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Lassoing the global market.

Lassoing the Global Market

The growth of asset securitization in the United States has been impressive. The most spectacular progress has been made in the securitization of U.S. residential mortgages. Other types of assets in the U.S. have recently been caught up in the growing trend of securitization and display similar signs of growth potential.

In other countries, the fields are being cultivated and seeds are being sown, but little actual harvesting of asset securities has occurred to date. Yet, the progress is clear and there are high expectations of bountiful asset security volume to come in the near term.

The forces at work favoring asset securitization are strong and pervasive. However, old ways carry with them substantial inertia resistant to change. Thus, on the frontier, the process remains very much a pioneering effort. In more mature markets, innovations continue to be fast paced and an integral component of the "financial manufacturing" process. All of this points to a brave new world of financial markets, as we close out the 20th century.

Growth in U.S. asset securitization

The story of asset securitization in the United States begins with the first issuance of GNMA securities in 1970. The first GNMA pool was issued in February 1970 with a face value of $6.7 million. A total of $300 million were issued that year. The following year brought the formation of Freddie Mac, along with the issuance of $2.7 billion of GNMA securities.

Freddie Mac introduced its first Cash Participation Certificate (PC) in late 1972. During the first half of the 1970s, issuance averaged $4.2 billion per year. The second half of the 1970s brought a major leap forward, as issuance of Ginnie Maes and Freddie Mac mortgage securities averaged $21.6 billion per year.

High inflation and interest rates during the period from 1979 to 1981 wrought several changes in financial regulations and practices. Fannie Mae began issuing mortgage-backed securities (MBSs) in November 1981 and Freddie Mac introduced its guarantor program. Issuance of agency MBSs jumped to $53.3 billion in 1982 and advanced to $109.3 billion by 1985. During this period, collateralized mortgage obligations (CMOs) were introduced by Freddie Mac in June 1983, adding impetus to the growth of agency MBSs. The year 1986 brought rapidly falling interest rates and massive refinancing of high-coupon mortgages originated from 1980 to 1983. Issuance of agency MBSs surged to a record $264.6 billion a year during the period from 1986 to 1990. During this time, the CMO market grew rapidly, leaping from $13 billion in total offerings in 1985 to $45 billion in 1986 and reaching $112 billion in 1990.

Partly responsible for this growth in CMO issuance was the passage of tax legislation creating the real estate mortgage investment conduit (REMIC) in late 1986, which made the structuring of CMOs much more flexible. Projections are that 1991 will result in the issuance of around $180 billion in CMOs. This represents roughly a 50 percent growth rate per year in the issuance of CMOs over the last six years, and the CMO/REMIC market is now the gemstone around which the entire mortgage securities market revolves. It is the REMIC bid that drives the narrow spreads, by historical standards, of MBSs that increases execution prices of whole loans through securitization that results in record volumes, ultimately lowers mortgage rates and helps stimulate the U.S. housing industry.

The year 1986 was also a watershed time for the issuance of whole-loan securities, which are backed by home mortgages but derive credit enhancement through insurance, letters of credit or various structuring techniques. The issuance of whole-loan securities hit $8.2 billion in 1986, up from $1.7 billion in 1985. Whole-loan security issuance went through a period of relatively stable volume, averaging $10.5 billion in 1987 through 1989, then surged in 1990 to $23 billion. The volume outlook for 1991 is expected to be in the range of $35 billion.

Asset-backed securities (ABSs), which are securities backed by assets other than mortgages, also took a prominent role in the fixed-income markets beginning in 1986, when issuance surged to $10 billion from $1.2 billion in 1985. The ABS market has grown also at roughly a 50 percent pace and should exceed the $50 billion issued mark in 1991.

These securities have been backed by automobile loans, credit-card receivables, manufactured housing, equipment leases, oil distribution rights, franchise loans, boat loans, high-yield corporate debt, time-share loans, floor plans, rental car loans, perpetual floating-rate notes issued by banks, recreational vehicles, foreign sovereign debt denominated in dollars and unsecured personal loans. This development is important to the CMO/REMIC market because these securities add liquidity to CMO/REMIC tranches that have similar characteristics, increase trading volume and competition, lower spreads, and generally expand the market for securitized products.

