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Author Biography
Dr. Joseph C. Hu is professor of the International MBA Program at the National Chengchi University, Republic of China (Taiwan) and visiting professor at Hanqing Advanced Institute of Economics and Finance, Renmin University of China, People's Republic of China. Dr. Hu was formerly Standard & Poor's China country manager. He also served as Standard & Poor's global head of structured finance research.
Prior to Standard & Poor's, Dr. Hu held positions as managing director at Oppenheimer & Co. Inc., senior vice president at Nomura Securities International, Inc., executive vice president at Shearson Lehman Hutton Inc., senior vice president at E. F. Hutton Inc., and vice president at Salomon Brothers, Inc. He also worked as economist at Fannie Mae and taught as assistant economics professor at University of Maine. Dr. Hu is also the author of Basics of Mortgage-Backed Securities.
Table of Contents
| Asset Securitization: Concept and Market Development | |
| The concept and market practice of asset securitization started in 1970, when mortgage bankers pooled their newly originated residential mortgage loans and issued residential mortgage-backed securities | |
| By issuing residential mortgage-backed securities, mortgage bankers were able to raise funds more efficiently in the capital market to finance their originations of residential mortgage loans | |
| It took only 20 years for the asset securitization market to become the largest sector in the U.S | |
| capital market with the outstanding balance exceeding one trillion dollars | |
| In the early development of the asset securitization market, residential mortgages were the only type of underlying assets that were being securitized | |
| Since the mid-1980s, a great variety of financial assets that had predictable and steady future receivable cash flows have been utilized as the underlying assets for securitization. | |
| This chapter will first discuss the basic concept of asset securitization | |
| It will then present the development history of the asset securitization market in the U.S | |
| over the past forty years | |
| Basic Concept of Asset Securitization | |
| Development of the Asset Securitization Market in the U.S. | |
| Originators and Investors of the Asset Securitization Market | |
| The story of the nearly four-decade long and successful development of the asset securitization market was written mainly by a great many originators of underlying assets and still far larger number of investors | |
| They cooperated to provide financing for consumers and businesses that created value and raised living standards | |
| Their cooperation was guided by the invisible hand in that the originators and the investors were driven by self-interest to participate in the asset securitization market. | |
| This chapter discusses the raison d'être of asset securitization: the originator's needs to raise funds efficiently in the capital market to finance their loan originations and the investor's varying demands for diversified investment products to earn attractive returns for their funds. | |
| Efficient Financing for Originators with Asset Securitization | |
| Satisfying Varying Investor Demands with Asset Securitization | |
| Intermediary Participants of the Asset Securitization Market | |
| In the asset securitization market, many intermediary participants are working either upfront or behind the scene with originators and investors to ensure the to-be-issued transactions are appropriately structured with respect to the tightness of legal documents, the rigor of accounting, the integrity of the cash flow, and the evaluation of the credit risk | |
| (Note that throughout the balance of this book, the terms of “transaction” and “securities” are used in such a way that a transaction refers to the issuance of asset-backed securities that are backed by a specific pool of assets | |
| In a transaction, several securities are often issued | |
| These securities have different maturities and different credit ratings | |
| Each security, which is support by a specific portion of the total cash flow of the underlying assets, has a specific expected maturity and a specific credit rating.) | |
| The purpose of the many different parties participating in a transaction is to clearly identify and protect the interests of the originator/seller, the issuer, the servicer, and the many investors in the transaction | |
| Further, after the securities of a transaction are issued, the participants will continue to monitor all the factors that affect the market value and credit performance of the securities for the benefits of the issuer and the investors. | |
| This chapter discusses the functions of attorneys, accountants, guarantors and credit enhancers, credit rating agencies, and investment bankers | |
| Attorneys | |
| Accountants | |
| Guarantors and Credit Enhancers | |
| Credit Rating Agencies | |
| Investment Bankers | |
| Necessary Ingredients and Benefits of Asset Securitization | |
| From the discussion of the previous three chapters, it is clear that the long and successful development of the U.S | |
| asset securitization market was not accidental | |
| Many professions with different backgrounds and expertise worked closely in the capital market to provide the needed financing for consumers and businesses | |
