Financial Innovation Securitization

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Financial InnovationSecuritization

• P.V. Viswanath
• Summer 2007

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Securitization

• The repackaging of receivables or other cashflows
  in a tradable form.
• SEC definition "the creation of securities that
  are primarily serviced by the cashflows of a
  discrete pool of receivables or other assets,
  either fixed or revolving, that by their terms
  convert into cash within a finite time period
  plus any rights or other assets designed to
  assure the servicing or timely distribution of
  proceeds to the security holder
• The goal is to sever the risk of originator
  insolvency from the risk of asset performance
  the investor can rely on asset risk rather than
  the general corporate credit of the originator.

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Earliest examplesThe market for home mortgages

• Banks provided loans for the purchase of homes.
• Government agencies, such as the Government
  National Mortgage Association (GNMA), and the
  FHLMC (Freddie Mac) and private corporations,
  such as the Federal National Mortgage Association
  (FNMA) were charged with providing broader and
  more stable sources of capital to the residential
  mortgage market.

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Mortgage Backed Securities

• These agencies started securitizing mortgages by
  purchasing home mortgage loans from local lenders
  and guaranteeing securities backed by pools of
  residential mortgages.
• Result
• Volume of funds available for housing expanded.
• Redistribution of mortgage funds from
  capital-surplus to capital-deficit regions.

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An example GNMA pass-throughs

• GNMA pass-throughs were issued by mortgage
  bankers and were backed by pools of newly issued
  FHA/VA single-family mortgages (i.e. loans
  guaranteed by the Farmers Home Administration or
  the Veterans Administration).
• GNMA guaranteed the timely payment of scheduled
  monthly principal and interest.
• These guarantees represent full faith and credit
  obligations of the US Government.

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Structure of a GNMA Pass-through
Homeowners
Scheduled Principal (Amortization)
Interest
Prepayments
Servicing Fee/ Guarantee Fee
Originator/Servicer
Delinquencies
Defaults
Investors
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Credit Enhancements

• The purpose is to improve the quality of the
  asset
• External Enhancements
• Corporate Guarantee
• Letter of Credit (a commitment by a bank on
  behalf of a client to pay under specified
  conditions)
• Pool Insurance covers losses due to borrowers
  economic circumstances, but does not cover fraud
• Bond Insurance covers all types of losses
  unconditionally usually bond insurers will not
  take the first-loss position.

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Credit Enhancements

• Internal Credit Enhancements
• Reserve Funds
• Cash Reserves
• Excess Servicing Spread Accounts
• Overcollateralization
• Establishing a pool of assets with principal ?
  principal amount of the securities issued.
• Senior/Subordinated Structure
• The subordinated class absorbs all losses on the
  underlying collateral, protecting the senior
  class.
• A Shifting Interest Structure redirects
  prepayments disproportionately from the
  subordinated class to the senior class according
  to a pre-specified schedule.

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Collateralized Mortgage Obligations

• CMOs are bond classes (tranches) created by
  redirecting the cash flows of mortgage-related
  products so as to mitigate prepayment risk.
• Sequential Pay tranches Principal payments are
  directed to the seniormost tranche until it is
  paid off, then to the next senior tranche, etc.
• Accrual bond/tranche The interest for this
  tranche accrues until more senior tranches are
  paid off.

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CMO Varieties

• Floating Rate Tranches
• can be created from fixed-rate tranches by
  creating a floater and an inverse floater.
• Useful for financial institutions that have
  floating rate/short term liabilities.
• Planned Amortization Classes (PAC) Bonds
• Created with support bonds that absorb
  fluctuations in principal payments, upto certain
  limits (collars).
• Targeted Amortization Classes (TAC) Bonds
• Protects against contraction risk (rapid
  prepayment), but not against extension risk.
• Very Accurately Determined Maturity Bonds
• Protection against contraction and extension risk.

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Mortgage Strips

• Interest-Only CMOs All interest is allotted to
  these strips.
• When interest rates rise, flows to IO CMOs rise.
  But these flows are discounted at a higher rate
  hence the IO CMO price could rise or fall. If
  interest rates fall, IO CMO prices usually fall.
  Hence IOs have negative duration.
• Principal-Only All principal payments are
  allotted to these strips.
• When interest rates rise, prepayments fall and
  flows to PO CMOs fall. Hence PO CMO prices fall.

