SECURITISATION

Traditionally, investors have favoured bonds for their safety and predictability. A fixed-rate bond promises
guaranteed cash flows: the amount and date of each interest payment are specified when the bond is issued, as are the
dates on which the bond may be redeemed. The investor therefore knows precisely how much money it will receive five,
ten or 20 years in the future, and the conditions, if any, under which the bond may be called prior to maturity.

An asset-backed security is a type of bond offering no such certainty. The security, in most cases, is not backed by
the full faith and credit of a government or a private company. Rather, a creditor, most often a lender, issues securities
supported by a stream of income the issuer expects to receive in the future from specific assets. There is no assurance that
the income will be received as anticipated. Some of it might not arrive at all. Sometimes the assets will be liquidated
earlier than expected, resulting in less interest income than the bondholders assumed they would receive. As a result,
future cash flows can only be guessed at rather than known with a high degree of confidence.

In return for accepting this uncertainty, investors in asset-backed securities are able to achieve higher returns than
on regular government or corporate bonds. At the same time, the securities are far more readily bought and sold (they
have greater liquidity, in market parlance) than the individual assets underlying them, making it easier for investors to get
into or out of a particular type of investment. These advantages have made asset-backed securities hugely popular.
Perhaps $10 trillion of securities backed by various types of assets are outstanding around the world.
Asset-backed securities are sold either with fixed rates of interest or with floating rates. They can be broadly divided into
two categories:

Mortgage-backed securities. These are supported by first mortgages on residential property.

Non-mortgage securities. These can be backed by assets of any other sort.

Mortgage-backed securities accounted for approximately 80% of the asset-backed securities outstanding throughout the
world at the end of 2004. Securitisation of other sorts of assets has been growing rapidly. The value of non-mortgage
asset-backed securities outstanding was more than $2 trillion at December 2004. Worldwide issuance in 2004, excluding
mortgage-backed securities, was $886 billion, according to Asset-Backed Alert, an industry publication. Of this amount,
$193 billion was issued outside the United States, and $693 in the United States.

THE SECURITISATION PROCESS

Securitisation is the process by which individual assets, which on their own may be difficult to sell or even to
attach a value to, are aggregated into securities that can be sold in the financial markets. The earliest known securitisations
occurred in Denmark, where mortgage bonds have served to finance house purchases for many years. Mortgage securities
became widely used in the United States in the 1970s. Since then, innovation has led to the securitisation of other sorts of
assets, and asset-backed securities have taken root in several countries in Europe and Asia.
 The securitisation process begins with the creation of the assets that will later be securitised. This usually occurs
in the normal course of business: a mortgage bank extends a mortgage to a homebuyer; a bank gives a customer a credit
card; a studio releases a feature film. Under normal circumstances, such an asset is carried on the firm’s books, with the
money earned by that asset, such as loan payments, to be reported as income in whatever future year it is received.

Securitisation involves transforming, or packaging, such assets into securities that can be sold to third parties.
Securitisation is accomplished with the help of an investment bank, which sets up a trust whose sole purpose is to own the
assets being securitised. Usually, each trust is created to own a pool composed of a single type of asset, such as $100m of
automobile loans. The trust will purchase the assets in the pool from the firm that created them, using money raised by the
sale of asset-backed securities to investors. The owners of the securities are entitled to receive whatever income the assets
generate, and in most cases to a pro- rata share of the assets themselves. When individual assets owned by the trust are
retired – for example, when an individual loan is paid off – the size of the trust diminishes. Eventually, all the assets will
be retired, at which point the trust will terminate.

In general, the diversity of the assets underlying an asset-backed security provides safety to investors. According
to Standard & Poor’s, a rating agency, 18 asset-backed securities defaulted in 2001 – more than had defaulted over the
previous 16 years. Six of these defaults were related to the collapse of Enron, a US energy company that entered
bankruptcy in late 2001. Defaults in more recent years have been rare.

