By Dada Adefolami
Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages.
Common use of securitization occurs when banks lend through mortgages, credit cards, car loans or other forms of credit, they invariably move to ‘lay off’ their risk by a process of securitization. Such loans are an asset on the statement of financial position, representing cash flow to the bank in future years through interest payments and eventual repayment of the principal sum involved. By securitizing the loans, the bank removes the risk attached to its future cash receipts and converts the loan back into cash, which it can lend again, and so on, in an expanding cycle of credit formation.
Securitization is achieved by transferring the lending to specifically created companies called ‘special purpose vehicles’ (SPVs). In the case of conventional mortgages, the SPV effectively purchases a bank’s mortgage book for cash, which is raised through the issue of bonds backed by the income stream flowing from the mortgage holder. In the case of sub-prime mortgages, the high levels of risk called for a different type of securitization, achieved by the creation of derivative-style instruments known as ‘collateralized debt obligations’ ( CDOs.)
Securitization may be also appropriate for an organization which wants to enhance its credit rating by using low-risk cash flows, such as rental income from commercial property, which will be diverted into a “ring-fenced” SPV.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgage-backed security (“MBS”) markets, mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy.
CDOs are a way of repackaging the risk of many risky assets such as sub-prime mortgages. Unlike a bond issue, where the risk is spread thinly between all the bond holders, CDOs concentrate the risk into investment layers or ‘tranches’, so that some investors take proportionately more of the risk for a bigger return and others take little or no risk for a much lower return.
A credit crunch also known as a credit squeeze or credit crisis is a sudden reduction in the general availability of loans (or credit) a sudden tightening of the conditions required to obtain a loan from the banks. Credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates
Interest is payment from a borrower to a lender of an amount above repayment of the principal sum (i.e. the amount borrowed). It is distinct from a fee which the borrower may pay the lender or some third party.
Each tranche of CDOs is securitized and ‘priced’ on issue to give the appropriate yield to the investors. The investment grade tranche of CDOs will be the most highly priced, giving a low yield but with low risk attached. At the other end, the ‘equity’ tranche carries the bulk of the risk – it will be very lowly priced but with a high potential, but very risky, yield.
CDOs are, therefore, a mechanism whereby losses are transferred to investors with the highest appetite for risk such as hedge funds, leaving the bulk of CDOs’ investors mainly other banks with a low risk source of cash flow.
THE STRUCTURE OF CDOS
An example of structure for a CDO are as follows. For a pool of mortgages taken over by the SPV, three tranches of CDOs are created:
1. Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising about 10% of the value of the mortgages in the pool. Throughout the CDOs’ life, the equity tranche will absorb any losses brought about by default on the part of mortgage holders, up to the point that the principal underpinning the tranche is exhausted. At this point the investment is worthless.
2. Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the principal and will absorb any losses not absorbed by the equity tranche until the point at which its principal is also exhausted.
3. Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and will absorb any residual losses.
The proportion of the principal held in each tranche is known as the CDO ‘structure’, and if there is perceived to be little risk of default then the percentage of value in the mortgage pool forming the equity and mezzanine tranches will be quite small. However, if the risk is high then CDOs will be created with a greater proportion of the principal in the equity and mezzanine tranches and a relatively smaller proportion in the senior tranche.
When cash flows are received from borrowers in the form of interest payments and loan repayments, these payments are paid to tranche 3 first until their obligation is fulfilled, then tranche 2, and anything left over is paid to the equity tranche. Any defaults hit tranche 1 first, then tranche 2 and so on. The repayments represent a ‘waterfall’ of cash with the investors holding the tranches like buckets. The senior tranches get filled first, the mezzanine holders get filled next and anything left falls into the equity pools at the bottom.
FOR EXAMPLE
A bank has made a number of mortgage loans to customers with a current total value of N350 million. The mortgages have an average term to maturity of ten years. The net income from the loans is 7% per year. The bank will use 85% of the mortgage pool as collateral for a securitization with the following structure:
1. 75% of the collateral value to support a tranche of A-rated loan notes offering investors 6% per year.
2. 15% of the collateral value to support a tranche of B-rated loan notes offering investors 11% per year.
3. 10% of the collateral value to support a tranche of subordinated certificates which are unrated.
The estimated cash flows for this arrangement would be as follows:
Cash inflows
Inflows from mortgages N350m x 7% = N24.5m
Cash outflows
A-rated loan notes
N350m x 85% x 75% x 6% = N13.4m
B-rated loan notes
N350m x 85% x 15% x 11% = N4.9m
Total outflows = N13.4m + N4.9m = N18.3m
The difference between the inflows and the outflows is returned to the high-risk unrated certificates.
Difference in cash flows = N24.5m – N18.3m = N6.2m
The subordinated certificates have a value of N350m x 85% x 10% = N29.75m.
The return on this high-risk investment is N6.2m/N29.75m = 20.8%
However this return is at risk should there be a reduction in the income from the mortgages resulting from customers defaulting on their mortgages. Because of this level of risk, the equity tranche may be unattractive to investors for some securitization arrangements.
Note that all of the income from the mortgages is used to pay the tranche holders, not just 85% representing the securitized amount. The reason why the securitization is performed is to get money in quickly. In order to sell the various tranches there needs to be an incentive; for this to be present for all tranches not all of the available pool of mortgages is securitized, but all of the income from the pool is distributed. The bank, in theory, loses out from this approach by distributing 100% of the income instead of keeping 15%, but has achieved the objective of getting the initial funds from the tranche holders as quickly as possible.
A bank run occurs when in a fractional-reserve banking system, many customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; and keep the cash or transfer it into other assets, such as government bonds, precious metals or gemstones. When they transfer funds to another institution it may be characterized as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.
Dada Suraju Adefolami, Professor of Finance, School of Business Administration, UNEM University, Costa Rica, is a Finance / management Consultant and Certified Forensic Accountant. You can reach him via: surajudada@yahoo.com: 08052043855