All in all, the total amount of annual asset securitization (eliminating the double counting for agency MBSs used in CMO/REMICs) is now around $335 billion. While there are clearly some limits to the market's capacity to grow, there is sufficient capacity for total issuance to climb to the $500 billion annual rate within the next few years. Eliminating the agency pass-throughs not used in CMOs, the annual issuance of asset-backed securities is currently about $265 billion and could easily grow to $350 to $400 billion.

Asset securitization in other

countries - growing pains

The impressive growth in asset securitization that has occurred in the U.S. has been enviously eyed by other fixed-income participants around the world. However, the growth in asset securitization elsewhere has been substantially slower and has encountered significant growing pains. The first country to follow in the securitization of mortgages in a major way was the United Kingdom, followed by Canada and Australia. Asset-backed securities issuance has begun in earnest in France, and a smattering of MBSs and ABSs have been issued elsewhere around the world. Currently, prospects appear brighter for further growth in the U.K. and French markets, as well as for the emergence of securitization in several other countries.

The securitization of U.K. mortgages was launced in March 1987, and a total of L1.1 billion floating-rate securities backed by floating-rate mortgages were issued for the year. That was followed by an issuance of L3.3 billion in 1988 - an auspicious beginning. Since that time, the market has been subjected to high levels of financial stress and strain. From 1988 to 1989, Sterling London Interbank Offered Rate (LIBOR) increased from 8 percent to 15 percent and contributed to a collapse in home prices as mortgage payments nearly doubled and the U.K. economy slid into a recession. Added to that was an unfavorable risk-based capital ruling by the Bank of England in January 1991 and a downgrading of several insurance companies that were providing credit enhancement for the securities. consequently, market issuance declined to L2.5 billion in 1989 and to L1.9 billion in 1990. Prospects for 1991 volume should be better, at nearly L3.0 billion, but below the issuance level posted in 1988.

The outlook for the U.K. market has taken on a brighter glow of late. Primarily responsible for this is a lowering of Sterling interest rates and a flattening of the Gilt yield curve (similar to the yield curve based on U.S. Treasury securities). Other factors include an apparent recovery in the U.K. economy and indications that the Bank of England may reverse its stand and not implement the 100 percent risk-based capital requirement for mortgage-backed securities scheduled to go into effect January 1, 1993.

Canada and Australia have followed a similar path to that of the U.K. mortgage market in the mortgage securitization effort. The Canadian Mortgage and Housing Corporation, Cannie Mae, a crown corporation issued its first guaranteed MBS in January 1987. In that year, issuance amounted to about C$475 million and increased smartly to about C$2.0 billion in 1989. Since then, issuance has been flat. Though 1991 totals will show some improvement, there is no clear signal of an immediate explosion in MBS issuance in Canada.

The MBS was introduced in Australia in the early 1980s, but only started to grow after 1986. In Australia, the current outstanding balance of MBSs is just in excess of A$6.0 billion. However growth in the Australian MBS market appears to be stalled at the present time.

France, as with most other nations with no experience with asset securitization, lacked the requisite legal and regulatory framework, prior to "La Loi Titrisation" enacted in December 1988, to have a strong asset securitization market. The principal impediments generally found in most countries are: the limitations and restrictions on the assignment of loans or legal participations in the cash flows from such assets; the fact that it is difficult or impossible to establish a perfected interest in the collateral of the assets that is above potential changes in contractual arrangements imposed by a court of law; the absence of bankruptcy-remote, and otherwise safe, special purpose vehicles to perform the functions of a trustee; and the existence of typically a variety of tax problems.

Changing the legal and regulatory environment to enable securitization does not change traditional ways of doing business immediately, particularly when the impetus for the changes was not generated from the ground up. The first French asset securitized under the new legislation was for FF674 million in December 1989. Total issuance in 1990 increased to FF6.3 billion and the outlook for 1991 volume is only slightly higher, roughly FF7 to FF8 billion.

To date, there have not been any French MBSs issued. However, one has been approved by the French authorities for issuance and is expected to come to market any day. also, it is rumored that several other mortgage originators are currently gearing up to issue French MBSs in 1992.

In addition to this, there have been a smattering of other asset-backed securities issued around the world. Relatively small issues, primarily backed by auto loans or credit card receivables, have been denominated in Italian lira, deutschmarks, sterling, Spanish pesetas, Canadian dollars, Australian dollars and Japanese yen. Swedish mortgages have been securitized and combined with a currency swap to produce U.S. dollar securities. These are beginnings, but only that at present.