Recourse to guarantees
In many cases, investors in an asset-backed trust benefit from certain guarantees. Governments frequently
guarantee part or all of the pay- ment on residential mortgages to encourage housing construction. The original lender may
also guarantee loan payments to induce investors to buy its assets. In this situation, the lender sells the assets to the trust
with recourse, meaning that the trust will seek reimbursement from the lender if an individual borrower should fail to pay
interest or principal as scheduled.

WHY SECURITISE?
The impetus for securitisation lies in the benefits that it brings to firms that choose to securitise their assets.
Securitisation may prove attractive for several reasons:

1. It enables a firm to specialise in particular aspects of a complex business in which it might have a special advantage,
rather than participating in all areas of the business. Many large financial companies have become successful by taking
unorthodox approaches to one specialised task, such as lending to owners of mobile homes or identifying the
characteristics of potentially profitable credit-card customers. A firm might have no unusual expertise in other parts of the
business, such as managing the assets once they have been created. Selling off the assets through securitisation allows the
firm to focus on what it does best, where it can add the greatest value.
2. Selling assets allows issuers to change their risk profile. Among the risks facing a recording artist, for example, is the
possibility that changing tastes will result in fewer sales of his or her albums. By securitising certain recordings, the artist
can receive a specified amount of revenue immediately. The artist might lose the opportunity to reap huge profits from a
release that turns out to be a hit, but also sheds the risk that he or she will fall from popular favour and experience
declining sales. If the artist so desires, it may even be possible to structure the transaction so that, should a record sell
more than a specified number of copies, he or she receives a portion of the windfall profit.

3. Issuers may wish to reduce their need for capital. Take the case of a bank that is required by regulators to maintain
capital according to the size and type of its assets. When the bank extends a loan, the loan’s market value appears as an
asset on its balance sheet, and the bank must then set aside the appropriate amount of capital to cover potential declines in
the value of that asset. The institution may find that having much of its capital tied up in this way limits opportunities to
use that capital for purposes that may generate better returns for shareholders, such as financing new investment or
acquiring other firms. Securitising the assets allows the bank to remove them in whole or in part from its balance sheet,
thereby freeing up capital for other uses. The bank will no longer receive the interest payments on the loans, but it also has
shed the risk that the loans will not be serviced in a timely manner. It can either return the unneeded capital to
shareholders or use it to build up parts of the business, such as the origination of loans that are to be securitised, which
may enable it to earn better returns for shareholders.

4. The sale of securitised assets creates publicly available prices. Some types of assets, such as property or rights to
recordings, are complicated to trade and, because they are unique, can be difficult to value. Asset-backed securities are
usually much easier to trade than the underlying assets themselves. If securities backed by office-building mortgages are
selling for half the price they were two years ago, investors, regulators and managers can then have a reasonable idea of
what a lender’s portfolio of commercial mortgages might be worth even when those specific assets have not been
securitised.

MARKET DEVELOPMENT
Until recently, securitisation was a huge business in the United States and almost non-existent elsewhere. Several
factors encouraged its development. First, the regulatory climate was generally favourable to innovation. The government
imposed few obstacles on the growth of the business and, particularly in the area of residential mortgages, even
encouraged it. Second, the American legal system did not stand in the way. In countries such as Japan and Italy, by
contrast, laws intended to protect the rights of borrowers have until recently inhibited the securiti- sation of assets, as it
has been uncertain whether a trust would have clear title to any assets it might purchase from an issuer. A third influ- ence
has been the willingness of investors to perform the complicated mathematical analysis required to determine the value of
asset-backed securities. In some countries, investors who were accustomed mainly to buying and holding bonds and
equities were not used to such sophisti- cated analysis, and were slow to accept asset-backed products.

