securitization

Foundations of Financial Markets: Securitization-Based Financing Christopher J. Creed November 2005

Introduction – “… remember back to EC177 and 179” All companies must be concerned about how to fund their projects and programs – irrespective of their size. Sources of capital: Equity – Shares of Stock, ownership, partnerships, etc. Debt – Issue bonds, borrow from credit lines, etc. So – the topic for today: What is “Securitization”… and how does it fit into Corporate Finance and the Financial Markets?

Outline Overview of Fixed Income Introduction to Asset Securitization – Mortgages Financial Markets – The MBS Market Q & A

Fixed Income - Introduction This business can be thought of as having 2 major components: - Interest Rate Products - Credit-Sensitive Products Which breaks down into two questions: “ What is the probability that I will get my investment back? - “How much should I get compensated for loaning my money out for that time-frame?” Are there any securities that are just “interest rate products”? Any that are just “Credit-Sensitive products”?

Fixed Income Basics - Rates Basically, the time value of money is defined as: Where: PV = Present Value D = Discount factor for time-period i CF = Cashflow received in time-period i So – in your class you have been spending time figuring out how to calculate D and CF .

Fixed Income Basics - Rates What are the discount factors and how do I calculate them? How do I figure out the relative value between two different types of bonds? What is the benchmark for me to compare other bonds to? Why do I need a benchmark?

Yield of a Bond Using what we know about how to calculate D – we can express the value of a bond as the PV , or Price: Price = So – the question is – what is y? If you know the price and you solve for y , you will get the “interest rate” required to solve the above equation. How will this enable us to compare two different bonds?

“Minimum Yield” – Treasuries “ Foundation of Fixed Income” – provides a risk-free benchmark Why? Credit-Free yields of different maturities Liquid Hedging instrument 2 – 4.34654 3 – 4.35757 5 – 4.37614 10 – 4.47241 30 – 4.70486 Source: Goldman Sachs

Comparing Bonds vs. US Treasuries If a 5-year bullet bond issued by CitiGroup traded at a yield of 4.970% what could we say about that? Is that cheap? What do we need to know first? What is the risk-free rate of a 5-year bond? (5yr UST = 4.470). So – now what can we say?

“Spread Products” Many Fixed Income Products are quoted as a spread in yield above the treasury curve. e.g. A Corporate bond with a spread of 50bps with a maturity of 11/15/10 would have a yield of what? 5-year yield = 4.470% 4.4700+0.50 = 4.970% What is the problem w/ the UST Curve analysis?

Interest Rate (Vanilla) Swaps Bank Customer Bank Pays the Customer a fixed rate (4.895%) Bank receives from the Customer a floating rate (3mo Libor) Why is this exactly the same as the bank selling a bond to the customer? What if I found the rate at which the bank is indifferent to paying fixed or receiving fixed? What if I found that rate for multiple maturities?

Interest Rate Swaps (Refer to Professor Palacios’ Lecture Note number 13 for an in-depth discussion). 2 4.77127 3 4.80257 4 4.83588 5 4.86864 6 4.89790 7 4.92840 8 4.95754 9 4.98668 10 5.01491 11 5.04320 12 5.06866 13 5.09223 14 5.11359 15 5.13302 20 5.19363 25 5.22237 30 5.23361 35 5.23369 40 5.22861 45 5.22077 50 5.21361

Interest Rate Swaps (cont.) Swaps are also very liquid – and an effective form of hedging spread product. Why? Many Spread Products can be quoted in spread above the USD Swap curve in addition to the US Treasury Curve. In fact, our CitiGroup 5 year bond example really was quoted as Swaps + 11bps Should Corporate Debt ever trade tighter than Swaps+0? Tighter than Treasuries+0?

2003 vs. Today… A Brand New World November 2003 November 2005 Source: Goldman Sachs

Introduction to Asset Securitization - Example Keep in mind our initial question: What is “Securitization”… and how does it fit into Corporate Finance and the Financial Markets? Simplified Example – Pawtucket Savings and Loan’s business plan is to provide banking services to local residents. They provide FDIC insured savings accounts to their customers and provide mortgage and small business loans to local residents. They have loaned out 150 mortgage loans totaling $195mm. They have 500 clients with savings accounts totaling $195mm. What are the risks to this business plan? What are the barriers to expansion?

Tradable Fixed Income Supply Source: Federal Reserve Flow of Funds, June 10 th , 2004, debt growth table

The Mortgage Market As of the first quarter of 2004, there were $9.6 trillion mortgages outstanding The breakdown of these by property type is as follows (all numbers in billions): Source: Flow of Funds 1Q2004 report

What is a Mortgage? Simply: Mortgages are the loan that homeowners borrow from banks to purchase their homes The homeowner pays a monthly amount that consists of both Principal and Interest. The borrower pledges the underlying land as collateral for the loan If the borrower fails to make re-payment, the mortgage gives the lender the right of foreclosure on the loan and therefore can seize the property This can be viewed as an investment by the banks in the mortgage market – they are purchasing an asset that pays a monthly amount of Principal and Interest (P&I) The banks often sell these assets to other investors to raise capital Home Owner Lending Institution Mortgage Funds =

Calculating Mortgage Payments In a flat amortizing fixed mortgage, the monthly payment is determined at the beginning of the contract. Assume that A is the original balance, r is the interest rate, and N is the number of months in the contract. Then, the monthly payment is equal to: On a fixed amortizing mortgage, if the original balance is $250,000, and the rate is 6.0% for 30 years, each month the principal and interest payment is: = $1,498.88

Calculating Mortgage Payments – (cont.) Using the previous calculation (and example) a cash flow schedule can be created: * Note that $1498.88 – $1250.00 = $248.88