Other countries are actively at work to change the legal environment to enable asset securitization. In particular, Belgium and Spain should complete the initial phases of building such a market this year, and ABSs and/or MBSs should be issued in these countries before 1992. Pressures in Belgium are being fueled in part by that country's desire to be the financial center of the European Economic Community (EEC). In Spain, economic conditions are ripe for securitization, with a strong, growing economy in place. Interest rates there have recently fallen by 400 to 500 basis points. Lending institutions in Spain are currently sitting with assets on their books carrying rates in the 18 percent vicinity, with current rates hovering in the 13 percent range. These institutions are highly desirous of capturing the net present value of this excess interest and plowing it back into the expanding market.

In summary, asset securitization is growing unabated in the U.S., while in other countries there are signs of potential, but there are also signs of growing pains.

Forces favoring securitization - financial


The forces favoring broader and deeper securitization are fundamental and pervasive. First of all, securitization creates value. It creates value by taking traditionally illiquid, raw assets of financial institutions and turning them into securities that can be bought and sold much more easily. Over and above that, securitization generally takes the different characteristics of the raw asset and puts them into separate classes. In this way, the securitization process is analogous to refining raw ore, separating the slag and sludge from the precious metals.

For example, a traditional bank loan from a German bank to a manufacturing firm in Spain has a number of different risks associated with it. There is the credit risk, spread through time, that the Spanish firm will be delinquent and/or default on its obligations under the loan agreement. Generally, there will be prepayment options or put options for the lending bank. There are exchange rate risks, exchange control risks, other forms of political and judicial risk, and so on. Most importantly, there is also interest rate risk, the risk that funding for the loan will not match the revenue generated from the loan.

Conceptually, each of these risks can be put in a separate category. The holder of the separate securitized classes has now the option of selling only the credit risk or only the prepayment risk, rather the entire bundle. This means that the market for the asset can be broadened with a particular characteristic being sold to the one who is the highest bidder for that characteristic. In that way, credit risk can be sold to those who best understand credit risk, or who are naturally hedged against credit risk, without having to also take other risks that they understand less, or for which they are not the best bidder.

The bank for International Settlements (BIS) risk-based capital guidelines are another force favoring securitization. Many banks are not in compliance with those guidelines and will have to raise equity capital or shrink the balance sheet. Securitization can allow an institution to retain the economic juice of raw assets, while removing them from the balance sheet. However, the BIS guidelines are simple out of necessity, and, as a result, create many economic inequities. Such economic imbalances are grist for the securitization mill. This creates many opportunities to slice and dice raw assets to take advantage of these simple guidelines.

There are a number of other forces from a balance sheet perspective that favor securitization. In the simplest framework, the value of securitization to the seller is often assessed as simply the relative cost of funding through securitization versus other sources. This, however would only be a valid means of comparison if the following conditions are present: * the relative funding source exactly

matches the principal paydown

schedule of the assets being funded; * the securitization is treated as a

pure financing and the assets remain

on the balance sheet; * the assets have no other option

provisions; * the credit risk of the assets is

bounded and is less than the "excess"

interest of the assets; * the availability of alternative funding

is perfectly elastic (totally available)

at the stated cost comparison; * there are no timing differences between

the payments made on the alternative

funding source and the

asset-backed securities; * there is no benefits derived from

the "process" of securitization; * there is no benefit from being able

to actively manage the portfolio by

buying and selling "characteristics"

of the raw asset rather than the entire

raw asset; in short, when it is

not truly an asset securitization.

In practice, all eight of the preceding conditions are rarely present. Therefore, securitization, from the seller's point of view, is generally the most valuable option.

Forces opposing securitization - parental


The forces opposing securitization fall into two general categories. The first is the direct costs of creating the securities and the markets for them. The second is institutional opposition.

The costs associated with creating and establishing markets for asset securities are, to a large extent, fixed costs. Legal costs, establishing the necessary technology, the education of the various market players, and the like, are largely fixed costs. Once in place, the marginal costs of producing more securities are dramatically reduced. Furthermore, the information technology associated with securitization and market making is an area that continues to exhibit dramatic cost cutting innovations.

