SECURITIZATION

SECURITIZATION

MATT BRIGIDA

Associate Professor of Finance (SUNY Polytechnic Institute)

What can we securitize?

Any asset which generates a stream of cash flows (often loans, but can also be leases and other trade receivables).

To securitize an asset it is necessary to be able to statistically describe the assets' cash flows.

The ownership of the assets must also be transferable.

Assets are more appropriate for securitization if:

• they provide diversification---geographic or economic.
• there is a large number of assets.
• there correlation structure is known, and the assets preferably have low correlations.
• Correlation is key...

Why Securitize Assets?

• diversification
• financial engineering---structuring tranches to meet different risk-reward profiles, and investment horizons.
• increased liquidity.

• lower transaction costs in secondary market.
• moves assets off of a firm's balance sheet
• lowers funding costs.

• Separates the credit rating of the originator from the security.
• Facilitates geographic dispersion of funding to areas underserved by depository institutions.
• Issuers can tailor the maturity, yield, and seniority to suit investor preference.

Background and History

• Pre-1970s: Securitization was an effectively non-existent industry.
• 1970s:Ginnie Mae, Fannie Mae, and Freddie Mac started providing a guarantee on mortgage pass-through securities.
• 1983: Fannie Mae issued the first Collateralized Mortgage Obligation (CMO). CMOs address pre-payment risk by tranching.
• 1985: Asset Backed Security (ABS) offerings.

Today

• Common to securitize auto loans, credit card receivables, student loans, entertainment royalties, and home equity loans among other assets.
• Annual issuance in the trillions of dollars.
• Securitization Finances 30% of US Capital Markets Funding Needs Annually and 40% Historically

Steps in the Securitization Process

1. Assets are created.
2. A special purpose vehicle (SPV) is created and ownership of the assets is transferred to the SPV.
3. A claim structure, and credit enhancements, are added to the cash flows generated by the assets in the SPV.
4. The SPV issues the claims as securities.
5. NRSROs rate the claims.

Source: fdic.gov

Participants in Securitizations

• Originator: initially originates the loan or asset.
• Special Purpose Vehicle: a legally separate entity which holds the assets bought from the originator.
• Trust: the assets may be held by the SPV, or transferred to a trust.
• Underwriters: lessen risk in the security's sale, and often assist in structuring the security.

• Dealers: make a secondary market in the security.
• Rating agencies (NRSROs): determine the likelihood of default (amount of credit risk) in the security.
• Insurers: Private companies and government agencies ensure payment for a fee or through credit default swaps.

• Servicers: collects payments from borrowers (or asset) and forwards them through to the SPV.
• Investors: households, institutions, and governments.

Credit Enhancement

Methods used to lessen the risk borne by investors in a securitization.

• Tranching: Transfers risk from one subset of the security’s investors to another by assigning securities first, second, third, etc claim on cash flows.

Credit Enhancement

• Overcollateralization: the security collateral exceeds the value of the security ensuring, that even with some default on underlying assets, the security can make timely payments.

Credit Enhancement

• Third-party guarantee: an entity assumes some of the bondholders' risk.

Is There a Downside to Securitization?

This process relies on the investors ability to determine the underlying asset credit risk, and thereby relies on credit rating agencies.

• If the risk is assessed incorrectly, this will cause misallocation of funds.
• This is exacerbated by complex capital structures, the separation of ownership and origination, and the origination incentive system.
• Example: US housing market prior to 2008.

• See Securitization: Lessons Learned and the Road Ahead for a good summary of how components of the securitization process failed in the lead-up to the 2008 financial crisis.

An Example

The Problem: The risks and costs of biomedical research have increased due to underlying factors in the research and approval process.

• This has lessened the ability of traditional public and private equity to finance such research.

This has caused a funding gap in biomed research, often referred to as the "valley of death".

In 2010 $48 billion was spent on basic research in drug development, $7 billion was spent on translating that into marketable componds, and $52 billion was spent on clinical development (Fagnan et al 2013).

Attempts are being made to use securitization structures to fund biomed research through selling "Research Backed Obligations",

• RBOs have bond-like tranches, and investment horizons which are acceptable to investors.
• The primary market for bonds is much larger than equity.

Cash Flows

Assume the following cash flows for an investment in drug-development if the drug is a success, and failure, respectively.

• Success: $200 million cost at time 0, no cash flows in years 1 through 10, and $2 billion a year in years 11 through 20.
• Failure: $200 million cost at time 0, and no further cash flows.

Probabilities

Further, assume the following probabilities of success and failure.

• Success: 5%
• Failure: 95%

Parameters of an Individual Asset

• Expected Return: 11.9%
• Standard Deviation: 423%

Parameters of a RBO Backed by 150 Assets

Assuming the assets are independently and identically distributed (=> pairwaise correlation is 0%).

• Expected Return: 11.9%
• Standard Deviation: 34.6%

...but this requres a much greater capital committment.

See this SPREADSHEET for an analysis of this example RBO.

Matt Brigida