FDIC: Outlook Fall 2006


		Home > Industry Analysis > Research & Analysis > FDIC Outlook

FDIC Outlook

A New Plateau for the U.S. Securitization Market

Banks exist to provide credit to household and business borrowers. But the traditional practice of holding bank loans on the balance sheet until maturity is increasingly giving way to off-balance-sheet securitization. During the past 30 years, new information technologies and new financial practices have made it possible to securitize a wide range of loan types, from mortgages to credit card receivables and beyond. Recently, these changes have brought about "synthetic" securitizations in which only certain types of risk move off the balance sheet.¹ These new structures are intended to improve the ability of individual institutions—and the system as a whole—to bear the risks of providing credit. But as the complexity of securitization structures has increased, so too have concerns about their transparency and how they might perform in periods of financial market turmoil. This article provides a brief summary of the factors that continue to drive growth and innovation in the securitization of bank loans.

Look How Far Securitization Has Come
What Is Securitization?
Securitization is a method of funding in which illiquid, balance sheet assets are converted into marketable securities. The process starts when assets are transferred from the balance sheet of the originator to a special-purpose entity (SPE). The SPE is a bankruptcy remote trust that is set up by the originator to hold the assets.² The SPE is financed by issuing tradable, capital market securities against the pool of assets. Then the SPE uses cash flows generated by the assets to make principal and interest payments to the investors.

SPEs typically issue multiple classes of securities, which are referred to as tranches. Tranches are classified as senior, mezzanine, or junior, depending on their priority in receiving cash flows and sustaining losses from the underlying pool of assets in the SPE. Principal and interest payments generally "cascade" first to the senior tranche, then the mezzanine tranche, and last to the junior tranche, with all of the payments satisfied in the higher tranche before any payments are made to the next tranche. Conversely, losses are generally sustained from the bottom up, with the junior tranche absorbing all of the losses before the mezzanine tranche sustains any losses.

The securities in each tranche have their own risk/return profile. Senior tranches typically carry AAA credit ratings and yields. The most junior tranche is referred to as the residual or equity tranche. It is unrated, has a higher expected return, and typically has been carried on the balance sheet of the originator to enhance the credit quality of higher tranches. Other credit enhancements, such as third-party insurance purchased by the originator, can be incorporated into the securities to protect investors in the event that cash flows from the underlying assets are insufficient to pay principal and interest in a timely manner. Credit enhancements improve the credit rating, and therefore the pricing and marketability, of the securities.

Securitization has thrived during the past 25 years because it is highly efficient at redistributing risk from illiquid, balance sheet assets of the originator to the capital securities markets. Instead of issuing securities based on its overall credit rating, the originator can stratify the risk in the underlying assets and issue securities based on the stratified risk. This efficient redistribution of risk enables the originator to access capital market funds at more favorable rates, and it enables investors to purchase capital market securities tailored to their specific risk/return profile.

A Brief History of Securitization
Securitization dates back to the early 1970s, when the Government National Mortgage Association (Ginnie Mae) pooled mortgage loans and sold single-class, mortgage-backed securities (MBS) against the pool. MBS enabled Ginnie Mae to access national credit markets to fund local mortgage lending. The Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae) followed Ginnie Mae in securitizing mortgages in the early 1980s. These government-sponsored entities (GSEs) realized that they could access capital market investors more efficiently by issuing multiple classes of securities against the pooled mortgages, which led to multiple-class collateralized mortgage obligations (CMOs).

Mortgage securitizations were followed by asset-backed securities (ABS) and collateralized debt obligations (CDOs). ABS is a general term that denotes the securitization of any balance sheet asset. In the narrower sense, however, ABS typically refers to the securitization of a large pool of homogeneous assets, such as receivables, and they generally have simple structures. CDOs are securitizations against a pool of heterogeneous loans (collateralized loan obligations, CLOs) or bonds (collateralized bond obligations, CBOs).³ CDOs can have a variety of complex structures depending on their purpose, exposure to the underlying assets, and credit structure.