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Asset Backed Securities

• Securities created by pooling loans other than
  first-lien mortgage loans
• Auto-loan backed securities
• Credit Card Receivable-backed securities
• Home Equity Loan-backed securities
• The underlying assets are purchased by a
  Bankruptcy-remote Special Purpose Vehicle (SPV),
  which issues the ABSs.
• The SPV is typically a wholly-owned subsidiary of
  the seller of the collateral.

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ABS structure resembling notes

• Chase, in Sep. 1999 sold an 18.5bn pool of
  receivables to a master trust, which issued a
  certificate, conveying an undivided interest in
  the whole pool.
• This certificate was placed in another SPV, which
  issued three tranches of bonds
• 850m of 5-yr senior bonds, rated AAA, priced at
  98bp over Treasuries.
• 48.295m of single-A paper at 128bp over
  Treasuries.
• 67.615m BBB at 95bp over 1-month Libor.
• The repackaging enabled the tranches to be called
  notes and hence all the tranches could meet ERISA
  investment guidelines followed by pension funds.

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Securitization of RisksUsing Bonds to Buy
Insurance

• Insurance companies can go bankrupt traditional
  insurance requires a very large amount of
  capital.
• The problem is greater with insurance lines that
  have long tails policies where claims can be
  filed long after the policy is issued.
• Insurance companies are locked into the deal for
  a long time. Investors in capital markets are
  more willing to hold these risks, because they
  can sell them off.
• Specialized bonds, such as cat bonds may be able
  to resolve these problems.

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Catastrophe Bonds

• Oriental Land Company placed two 100 million
  catastrophe bonds with special purpose reinsurers
  to protect against earthquakes.
• First bond has a five-year maturity. Payment
  depends upon magnitude, location and depth of
  earthquake, regardless of actual property damage.
  (Why? Auditing problems?)
• Second provides post-earthquake financing
  Oriental Land will issue a 100 million 5-yr bond
  to the reinsurer with no interest for the first
  three years. (Put like?)

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Weather Bonds

• In Oct. 1999, Koch Ind., of Wichita and Enron
  Corp, of Houston issued 200 m. of weather bonds.
• The interest on the Koch bonds depends on the
  weather in the 19 cities in which Koch operates.
• If temperatures are similar to historical levels,
  the coupon is 10.5.
• If temps are colder (warmer) by ¼ degree on
  average, the coupon is 10 (11).
• Kochs objective Hedging
• Value for investors Diversification

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Alternatives to Securitization of Insurance Risks

• Catastrophe Insurance
• Catastrophe Derivatives
• Pros and Cons
• Information Costs versus Basis Risk

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Securitizing future cash flow

• This is the purpose of standard bonds. However,
  they draw upon the general cashflows of a
  company.
• Project financing channels pre-specified subsets
  of a companys cashflows to bondholders.
• More specialized projects like rock-n-roll
  bonds.

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Rock-n-Roll bonds

• David Bowie, issued February 1997, raised 55 m.
  by selling securities.
• Backed solely by expected royalites from future
  sales of his first 25 albums.
• 7.9 coupon, 15 yr maturity, 10 yr. av. maturity.
• Investment banker on the deal was David Pullman
  at Gruntal Co.
• Prudential Insurance Co. is purchaser.
• Bonds guaranteed by EMI Group Plc.

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Rock-n-Roll bonds

• Ethan Penner, in Sept. 1997, set up Nomura
  Capital Entertainment Finance to be sole investor
  in making 1 billion in loans to musicians,
  actors and studio executives. (not quite
  securitization).
• Bear Stearns is interested in securitizing the
  expected cash flows of existing and
  soon-to-be-released films.
• Target Insurance companies looking for
  diversification.

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Problems/Questions

• What is the purpose of the loan for the issuer?
• Consumption
• Diversification
• Artists might want to repurchase artistic works
  that they were forced to sell earlier in their
  careers.
• To buy other artists intellectual properties.
• Tax reasons
• What about the issue of Moral hazard?

