will invest the insurance premiums received to match the predicted payout schedule. To accommodate the needs of investors like insurance companies, many issuers of mortgage-backed and asset-backed securities divide the securities into classes called tranches. Each tranche will have a different priority of payment of interest and principal from the pool of loans. For example, if a pool of automobile loans contained $4 million in loans, the underwriter might divide the pool into four tranches of $1 million each (A,B,C,D), with each tranche to be paid after the other. Almost all automobile loans are for a maximum of five years, but many loans will be paid off in two or three years as consumers trade in their cars. Overall the pool of loans may average 10 percent, but investors in tranche A, to be paid the first $1 million, would accept a lower interest rate because they would be paid back in the first year or two. Investors in tranche D, the last $1 million in payments, would want a higher rate, because they will not be paid back until much later. The underwriter will adjust the rate offered for each tranche to attract investors but also, preferably, at a rate low enough to provide a profit for its securitization effort. One of the problems associated with mortgage- and asset-back securities is called negative convexity, or price compression. When INTEREST RATES decline, borrowers are more likely to refinance their loans, paying off old loans. Holders of mortgage- and asset-backed securities will receive more repayment of principal, reducing the yield to investors and giving the investor principal to reinvest in a lower-interest-rate market. When interest rates rise, prepayments fall, but since asset-backed securities are priced based on the average life, a longer average life caused by slower repayment will reduce the security’s value.