CDOs first appeared in the market in the late 1980s.⁴ In the 1990s, CDOs were issued against a much broader universe of underlying collateral, including corporate bonds, corporate loans, trust preferred stocks, high-yield loans, middle-market loans, asset-backed consumer debt, and a combination of these asset classes. In 1997, the development of the credit derivatives market led to the construction of synthetic CDO structures in which credit derivatives are used to transfer risk to the SPE instead of actually transferring the underlying assets. Synthetic CDOs allow banks to maintain their loan portfolio on their balance sheet while simultaneously securitizing the credit risk in their loan portfolio. Synthetic CDOs have played a critical role in the growth of CDO issuance and the emergence of a market for traded credit securitizations.

Measuring Risk in the Pool of Assets
All securitized products share three key characteristics: (1) the pooling of assets into a common asset pool, (2) the issuance (tranching) of securities backed by the asset pool, with each tranche having a distinct risk/return profile, and (3) the delinking of credit risk in the underlying pool of assets from the credit risk of the originator through the creation of an SPE.⁵ Securitized products can differ in the types of underlying assets they securitize, the degree of diversification of the underlying asset pool, and the complexity of their capital structure.

MBS, CMOs, and ABS typically bundle together a fairly homogeneous pool of assets such as mortgages or some type of receivable. Idiosyncratic risk from individual assets in the asset pool typically is well diversified. Consequently, the asset pool can be valued based on default probabilities that draw on the historical experience of similar asset pools. In contrast, CDOs often are collateralized by a relatively heterogeneous pool of assets, such as different types of bank loans, corporate debt, emerging market debt, other CDOs, ABS, and many different types of derivative instruments. Both systematic and idiosyncratic risks remain critical factors in pool performance. Consequently, valuing CDO asset pools on the basis of historical default probabilities is a useful, but inadequate valuation method because of the idiosyncratic risk that remains in the asset pool. The CDO market gradually is moving toward valuation models that are based on statistical techniques, but this area remains a challenge.

Innovation Continues to Accelerate Growth
The U.S. securitization market has experienced tremendous growth over the past 20 years. Total securities issuance has grown from $126 billion in 1985 to more than $2.7 trillion in 2005 (see Chart 1). The industry's ability to innovate and adapt to changing circumstances and demands of the market has fueled this growth. Several trends have emerged in the securitization market. Four examples are discussed here: (1) the growth in nonagency MBS, (2) the growth of nonmortgage ABS, (3) the growth in cash funded CDOs, and (4) the issuance of new securitized products.

CHART 1

MBS Growth Has Shifted from Agency to Nonagency Issuers
The market for securitized mortgages appears vastly different in many respects than just a few years ago. Until recently, GSEs dominated the market for MBS issues. However, nonagency (or private-label) MBS issuance more than doubled between 2003 ($586 billion) and 2005 ($1.191 trillion), and for the first time surpassed agency MBS issuance in 2005 ($966 billion) (see Chart 2). The most important of the many factors driving this transformation are high housing valuations, a heightened appetite for yield, a reduction in agency issues, and better technology.

CHART 2

As home prices increased and mortgage rates fell to generational lows since 2000, more homeowners have opted for jumbo loans or nontraditional affordability loan products such as interest-only loans, option adjustable-rate mortgages (ARMs), and 40-year loans to finance their home purchases. Standard & Poor's (S&P) has stated that affordability loan products represented 45 percent of S&P-rated originations in 2005, with option ARMs representing 27 percent of the affordability product originations. Moody's reported that more than 35 percent of the securitized collateral (rated by Moody's) consisted of option ARMs, up from approximately 12 percent in 2004.⁶ Origination volumes in these products have been sufficient to permit securitization structures wholly backed by option ARMs.

Homeowners have increasingly used home equity loans to extract their home equity. Many of these home equity loans (of which the vast majority are deemed subprime) were subsequently securitized (see Chart 3). Despite their subprime status, high yields propelled nonagency lenders to underwrite and securitize jumbo and affordability loan products (see Chart 4). Investor demand for higher-yielding MBS and improved technology in structuring deals ensured a readily available market for these securitized loan products. Last, there was a reduction in agency issuance over this period, which was likely the result of the accounting scandal facing agency MBS issuers.

