Sunday, February 22, 2009


"Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets).

But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding.

To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well."[9]

In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans. [10]

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements.

In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.[9]

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).[11]

The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.[9]

Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.

The first public securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods. [12]

As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States.

In nominal terms, over the last ten years, (1995-2004,) ABS (Asset Backed Securities) amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion. [13]

At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent)*. (See below, these are the second worst forms of securitizations) Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations) (That is greatly exaggerated – A small-business loan is far greater than the 3 and 4 employee example – SBL’s could be to even a 200 employee company, depending on output and classification by the lender) , and aircraft leases. [13] More recently an attempt to securitize excess energy generated by renewable energy resources is being attempted bt J. Brant Arseneau and his team.

As the result of the credit crunch precipitated by the subprime mortgage crisis the market for bonds backed by securitized loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. As a result interest rates are rising for loans that were previously securitized such as home mortgages, student loans, auto loans and commercial mortgages[14]

* I add this further explanation of the current crisis:

Collateralized debt obligations (CDOs) are a type of asset-backed security (ABS) and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. CDOs are divided by the issuer into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk.

Since 1987, CDOs have become an important funding vehicle for fixed-income assets.

During the credit bubble of the mid-2000s, a few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that financial derivatives such as CDOs and other ABSes were greatly increasing risk in the financial markets, but their views were dismissed.

With the advent of the 2007-2008 credit crunch, it has become clear that CDOs, like all ABSes, suffer from a fundamental flaw that causes all tranches to be extremely high risk for investors: loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance, which causes unchecked degradation of underwriting standards. This problem was exacerbated by the failure of credit rating agencies to take into account the collapse of underwriting standards when valuing these products. (Who were paid by the originators to keep their mouths shut!)

The institutions buying CDOs relied on the ratings agencies, as they lacked the competency to monitor credit performance and/or estimate expected cash flows. Major loss of confidence has therefore occurred in the validity of the process used by ratings agencies to assign credit ratings to CDO tranches and this loss of confidence persists into 2009.

As many CDO products are held on a mark to market basis, the new understanding of the underlying risks of CDOs and the associated collapse of liquidity in these products led to substantial write-downs starting in 2007 and continuing into 2009.

That last statement is a big explanation of the crisis: Now that we have no reliable agency to rate these pooled assets, how can we take them back to the values they were sold at?

All sources: Wikipedia. Simple, brief, digestible. Good for stuff like economics, bad for stuff like religious views or who is the best sports-team!



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