Calculating Mortgage Payments Continued The higher the mortgage rate, the greater the proportion of each monthly payment is devoted to interest. Hence, the higher the rate, the slower the principal balance pays down Rate

What are Mortgage Backed “Pass-Through” Securities? A number of similar mortgages (underlying collateral, design, rates and maturities) are combined into a single group Mortgage documents associated with this group are delivered to a custodian and are assigned an identification (pool) number A Mortgage Backed Security (MBS) is issued with a face amount equal to the cumulative outstanding principal balance of the mortgages (original balance) The mortgages that have been pooled together serve as the collateral for the security Most MBS are guaranteed and/or issued by a U.S. Government Agency (FNMA, Freddie Mac or GNMA) + + = Securitized Mortgage Pool or Pass-throughs

Agency Conforming MBS Origination Process Residential loans originated within the conforming Agency guidelines are guaranteed by an Agency, sold to the Street then either traded in pass-through form or used to structure a CMO…

Non-Conforming MBS Origination Process Loans that do not conform to Agency standards are sold in “whole loan” form or structured into a senior/subordinate private label CMO…

Credit Enhancement Subordination Terminology Senior bonds Almost always rated triple-A Mezzanine bonds Investment grade, but subordinate to senior bonds Junior bonds (or B-pieces) Rated below investment grade Significantly exposed to real estate risk of underlying collateral pool First loss piece Most junior class Any significant loss on collateral pool likely to eliminate first loss piece

Credit Enhancement Continued Other types of credit enhancement include: Over Collateralization: Put in more principal then you are issuing in bonds (the excess goes to the owner of the “residual cashflow”). Reserve Account: Initial cash deposit from the seller provides liquidity. Excess spread may be captured when increasing the reserve account Purchase Insurance: Insurance policy usually provided by a monoline insurance company. Monoline-enhanced transactions are frequently limited to new assets or "story" credits FSA, MBIA, AMBAC, and FGIC are typical surety providers In 1Q04, 6.63% of new issuance were insured by these agencies (This is also used by A/AA entities to issue AAA debt (ex: The City of New York) Letter of Credit (LOC): Supplied by a triple-A rated bank. Rarely used now. Credit enhancement provided by LOCs, corporate grantees and wrap guarantees are less issued since they introduce third-party event risk.

Who Buys MBS? There are many different types of investors who buy MBS Mortgage and Asset Backed security holdings by investor type 2003 Year End: Source: Inside MBS & ABS

Overview of the U.S. Mortgage Securities Market Largest Sector of the U.S. Debt Market: Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion as compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate bonds. Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure to the U.S. Government securities. The U.S. investment grade corporate debt market is less than 1.5 trillion in size. MBS can enhance portfolio performance significantly Major mortgages indices have outperformed comparable duration U.S. Treasuries by an average of more than 140 bp over the past 10 years. The U.S. mortgage market consists of a wide array of securities to suit most investor needs. A full range of credit qualities, durations, risk profiles and yields exist in this market. High Credit Quality Most of the MBS market is issued by U.S. Government agencies which have an implied AAA rating: GNMA issues carry full faith and credit of the U.S. Government, Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government. Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower rated securities (down to single-B) are also available.

Why Invest in Mortgages? Yield and no credit concerns Yield … Yield … Yield … Yield …

What’s the catch? You are purchasing a product with an imbedded call option Duration is very hard to determine. Variability in Average Life can be substantial You are purchasing an amortizing product Reinvestment of Principal monthly can reduce yield.

"Duration" Deserves Special Focus in Mortgages... Modified duration, Macaulay duration, cashflow duration: all measure a mortgage's price sensitivity to rate movements, assuming the cashflows are held constant. Usually not a good assumption in mortgage product owing to prepayments Durations often quoted as a percentage of modified duration Option-adjusted duration (OAD), model duration: measure price sensitivity for small rate movements, assuming constant OAS Doesn't account for how securities actually trade Reliant on prepayment model Empirical duration, EOAD: regression of performance vs rates can be price or OAS vs rates adjusted for volatility, slope of the curve

Prepayment Option Any payments by borrower made in excess of scheduled principal payments are called prepayments The option is defined by the borrower's right to prepay all or part of the mortgage at any given time The uncertainty for the mortgage holder which results is termed prepayment risk Prepayment Motivation Prepayment may occur for one of several reasons sale of property default refinancing Motivations beyond rational economic considerations play an important roll in assessing prepayment risk Risk for Mortgage Holder Interest rate risk (re-investment risk): Should mortgage be fixed-rate, market risk arises as a result of prepayment if rates fall and coupons are above market Liquidity risk: Should mortgage portfolio be securitized for debt issuance, prepayment implies the need to raise new financing Prepayment Risk

Prepayments PSA Continued Based on this, PSA prepayments affect principal paydown:

Duration and Convexity Duration (simply): Convexity is the change in Duration as yields change 2 3 4 5 6 7 8 0 5 10 15 20 25 30 35 40 Yield (%) gain from convexity (negative) 2 3 4 5 6 7 8 5 10 15 20 25 30 35 40 45 Yield (%) gain from convexity Price Price Positive Convexity Negative Convexity

Options and Convexity If you are long a call option – are you long gamma or short gamma? Why is being long an MBS similar to being short a call option? Who are you short this option to? Can you hedge this with options?

Non-Mortgage Asset-Securitization Commercial Mortgage Products (multi-family houses, office buildings, shopping malls, golf courses…) Traditional ABS: Credit Card Receivables, Home Equity Credit, Student Loans, Automobile Leases/Loans,… Other ABS: Television Syndication Rights, Power Utility Rentals, Revenue from Oil Drillings; Revenue from Aircraft usage; Revenue from Bars…. If it pays a fairly predictable payment over time, and if you can tell a story, if you can solve the credit problem… you can securitize it.

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