CHART 3

CHART 4

ABS Growth Has Shifted from Mortgage to Nonmortgage Assets
The market for securitized assets other than mortgages has undergone its own transformation. As illustrated in Chart 5, nonmortgage ABS issuance continues to grow at a steady pace, achieving a record issuance of $292 billion for 2005. However, it is interesting to note from where most of this growth is coming. In 1995, credit card and vehicle financing made up approximately 81 percent of ABS issuance, while student and business financing made up just 6 percent. In 2005, credit card and vehicle financing represented only 56 percent of ABS issuance, whereas student and business financing increased their portion to 40 percent (see Chart 6).

CHART 5

CHART 6

ABS backed by student loans experienced the most significant growth over this period, increasing from $3.1 billion (3 percent of total ABS issuance) to $77.5 billion (25 percent of total ABS issuance). However, much of the growth in student loan ABS issuance occurred since 2001, when total issuance stood at $13.4 billion. Historically low interest rates and increased issuance from nonagency issuers were the primary drivers of growth in student loan issuance since 2001. Last, increases in 2005 issuance volumes were driven in large part by consolidations, whereby borrowers consolidated their student loans before interest rates increased.

The Cash-Funded CDO Market Has Grown Dramatically
In recent years, CDOs have become a dominant vehicle for funding, hedging, and trading virtually all types of debt instruments. There are a variety of structures that CDOs can adopt, depending on their purpose, credit structure, and underlying assets.⁷ Consequently, there are a variety of ways to report CDO issuance data. One important way of reporting CDO data is based on whether the underlying debt is sold to the SPE for cash (cash-funded CDO) or synthetically transferred to the SPE using credit derivatives (synthetic CDO). This section focuses on trends in the cash-funded CDO market.

The cash-funded CDO market has grown dramatically over the past ten years (see Chart 7). One estimate puts global cash-funded CDO issuance at $224 billion in 2005, up 196 percent since 2000. Prior to 1995, global cash-funded CDO issuance never exceeded $4 billion annually. The U.S. cash-funded CDO market experienced similar growth during this period. U.S. cash-funded CDO issuance was $165 billion in 2005, up 198 percent since 2000. Recent issuance data suggest that 2006 will be another strong year. Through July 20, 2006, global cash-funded CDO issuance has been $174 billion, and U.S. cash-funded CDO issuance has been $138 billion.⁸ Many market participants expect cash-funded CDO growth to continue for the remainder of 2006. Originators continue to supply new issues, investors continued to demand new issues, and the market continues to innovate with novel securitization structures and new classes of underlying collateral.

CHART 7

Much of the growth in U.S. cash-funded CDO issuance since 1997 was driven by a general increased demand for CDO products. However, there was clearly a shift in preference away from CDOs collateralized with high-yield bonds and investment-grade debt to CDOs collateralized with structured finance products (both mezzanine and high grade; see Chart 8). Structured finance CDOs typically invest in MBS, ABS, and other CDOs, whereas high-yield loan CDOs typically invest in sub-investment-grade loans. U.S. cash-funded CDOs collateralized with structured finance products have grown from approximately $250 million in 1997 to more than $76 billion in 2005. U.S. cash-funded CDOs collateralized with high-yield loans also grew significantly during this period, increasing from $4.8 billion to more than $60 billion.

CHART 8

Strong global demand for high-yield CDOs, a robust housing market, and innovations in capital structures, technology, and underlying mortgage products have helped drive CDOs to the forefront of structured capital market securities. The concentration of residential mortgage products, in particular subprime home equity loans, increased significantly in the 2005 vintage. On average, 81 percent of collateral pools in the 2005 vintage were composed of residential mortgage products, with home equity loans accounting for 66 percent of all pools. This compares with a 65 percent residential mortgage concentration in the 2004 vintage, of which home equity loans represented 46 percent of all pools.⁹ According to Credit Suisse First Boston, many structured finance CDOs contain as much as 50 to 60 percent subprime mortgages (also called residential B&C mortgages) and home equity loan bonds.¹⁰ An increase in private-label MBS issuance collateralized by subprime mortgages and an increase in ABS collateralized by home equity loans (most of which are deemed subprime) soon followed (see Chart 8).