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Valuation of Rock-n-Roll Bonds

• Actuarial approach is not possible.
  One-of-a-kind.
• The riskiness of cashflows from the asset itself
  as opposed to the issuer (e.g. if Citibank
  securitizes its credit card receivables)
• Collection of cashflows (from the entertainment
  industry) will have to be more scientific and
  specialized.
• How to evaluate cashflows that are projected to
  grow, rather than depreciate? (Lengthens the
  life of the asset.)

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Rock-n-Roll Bonds

• Possible solutions
• Diversification of trust issuing the security.
  This is the Penner strategy.
• Securitize cashflows from known artists and/or
  known works with a history.
• Credit Enhancement

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Tobacco Bonds

• In 1998, 46 states settled a major case against
  the Tobacco industry. The agreement was for
  approximately 205 Billion for 25 years. It is
  referred to the Master Settlement Agreement (or
  MSA).
• States, and various Counties in a few States,
  have opted to securitize their payments from the
  MSA. They have issued Municipal Bonds and taken
  an early lump sum payment instead of waiting for
  the Tobacco industry payments to come in over
  time.
• The bonds secured by these tobacco settlement
  revenues are called tobacco bonds.
• The risk for these bond investors is the strength
  of the Tobacco industry, cigarette sales and so
  on.

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Train Securitization in the UK

• Earliest deals securitized leases guaranteed by
  the UK government in 1994.
• In 1998, Porterbrook securitized unguaranteed
  leases on trains still under construction.
• In August 1999, the Royal Bank of Scotland placed
  480m to fund Virgin Rail Groups purchase of 53
  hi-tech trains that were custom-made.
• The transaction cannot rely on the diversity of
  its obligors (as with credit card debt) or the
  transferability of the hard assets.
• Also, the deal is non-recourse to Angel Trains.

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Train Securitization in the UK

• Porterbrooks deal comprised 140m. of Floating
  rate loans in three tranches.
• Royal Bank of Scotlands financing wing West
  Coast Train Finance Plc offered one fixed class
  of bonds, to be amortized according a schedule
  between 2003 and 2015 av. life 10.4 yrs.
• A rating from Duff and Phelps, AA from Fitch
  IBCA and A from SP.
• The bonds are delinked from the credit risk of
  the company operating the trains permits a
  higher rating for the bonds than for the company.
• There is an assurance from the Office of
  Passenger Rail Franchising to take over the
  trains even if Virgin fails.

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Special Facilities Bonds

• Most debt issued by airports represents long-term
  bonds secured by a pledge of general airport
  revenues.
• Recently, however, more airports have been
  issuing special facilities secured debt where the
  lender has recourse only to revenues generated by
  the special facility.
• There is no equity investment by the airport
  authority.
• General airport revenues can be reserved for
  projects that are more central to airport
  operations or can only be funded through
  traditional avenues.

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JFK Intl Arrivals Terminal Bonds

• Issued by the Port Authority of NY NJ
• Secured by Facility Rental Payments made by the
  lessee JFK IAT to the Port Authority, the lessor.
  However, JFK IAT agrees to set rates to provide
  revenues ? 125 of debt service on bonds.
• Bondholders have no recourse to JFK IAT, or the
  Port Authority, if the project fails to perform
  as projected.

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Automobile ABS

• Traditional Auto ABSs price up to 10 bp wider
  than credit card ABSs because auto deals have
  amortizing tranches that depend on prepayments.
• In Aug. 99, GMAC securitized a pool of amortizing
  auto loans and created bullet maturity structures
  by having all the amortization that occurs
  between bullet payments get absorbed by a
  variable funding certificate.
• This structure matches corporate bonds and makes
  it easier to construct swaps.

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Pub Securitization

• In June 1999, Pubmaster, a UK corporation that
  owns pubs securitized beer revenues.
• This allows Pubmaster to tailor costs to
  revenues, and reduces the probability of
  bankruptcy.
• For the investors, its possible to obtain
  tighter covenants, because the source of the
  revenues is more defined.

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Sport Securitization

• Formula One, the British company that manages the
  international car-racing championship has issued
  1.4 b. in bonds securitized by all assets of
  Formula Ones business, including its TV and
  promotional contracts.
• Shows that intangible assets and intellectual
  property rights can be the basis for
  securitization.