Issuers assemble pools of individual loans to create new debt securities.
Securitization is the process of buying and bundling assets that produce a regular revenue stream — such as groups of mortgage loans, student loans, car loans, or credit card debt — to create asset-backed securities (ABS). The bundlers, or issuers, sell ABS to investors who are looking for income-producing alternatives to traditional bonds.
Selling the bonds allows the lenders to transfer the risk of holding outstanding debt. Securitization is part of a recurring cycle that was developed to increase the amount of capital that’s available to borrowers at the same time it provides financial benefits for lenders, issuers, and investors.
Here’s how it works.
- Lenders originate, or make, loans and sell them to issuers who pool them to create ABS. Selling the loans allows the lenders to transfer the risk of holding outstanding debt.
- Lenders use the money they receive from selling loans to make more loans that they can also sell.
- Issuers sell the ABS to investors and use that revenue to purchase new loans. The individual borrowers whose loans are included in an ABS asset pool make their regular payments to the ABS servicer, who handles the recordkeeping, collection, and other administrative details for the issuer. After subtracting its fee, the servicer forwards the payments to the investors. That’s why ABS are known as pass-through securities.
ABS’ cash flow
The income stream, or cash flow, from ABS differs substantially from the cash flows of traditional bonds. Investors typically receive their pass-through payments monthly rather than semiannually as they do with most bonds. In addition, each payment is a combination of interest and principal, just like the payment on the underlying loan. Instead of receiving a lump-sum return of principal when the ABS matures, investors collect it throughout the term.
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However, borrowers usually have the right to pay off their loans early, something that homeowners, in particular, are likely to do, either because they move and sell their property while they still have a mortgage loan — a common occurrence — or they refinance because interest rates have dropped. Prepayments initially increase cash flow and current yield. But you can’t tell exactly how long any particular asset-backed product will pay out, or how much. This unique phenomenon is called prepayment risk.
Mortgage money
Mortgage-backed securities (MBS) created from pools of mortgage loans are the most common ABS. They can be attractive to investors because they have longer terms than most other ABS, and they tend to pay a somewhat higher interest rate than conventional bonds with comparable terms. Most MBS are issued by a federal government agency, such as Ginnie Mae, or by a government-sponsored enterprise (GSE), such as Fannie Mae.
Private MBS issued by arrangers or packagers created by banks and other financial institutions were plentiful in the years leading up to the financial crisis of 2008 but have essentially disappeared. The exceptions are a small number of securities backed by jumbo loans, which the GSEs don’t securitize because the loan amounts exceed their cap. Before 2008, financial institutions also created multi-class mortgage-backed securities known as collateralized debt obligations (CDO) or collateralized mortgage obligations (CMO). They were pools of MBS with different credit qualities structured into tranches, or slices, which matured at different times and paid different rates of interest to meet different investment objectives.
Market meltdown
The process of buying residential mortgages, creating MBS, and packaging them into CDOs was described, before 2008, as a way to reduce credit risk through diversification. That view ignored the fact that the subprime loans that backed these products were actually highly correlated as well as default-prone.
The large returns that investment firms were realizing on the CDOs led some of them to buy loans indiscriminately from lenders who, eager to meet the demand, relaxed their criteria for evaluating borrowers. In this environment, credit rating firms, which were generating profits by rating the issues, were slow to raise red flags. So were the regulators who misread the booming real estate market as healthy growth.
Assessing ABS credit and interest rate risks
In the case of pass-through securities, credit risk is the potential that the borrowers whose loan repayments create the income streams that the issuers promise to deliver to investors will default. MBS guaranteed by a federal agency, such as Ginnie Mae, have minimal credit risk. Those issued by GSEs, including Fannie Mae and Freddie Mac, while not explicitly guaranteed, were not allowed to default in the financial crisis. Investors continue to assume there’s minimal credit risk exposure with these products.
On the other hand, one of the reasons that private sector MBS and CDOs have all but disappeared is that there is no government guarantee. Investors, who suffered major losses in the crisis, have little appetite for these products.
Because of prepayments, mortgage-backed securities fare worse than other bonds when interest rates change. Normally, when rates drop, bond prices rise. But investors tend to refinance when rates drop, causing a spike in prepayments. Prepayments decrease an asset-backed issue’s yield to maturity, making it less attractive to investors. When rates rise, however, bond prices fall — and the prices of asset-backed bonds fall even more. That’s because prepayments slow down when rates are high, lengthening the lifespans of MBS with lower-than-market yields.
What Is Securitization? Definition And Process Explained by Inna Rosputnia
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