High yields have made these new CDO structures very attractive relative to other fixed-income instruments. However, the increasing use of subprime debt in the collateral pools is of growing concern, particularly in a rising interest rate environment. According to JPMorgan, "With clear deterioration in U.S. home price appreciation (HPA), the full downside [risk] is still unclear for SF [structured finance] CDO tranches, and potential interest rate increases are likely to be far more penalizing compared to the benefit from one or even two (interest rate) cuts."¹¹

New Structured Finance Products: Net Interest Margin Securities (NIMS)
Many new structured products are introduced in the capital markets every year, but many either do not succeed or take years to gain acceptance in the market. There are a variety of reasons for this, such as lack of credit enhancements, poor transparency, or difficulty in modeling cash flows. This section discusses net interest margin securities (NIMS), which were introduced in the mid-1990s but did not gain wide market acceptance until recently.

NIMS are structured finance products collateralized by the residual cash flows from one or more securitizations (underlying deals). They may be structured within a securitization, but more frequently they are structured as a separate issuance after the inception of the underlying securitization.¹² NIMS are a popular option for subprime residential mortgage securitizations because they allow the issuer to securitize the excess spread, which is the difference between the income on the underlying pooled assets and the financing cost, as well as prepayment penalties. If not securitized, the excess spread would remain on the issuers' balance sheet as a form of credit enhancement used primarily to absorb credit losses on the senior tranches of the deal.

NIMS are either sold in the secondary market, which provides regulatory capital relief to the issuer, or maintained on the issuer's balance sheets. The recent growth in NIMS issuances is the result of growth in the subprime mortgage market, new structures, and attractive yields that have increased investor demand. Although issuance statistics on NIMS are not widely published, S&P experienced significant growth in its rated NIMS deals. According to S&P, the par value of rated NIMS in 2003 increased more than sevenfold to $3.4 billion, and growth in 2004 was more than fourfold to $14.97 billion.¹³

The Future of Securitization
Securitization has continued to thrive because it is highly efficient at converting illiquid balance sheet assets into capital market securities. We are likely to see continued advances in technology, more accurate modeling of future cash flows, more complex securitization structures, and increased participation by institutional investors. Continued refinement in stratifying and managing the risk/return profile of securities through tranching will enable originators to reduce funding costs and investors to increase value through investments that meet their specific risk/return profiles.

Advances in Technology
Technological advances in cash flow modeling, data processing, and data availability will continue to play an integral role in the highly innovative market for securitizations. Advances in computer processing speeds and improvements in modeling irregular cash flows—such as late payments, partial payments, defaults, recoveries, prepayments, and payment triggers—will enable issuers and investors to model the timing and amount of cash flows from the underlying asset pool in a securitization more accurately. Both issuers and investors will benefit from technological advances.

Data availability will continue to have a significant impact on growth in the securitization market. Long periods of historical data are needed to model cash flows and default probabilities in the underlying asset pool so that the securities issued in each tranche can be priced accurately. As more historical data become available, originators will be able to securitize new assets such as hybrid loan products, ABS structures, and derivatives. Data available to investors also have improved significantly. Information on loan pools that was once available only to issuers is now available to investors. This information has added a new level of transparency that will continue to increase demand for securitized products.

Increasing Capital Structure Complexity
Much of the complexity of today's securitizations stems from the introduction of new types of collateral used in the underlying asset pools. There is less homogeneity in the underlying collateral than in the past, which makes it more difficult to value and price the deal. For example, CDOs now pool a number of different types of assets, including corporate loans, high-yield bonds, emerging market debt, other CDOs, ABS, and many different types of derivative instruments. Because innovation in the securitization market tends to coincide with advances in technology, structuring and pricing many of these more complex deals was improbable only a few years ago.

Refined Risk/Return Profiles of New Securitization Structures
One of the major factors driving new securitization structures is the desire of issuers to reduce funding costs and of investors to purchase securities that increasingly meet their risk/return profile. For example, banks, pension funds, and insurance companies will continue to invest in AAA-rated securities in the senior securitized tranches, while hedge fund and money managers seeking yield will invest in securities in the mezzanine and equity tranches.¹⁴ The combination of historically low interest rates and the explosion of hedge funds over the past several years has increased the demand for yield, which has increased demand for securities in the mezzanine and junior structures.