Aside from the lengthy history of MBSs in the United States, asset securitization, in the broad scope of things, is relatively new. The techniques, technology and the bricks and mortar necessary to establish such markets are different from the traditional practices of financial institutions. Furthermore, securitization creates value at a relatively small cost. Thus, asset securitization is also a reflection of the process of financial disintermediation. Consequently, there is a natural resistance by existing institutions to the changes implied by the process of asset securitization. Furthermore, the resistance is naturally greater in countries where the financial system has been historically strong, such as in Germany and Japan. Things do change though, and it is more a question of when, rather than if they will do so.

Innovations on the frontier - the

pioneer's life

In countries where asset securitization is still in embryonic stages, it is very much a pioneer's life. Issues that have to be addressed and, typically, solved through innovative and tedious efforts fall under the general headings of: management information, legal, tax, accounting, credit enhancement, rating agencies, structuring techniques, underwriting, marketing, pricing and trading and more.

Information technology is the core of asset securitization, both from the point of view of balance sheet analysis and selection of the assets to be securitized, as well as from the design and management of the transaction. Typically, systems have to be established to track separately the performance of individual loans and to generate reports for disbursements, rating agencies, regulatory bodies, auditors, tax authorities and investors. A historical database of loan performance (that tracks delinquencies, cures, recoveries, prepayments) is essential for proper valuation, rating and pricing, as well as to enhance the development of a secondary market for the securitized asset. Such information technology not only facilitates securitization but brings substantial ancillary benefits to a firm's management.

As in the case of France, it is generally necessary to change the legal and regulatory framework to enable securitization. Given that, pioneers have to design the optimal legal structure in light of the country's specific tax, accounting, marketing and institutional conditions. Opportunities abound for financial engineers to create structures that minimize tax liabilities by taking into account income, capital gains and other tax treatment of interst income, servicing fees, management fees and various expenses that are applicable to the specific entity.

Innovations on the securitization frontier entail modifying the old technology and techniques to better serve the new environment. Consequently, the structures are generally simple with innovative adaptations for the new terrain.

Innovations on the interior - financial


Back on the interior, where the markets are mature, structural innovations seem never-ending. New ways of mining and refining raw assets continue to come to market, as the size of the market and the liquidity within it continue to build. Major refinements that have occurred of late in the U.S. fall into structuring and credit enhancement categories.

In the structuring of credit-enhanced securities, the major advances, which have come from the CMO/REMIC market in the United States, are: stripping of principal and interest; isolation of option components into separate classes, such as planned amortization classes (PACs) and companion classes; and creating floating-rate bonds and inverse floaters from fixed-rate collateral; with numerous variations on those themes.

In the area of credit enhancement there are several dimensions of credit risk. These include: loan-to-value ratios; standard hazards; special hazards; borrower bankruptcy; servicer bankruptcy; fraud by various parties; delinquency cash shortfalls; foreclosure losses; and interest rate shortfalls because of early repayment. Many view the public involvement in the U.S. through GNMA, Fannie Mae and Freddie Mac as primarily responsible for the dramatic development of the MBS market. While that may be true, it is not an essential ingredient for the development of other markets today. Forms of private credit enhancement that can be applied in innovative ways are: hazard insurance, both loan specific and pool-wide; letters of credit; corporate guarantees; asset substitution; senior/subordinated structuring; reserve funds; shifting interest; and spread accounts and other liquidity sources.

The innovations don't stop with the refinement process. They extend all along the financial manufacturing process - the melding of the pieces generated in the refinement process into optimal portfolios of assets to match particular liability structures. It is in this total framework that asset securitization evolves.

The outlook - a brave new world

In spite of some obvious growing pains, the outlook for broader and deeper asset securitization has never been brighter. The forces favoring securitization appear formidable, and the forces opposing securitization seem destined to wither.

All of this points to a brave new world for fixed-income markets in the coming decade. What has been an impressive growth pattern for asset securitization in the U.S. during the past five years may very well appear, in retrospect, as just a very small piece of the financial picture as we enter the 21st century.

Dr. R. Blaine Roberts is a senior managing director in the fixed income department and is a member of the board of directors of Bear Stearns. He heads the Financial Analytics and Structured Transactions Group, which is responsible for asset securitization both domestically and internationally.
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Title Annotation:Secondary Marketing; mortgage securitization
Author:Roberts, Blaine
Publication:Mortgage Banking
Date:Nov 1, 1991
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