This situation has begun to change quite rapidly. Although about three-quarters of all asset-backed securities are
still issued in the United States, securitisation has become popular in Europe and is starting to catch on in Asia.
 This geographic distribution is likely to change significantly. Japan began to permit securitisation in 1993 as a
means of allowing troubled banks to dispose of assets, such as property held as collateral for debtors who have defaulted.
An estimated ¥4 trillion ($40 billion) of securitised instruments was issued in 2003. Taiwan passed a law to encourage
securitisation in June 2003, and securities worth over NT$50 billion ($1.7 billion) were issued in 2004. Indian issuers sold
Rs308 billion ($7 billion) of securitised instruments in the year to March 2005. Other emerging- country governments are
also eager to promote development of mar- kets for asset-backed securities, although legal uncertainties continue to stand
in the way.

MORTGAGE-BACKED SECURITIES
Mortgages are by far the most important source of asset-backed securi- ties. Such securities give investors the right to
interest payments from a large number of mortgage loans, which are bundled together into secu- rities. Most mortgage-
backed securities are based on residential mort- gages, but there is also a significant market in commercial mortgage-
backed securities (cmbs). These are usually based on pooled loans of a single type, such as mortgages on hotels or office
buildings.

Fannie Mae led the way

Although the Danes are credited with first developing the idea of issuing mortgage bonds, the most important step
in the creation of the modern market for asset-backed securities was the establishment of the Federal National Mortgage
Association (fnma) in 1938. This company, known as Fannie Mae and originally a government agency, was established to
create a secondary market in mortgages. The primary mortgage market involved the decision by a private company,
known as the originator, to lend to a home buyer. When it purchased such a loan from the origina- tor in the secondary
market, Fannie Mae made it possible for the origi- nator to make yet more loans, providing a substantial impetus to the
housing market. With Fannie Mae as a model, private-sector entities began to purchase individual mortgages in
secondary-market transac- tions as early as 1949, and US government regulators formally permitted thrift institutions to
buy and sell mortgages in 1957.
From its earliest days, Fannie Mae took steps that were essential to the growth of the secondary market. It
established standard procedures to be used in originating the mortgages it would buy, including methods of valuing
property, rules for assessing individual borrowers’ credit- worthiness, and rules relating mortgage eligibility to income. It
also set rules to govern servicing, the collection of interest and principal pay- ments from borrowers, which most often
was handled by the origina- tor. Such standards eventually smoothed the development of mortgage-backed securities:
although each mortgage backing a particu- lar security would be different in detail, investors could be assured that every
individual mortgage complied with the same general standards.

Pass-through certificates
Initially, Fannie Mae used government money to purchase mortgages from the lenders that had originated them,
with the interest payments on the mortgages serving to repay the government. Then, in the 1960s, investment bankers hit
upon an idea for tapping private investment by turning mortgages into securities, rather than buying and selling indi-
vidual mortgages. These new securities were called pass-through certifi- cates, so named because the principal and
interest due monthly from the mortgagors of the loans backing the security would be passed directly to the investors. Pass-
throughs, first issued in 1970, were the first modern asset-backed securities.

CMBS
Many different types of mortgages are securitised. As well as a lively market for single-family mortgage
securities, there is substantial issuance of commercial mortgage-backed securities, known as cmbs. These may be based
on mortgages for apartment buildings, housing for the elderly, retail developments, warehouses, hotels, office buildings
and other sorts of structures. cmbs were first issued by Resolution Trust Corporation, a US government agency established
to dispose of the assets of failed thrift institutions in the early 1990s. Discovering that it could dispose of these loans far
more quickly by securitising them than by selling them off one by one, Resolution Trust Corporation issued nearly $18
billion of securities before ceasing operations in 1998.
Following in its footsteps, investment banks now routinely securitise commercial mortgages, primarily for sale to
life insurance companies. Total cmbs issuance in 2004 was approximately $94 billion in the United States, $25 billion in
Europe and about $8 billion in Asia.

REMICs
Another important step in the development of securitisation came in 1986, when the US Congress amended the
tax laws to provide for Real Estate Mortgage Investment Conduits, known as remics. Remics are a legal device to ensure
that the income produced by a mortgage-backed security is taxable to the investors who have purchased the securities, but
not to the trust that nominally owns the underlying mortgages and collects the payments from individual mortgagors.
Many mortgage- backed securities in the United States are now issued through remics.