What Does the Reemergence of Risk Aversion Mean for the Market?
Risk aversion in the financial markets can reemerge gradually or quickly. Should the reemergence of risk aversion happen quickly as a result of a major market disruption, the subsequent flight to quality may cause significant losses for investors in securitized products, especially investors in the higher risk mezzanine and equity tranches. For example, many hedge funds, traders, and other market participants experienced sizeable losses in securitized products resulting from the flight to quality that took place following the Russian debt default in 1998. Material losses also were noted at hedge funds in spring 2005, when default risk at General Motors and Ford increased.

Currently about 8,500 hedge funds are operating worldwide, managing more than $1 trillion in assets, compared with about 2,800 hedge funds managing $2.8 billion in 1995.¹⁵ Credit-oriented hedge funds, which are the most likely to hold securitized products, have also grown significantly in recent years, from about $30 billion in 1997 to about $340 billion in 2005 (see Chart 9). Consequently, given the significant increase in assets under management at hedge funds in recent years, the potential for losses among investors (especially in mezzanine and equity tranches) should a major market disruption occur is even greater today than in the past.

CHART 9

Mitigating the Risk Associated with New Securitization Structures
As the securitization market continues to innovate and offer new structured products, issuers and investors need to perform proper due diligence before taking positions. Market participants should have a thorough understanding of the risks associated with each structure, such as market, credit, and liquidity risks, and how these risks fit in with their overall market strategy. More historical data, advances in technology, improved modeling techniques, and more experience will help issuers and investors understand the risk/return profile of increasingly complex securitized products.

David E. Vallee, Senior Financial Analyst,
FDIC Division of Insurance and Research
dvallee@fdic.gov

¹ Synthetic securitizations use credit derivatives to construct an asset pool with characteristics similar to a traditional securitization.
² Some SPEs purchase loans from the originators to securitize.
³ The first rated CLOs backed by U.S. bank loans were brought to market in 1990, and the first CBO backed by high-yield bonds was brought to market in 1988. Janet M. Tavakoli, Collateralized Debt Obligations and Structured Finance: New Developments in Cash and Synthetic Securitization (New York: John Wiley & Sons, 2003).
⁴ Merrill Lynch, "U.S. Cash Flow CDOs and Their Assets," Fixed Income Strategy, no. 6 (February 9, 2005): 5.
⁵ Committee on the Global Financial System, Bank for International Settlements, The Role of Ratings in Structured Finance: Issues and Implications, January 2005: 5.
⁶ Data taken from a presentation at the Federal Financial Institutions Examination Council's Capital Markets Conference, June 12, 2006, by Brian D. Grow and Martin C. Kennedy, Directors, Residential Mortgage-Backed Securities (RMBS) S&P's Rating Services, New York, N.Y.; and "2005 Review" and "2006 Outlook: Alternative — A RMBS," Moody's Investor Service. Included in the category of affordability RMBS are interest-only loans, 40-year amortization loans, and option ARMs. There is research indicating that the pace of origination of option ARM loans has slowed in 2006.
⁷ JPMorgan, CDO Handbook, May 29, 2001.
⁸ Data obtained through conversation with JPMorgan analyst.
⁹ Credit Suisse, "U.S. CDO Strategy, Insight & Market Recap," The CDO Strategist, June 29, 2006.
¹⁰ Credit Suisse First Boston, "Classification Conundrum: Residential Mortgage Classifications in SF CDOs," Fixed Income Research publication, December 23, 2004.
¹¹ JPMorgan, CDO Monitor, October 30, 2006: 3.
¹² Yogesh Gupta, "Understanding Net Interest Margin Securities (NIMS)," Structured Finance Group publication, PricewaterhouseCoopers Web site.
¹³ National Mortgage News, "S&P Tracks and Forecasts U.S. NIM Trends," Nonprime News 30, no. 8 (November 14, 2005): 26.
¹⁴ It is believed that the main participants in the market for equity and mezzanine tranches are the hedge funds and dealers, whereas the insurers and pension funds are more focused on the mezzanine and senior tranches. Banks are also buyers of senior and super senior tranches. See Global Financial Stability Report, The Influence of Credit Derivative and Structured Credit Markets on Financial Stability (April 2006), 51.
¹⁵ Angel Ubide, "Demystifying Hedge Funds," Finance and Development 43, no. 2 (June 2006).

Last Updated 01/04/2007

insurance-research@fdic.gov

Each depositor insured to at least $250,000 per insured bank