DEVELOPMENT AND MARKET DRIVERS

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Mortgage- and Asset-backed Securities

Mortgage-backed securities

Pass-through securities

Asset-backed securities

Credit card securitizations

Home equity loan securitizations

Other asset-based securitizations Stripped mortgage

products Collateralized mortgage obligations

Figure 4.1 General MBS and ABS classes

Following the initial success of “vanilla” residential MBS, financial intermediaries applied the same technologies in other areas, including nonconforming “whole loans” (i.e. those not meeting the size or loan-to-value requirements of the mortgage agencies). This was an im- portant evolutionary step, since many large residential loans, which were otherwise ineligible for inclusion under agency programs, became securitizable and transferable. Pooling and se- curitization of commercial property mortgages into commercial MBS (CMBS) appeared in the mid-1980s, but grew primarily during the late 1980s, when many US savings and loans were forced to divest their commercial loan portfolios in order to comply with new solvency regulations. The recovery of the US commercial real estate market during the mid-1990s led to even greater primary and secondary activity.

Financial intermediaries next centered on securitizing pools of MBS into instruments known as collateralized mortgage obligations (CMOs). The advent of the CMO in 1983 (via FHLMCs inaugural issue) was again a vital step in the development of the secondary mortgage market, leading to the creation of new structured assets capable of addressing the customized risk/return needs of investors. Specifically, CMOs allowed investors directly and accurately to manage their exposures to prepayment risk, a key mortgage product risk that we discuss at length below.

The financial creativity of financial intermediaries led ultimately to the development of many different styles of CMO – some of which proved particularly risky (and financially damaging) in a rising-rate environment (in fact, when US interest rates rose sharply during the mid-1990s, many investors and banks lost heavily on their risky CMO holdings, which led to a temporary curtailment in new securitizations and product development. Following that chastening, the CMO market returned to its original “vanilla” tranching, and has grown steadily since that time). At approximately the same time that. CMOs were emerging, intermediaries were also applying the stripping processes described in Chapter 3 to decompose MBS into principal- only (PO) mortgage strips and interest-only (IO) mortgage strips. These stripped mortgage products soon became a popular, if risky, method for expressing a view on rates; they also emerged as important tools for those seeking to hedge other classes of mortgage or fixed-income securities.

The overall US MBS market has grown rapidly over the past three decades, as a result of in- creased home ownership, property development/financing, and subsequent securitization; these

drivers have been central in creating product supply. In fact, mortgage originators continue to sell large quantities of loans into securitization conduits, in order to free up capital/balance sheets and create new business opportunities. Investor appetite for securities with strong liq- uidity, low credit risk, and attractive investment returns has helped fuel demand. Standard MBS can yield up to 100 bps more than comparable maturity government benchmarks; the yield pick-up is designed primarily to entice investors to accept a small amount of issuer credit default risk, and a reasonably significant amount of prepayment risk.

Though the MBS market developed in the US, it soon spread to other countries featur- ing large homeownership and relatively sophisticated financial intermediation processes. The UK mortgage market, for instance, launched securitizations of its own in the late 1980s; the Danish mortgage market developed at about the same time, and Spain, Australia, Germany, France, and Hong Kong followed with their own securitized mortgage products. While each national market features product specifications that reflect the unique characteristics of the local mortgage marketplace, most operate along similar principles, i.e. grouping together port- folios of diversified mortgages so that they can be converted into tradable assets. Naturally, not all financial systems feature local MBS. For instance, Japan and Korea, two countries with significant real estate mortgage markets, do not yet offer investors the chance to participate in the trading of local mortgage assets. Whether regulatory processes will allow such products to be introduced in the future remains to be seen.

Though early asset securitization mechanisms focused primarily on the pass-through struc- ture (e.g. directly passing through principal and interest flows from borrowers to investors), structural developments based on the concept of revolving, or hybrid, flows have allowed medium- and long-term securities to be created, even when the underlying assets have a short tenor (e.g. 3–12 months). This advance led to interest and growth in the ABS market, which is based largely on shorter-term assets. The US ABS market dates back to approximately 1985, when Chrysler securitized a portion of its auto loan portfolio. Credit card securitizations fol- lowed in 1987, and by the end of the decade the market had expanded to include securitizations on home equity loans, boat loans, manufactured housing, and student loans; deals on equip- ment leases (e.g. aircraft leases) followed in the 1990s. Though the market’s core is centered on credit card receivables, auto loans, and home equity loans, the sector also supports highly customized transactions that secure music royalties, sports ticket revenues, and film receipts.

Portions of the ABS market have also taken hold in certain other countries. For instance, the UK features a growing multi-asset ABS market, while European auto and consumer loan ABS have gained momentum since the late 1990s.

The use of standard securitization technologies has made development of these markets possible. In particular, the structures that we consider in this chapter can be created when four essential factors exist:

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collateral pools are of sufficient size and quality;

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asset originators and servicers are capable and creditworthy;

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proper internal/external structural enhancements exist;

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adequate legal structure and protection are available.

MBS and ABS have proven successful because they provide intermediaries/issuers and investors with significant benefits; in particular, either form of the security:

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gives investors access to unique assets (e.g. mortgages, receivables) in a customized manner reflecting specific preferences/requirements related to risk, return, maturity – this can be done in pure pass-through form, or in a revolving structure;

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creates an efficient mechanism by which to purchase a desired asset – administrative savings result when an investor purchases a tranche of an entire portfolio of assets through a single transaction;

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permits companies and other originators of future cash flows to monetize their stream of forward earnings for use in a current period;

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allows originators to transfer certain cash flow uncertainties (e.g. prepayments, credit de- faults) and risk exposures to investors, at a price;

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transforms otherwise illiquid mortgage and receivable assets into a more marketable form, adding greatly to financial sector liquidity – this ultimately helps lower issuer funding costs and creates more attractive and secure opportunities for investors.

Since risk/return characteristics of MBS and ABS are tailored via different tranches, they are suitable for a wide spectrum of investors, primarily from the institutional markets. Accordingly, purchasers of MBS and ABS include financial institutions, insurers, pension, mutual, and investment funds, and corporates. For instance, investors preferring little prepayment risk may be attracted to planned amortization class bonds; those seeking a significant amount of exposure to interest rate movements may purchase interest-only/principal-only tranches, and so forth.