US AGENCY SECURITIES
Several entities sponsored by the US government are authorised to pro- mote secondary markets for mortgage-
backed securities. Collectively, the securities they issue are known as agency securities. The market for US agency
securities has burgeoned into one of the biggest financial markets of any kind. By 2005 average daily trading volume in
agency securities exceeded $250 billion, having increased eightfold in ten years. In general, agency securities are called
after the agency that issued them, and each agency’s securities have slightly different characteristics.

Fannie Maes
Fannie Maes are issued by the former Federal National Mortgage Association, which is now a shareholder-owned
company using Fannie Mae as its corporate name. Each Fannie Mae security is backed by loans made in different parts of
the country, enabling investors to reduce the risk that economic woes in a particular region will cause a dispropor- tionate
number of the securities in a particular pool to go into default. The interest rates on the individual loans in a fixed-rate
mortgage pool may vary within a range of 2.5 percentage points. Based on these indi- vidual interest rates, Fannie Mae
issues each security bearing a specific rate of interest, and guarantees that investors will receive timely pay- ment of
principal and interest each month, even if individual borrowers fail to pay. The company makes its money from the
difference between the rates individuals pay to borrow and the lower interest rates paid to investors in pass-throughs, plus
various fees. The amount of outstanding Fannie Maes exceeds $1.8 trillion (see Table 5.2 on the previous page).

Ginnie Maes
Ginnie Maes are securities issued by private lenders, mainly mortgage bankers, under the auspices of the
Government National Mortgage Association, a US government corporation. The gnma (hence the name Ginnie Mae) was
split off from Fannie Mae in 1968, and is intended to promote home ownership among families of modest means. Each
individual mortgage in a Ginnie Mae pool is guaranteed by some US government agency, such as the Veterans
Administration, which guarantees mortgages for former members of the US armed forces. The lender groups the
mortgages to form a pool of loans having similar payment characteristics and maturities, and then receives Ginnie Mae
permission to issue securities based on these mortgages. The lender is responsible for collecting interest and principal
from individual borrowers and sending monthly payments to the holders of the securities it has issued, but the full faith
and credit of the US government guarantee that investors will receive all principal and interest payments due. Ginnie
Maes worth over $400 billion are now in the hands of investors.

Freddie Macs
Freddie Macs are issued by the Federal Home Loan Mortgage Corporation (fhlmc), a private-sector corporation
established under government charter. Like Fannie Mae and Ginnie Mae, Freddie Mac operates only in the secondary
market and does not lend money directly to individual borrowers. The corporation is obliged by government regulation to
devote a share of its mortgage financing to low-income and moderate- income families. Its securities are similar to those
issued by Fannie Mae, with which it competes, and do not constitute obligations of the US government.

Farmer Macs
Farmer Macs are pass-throughs of mortgages on farms and rural homes. The Federal Agricultural Mortgage
Credit Corporation (famcc), a shareholder-owned company established by the US government, securitises both
agricultural mortgages and loans guaranteed by the US Department of Agriculture, some of which are not mortgages. The
company guarantees interest and principal payments to the purchasers of its securities, and its guarantee is backed by a
$1.5 billion line of credit from the US Treasury. The volume of Farmer Mac securities is much smaller than that of the
other government-sponsored participants in the US secondary mortgage market.

MORTGAGE SECURITIES OUTSIDE THE UNITED STATES

A total of $329 billion of mortgage securities was issued outside the United States in 2004, nearly five times the
$66 billion issued in 2000 (see Figure 5.2). Here are examples of how markets for mortgage-backed securities have
developed in a number of countries outside the United States.
Canada
NHA MBS are mortgage-backed securities issued under the National Housing Act by Canada Mortgage and
Housing Corporation, an agency of the Canadian government. The corporation purchases and securitises mortgages issued
by authorised private-sector lenders in Canada. Its pass-through securities are backed by single-family mortgages,
mortgages on multi-family buildings, mortgages on social housing, or a combination of the three. Interest and principal
payments are guaranteed by the corporation, and thus by the Canadian government. The corporation had C$73 billion
(US$58 billion) of mortgage-backed securities outstanding at December 2004.

Denmark
Denmark has over $150 billion of mortgage-backed securities outstanding, an extremely large amount for a small
country. Danish mortgage securities are backed by fixed-rate residential mortgages with terms of 10–30 years, although,
as in the United States, individual borrowers are free to pay off a mortgage before its maturity date without penalty.
Unlike US mortgage-backed securities, those in Denmark combine commercial and residential properties, and investors
typically receive inter- est payments quarterly rather than monthly. The underlying mortgages remain on the balance sheet
of the mortgage bank that originated them, and are not sold to a trust.

Germany
Pfandbriefe are securities issued by certain mortgage banks or state banks in Europe. Pfandbriefe were a German
creation, but Spanish and French financial institutions also are major issuers. There are two basic varieties:
Hypothekenpfandbriefe, which account for 27% of outstanding Pfandbriefe and are backed by residential mortgages
meeting standards established by the German government; and Oeffentliche Pfandbriefe, which are backed by public-
sector debt from Germany or other European countries.
Pfandbriefe differ from other asset-backed securities in that they are issued directly by banks, rather than through
special-purpose vehicles, and the assets remain on the banks’ balance sheets. Also Pfandbriefe, unlike other asset-backed
securities, are not backed by a fixed pool of assets. The issuing bank can add to the asset pool from time to time and is
legally responsible if the assets fail to generate enough income to pay the bond holders. For these reasons, investors in
Pfandbriefe, unlike investors in most other types of asset-backed securities, must pay close attention to the financial
strength of the bank issuing the securities, as it is the ultimate guarantor of payment. Most German mortgages are not
securitised through Pfandbriefe, as only mortgages not exceeding 60% of the value of the property are eligible.
Pfandbriefe issuance hit a record €325 billion in 1999, but fell to €209 billion in 2004. Germany accounted for 70% of
total issuance, Spain for 18% and France for 9%.

The UK
The first mortgage-backed security in the UK was a £50m issue for National Home Loans in 1987. A total of £1
billion of mortgage-backed securities was issued that year in the UK, and the market has grown steadily since. Expansion
has been retarded by the unique characteris- tics of the British residential mortgage market. A high proportion of
mortgages have floating rates that adjust frequently; long-term fixed-rate mortgages are uncommon; and borrowers are
able to increase the amount of an outstanding mortgage or to change lenders at little cost. These characteristics make
many British mortgages unsuitable for pack- aging into long-term securities. Nonetheless, British issuance of mort- gage-
backed securities reached £77 billion in 2004.

Other parts of Europe

Elsewhere in Europe, issuance of mortgage-backed securities has been quite modest, although the creation of the
euro is encouraging mortgage securitisation. Issuance in the euro zone in 2004 was €59 billion ($71 bil- lion), mainly in
Spain and the Netherlands. Strictly private-sector trans- actions account for almost all of this amount, as there is no
European equivalent of Fannie Mae or Ginnie Mae.

Japan
In Japan, development of mortgage-backed securities was hindered by laws allowing mortgagors to object to the
resale of their mortgages. The first attempt to issue a mortgage-backed security failed in 1998. How- ever, several issues
were completed successfully in 2000, and issuance in 2004 exceeded ¥1 trillion ($9 billion).

China
The People’s Bank of China, the central bank, authorised the issuance of mortgage-backed securities in April
2000. However, there was no issuance until 2005.

NON-MORTGAGE SECURITIES
As investors became accustomed to purchasing mortgage-backed securities, financial-market participants
naturally began considering the possibilities of other types of asset-backed securities. The most avid participants in this
process are banks, which have been able to make use of securitisation to find a new role as intermediaries between
borrowers and investors rather than as the ultimate providers of the borrowed funds. Many non-bank lenders have also
turned to securitisation to fund their activities, particularly as securitisation allows them to grow far more rapidly than
they could if they had to raise capital to support a large portfolio of loans.

Credit-card securities
These were until recently the largest single category of non-mortgage asset-backed securities in both the United
States and Europe. Many large banks have securitised part or all of their credit-card portfolios in order to put their capital
to more profitable uses. Approximately $370 billion of credit-card securities, typically offering floating interest rates,
were outstanding in the United States in 2005, along with several billion dol- lars in Europe, mainly in the UK.

Home equity loans

Securities backed by home equity loans, often guaranteed by second liens (which offer security only after the
borrower’s debt to holders of the first mortgage has been satisfied), have flourished in the United States. These became
popular after tax-law changes removed prefer- ences for other types of consumer borrowing. Some $476 billion of home-
equity asset-backed securities was outstanding in mid-2005, accounting for one-quarter of the American ABS market.
Automotive loans
Often securitised by the finance arms of auto manufacturers, auto- motive loans are well established in the asset-
backed market. Some $226 billion of auto-loan securities were outstanding in the United States in 2005, and far smaller
amounts in Canada and Europe. There are also substantial amounts of securities backed by loans on agricultural and
construction equipment. Unlike most credit-card and home equity secu- rities, asset-backed securities based on auto loans
typically have fixed interest rates.

Manufactured-housing securities
Introduced in the early 1990s, manufactured-housing securities had been considered high-risk loans unsuited for
securitisation, as borrow- ers often have modest incomes, lending procedures were not uniform, and the homes themselves
were not considered likely to appreciate in value from year to year. However, once non-bank lenders began to offer and
securitise manufactured-housing loans, high interest rates made them attractive to investors. Some $12 billion of securities
backed by manufactured housing were sold in the United States in 1999. Many of the loans went into default as economic
growth slowed and unem- ployment rose in 2000 and 2001, when issuance fell to only $2 billion. Few new securities of
this type have been issued, and outstandings have declined as borrowers have repaid their loans.

Student loans
Student loans have been securitised only since June 1993. Most student- loan securitisation is conducted by the
Student Loan Marketing Associa- tion (slma), a shareholder-owned company established by the US government. The
company, known as Sallie Mae, purchases student loans in the secondary market and packages them for sale as securities.
Figure 5.3 shows the amount outstanding, which accounted for 7% of all US asset-backed securities by 2005.

CDOs
Collateralised debt obligations, created in the early 1990s, have become a major part of the asset-backed market.
cDos are securities representing ownership of corporate loans. Unlike the other types of assets most frequently securitised,
the loans underlying cDos are not standardised, and an investor may find it difficult to predict how they will perform.
Some cDos may also be based in part on bonds, other asset-backed securities, or credit default swaps (explained in
Chapter 4). Some cDos involve a large amount of leverage, which has caused financial regulators to express concern
about potential losses should the assets not per- form as expected. An estimated $287 billion of cDos was outstanding in
the US in mid-2005. cDos account for 15% of asset-backed securities.

Assorted others
Novel types of asset-backed securities are frequently offered for sale. Small-business loans have successfully been
securitised by several banks, even though they constitute a fairly heterogeneous asset. Film distribution companies, such
as The Walt Disney Co, have successfully securitised the anticipated revenue from groups of films, and in 1998 a singer,
David Bowie, securitised future revenue from recordings that had already been issued. Securities backed by anticipated
ticket revenue have been used to build sports stadiums in several American cities. Unlike loan securitisations, however,
sports and entertainment securiti- sations are usually one-of-a-kind deals and do not account for a large proportion of the
market. They pose some significant risks not present in other types of securitisation, as the value of the securities depends
heavily on the ability and willingness of particular entertainers or athletes to promote their product in future.

***End of Discussion***
References:
The Economist - Guide to Financial Markets (Fourth Edition) by: Marc Levinson