| This cooperation was guided by the market force and made productive by the presence of nine elements that are conducive to asset securitization | |
| This chapter will elaborate these nine elements | |
| It will also discuss in more detail the triple benefits of asset securitization to the originator, the investor, and the borrower | |
| The Nine Necessary Ingredients | |
| Benefits of Asset Securitization | |
| Residential Mortgages | |
| For a great majority of Americans, one of the most important transactions in their lifetime is to purchase a house | |
| Purchasing a house is a very important transaction primarily because its price is often several times the annual income of the purchaser | |
| For this reason, the purchase of a house is rarely done in cash | |
| It is almost always financed with a long-term residential mortgage loan | |
| This chapter defines what a residential mortgage is, how it works in terms of amortization, the most popular type of mortgage, and a wide variety of other types of alternative mortgages | |
| Description of a Residential Mortgages | |
| Characteristics of a Fixed-Rate Mortgage | |
| Various Alternative Types of Mortgages | |
| Residential Mortgage Market | |
| The previous chapter has illustrated that a mortgage is a long-term debt instrument that is originated to provide the necessary financing for the borrower to purchase a house | |
| It also pointed out that the purchase of a house is, in general, the most important and the largest transaction for the borrower | |
| For the reason, the underwriting of a mortgage needs to be prudent and careful to ensure that the borrower is financially qualified to borrow the money to purchase the house | |
| The qualification process considers specifically whether the borrower, once becoming a homeowner, is able to carry out the responsibility of paying the monthly payment, or in other words, “servicing the mortgage debt.” Thus, a residential mortgage has to be underwritten taking two factors into considerations: (1) the borrower's ability to pay the monthly payment and (2) the value of the property that secures the mortgage | |
| Once the mortgage is underwritten, there is a mechanism for the originator to insure against the ultimate default on the mortgage | |
| This chapter describes the process of originating a residential mortgage, the various types of mortgage originators, the mortgage servicers, and the mortgage insurers | |
| To wrap up the discussion, this chapter presents the history of the forty-year development of the primary residential mortgage market | |
| The Origination of a Residential Mortgages | |
| Major Mortgage Originators | |
| Mortgage Servicers | |
| Mortgage Insurers | |
| The Development of the Residential Mortgage Market | |
| Agency-Guaranteed Mortgage Pass-Throughs | |
| A mortgage pass-through security, or simply a mortgage pass-through, is backed by a pool of mortgages whose monthly payments are the sole source of cash flow for the security | |
| The security is called a “pass-through” because the monthly payments generated from the underlying pool of mortgages are “passed” from the borrowers (mortgagors) “through” the issuer (servicer) to the investors of the security | |
| This chapter will discuss the evolution of the various types of residential mortgage pass-throughs | |
| During the 1970s and the 1980s, the RMBS market has evolved to create four major types of pass-throughs to facilitate mortgage financing for the home buyers | |
| They are: government guaranteed mortgage pass-throughs (Ginnie Maes), GSE-guaranteed mortgage pass-throughs (Fannie Maes and Freddie Macs), private-label pass-throughs, and subprime mortgage-backed securities | |
| They represented the “four pillars” of the U.S | |
| housing finance system | |
| Each pillar is distinctive for its unique way of credit enhancement and the specific type of the borrowers | |
| Combined, the four pillars provided housing finance for Americans from all walks of life | |
| This chapter will also introduce the concept and terminology of mortgage pass-throughs and their trading and relative value | |
| Ginnie Mae Mortgage Pass-Throughs | |
| Concept and Terminology | |
| Freddie Mac Participation Certificates | |
| Fannie Mae Mortgage-Backed Securities | |
| Private Label Mortgage Pass-Throughs | |
| Subprime Mortgage-Backed Securities | |
| Trading and Relative Value | |
| Multiclass Mortgage Pass-Throughs | |
| The creation of mortgage pass-throughs was an important capital market innovation in the 1970s | |
| Mortgage pass-throughs flourished with rapidly expanding issuance volume in the early 1980s | |
| However, market participants always felt that mortgage pass-throughs could have been more successful and prominent both as an effective tool for housing finance for homebuyers and as an attractive instrument for fixed-income investors | |
| The one thing that held back the full development of mortgage pass-throughs was the undesirable aspect of the cash flows-the prepayment uncertainty, which is an inherent risk for the investor | |
| This chapter will first briefly explain the prepayment risk of mortgage pass-throughs | |
| It will then discuss the evolution of the market addressing the prepayment risk by creating multiple maturity classes of mortgage-backed securities | |
| This chapter will also describe the rise, collapse, and recovery of the multiclass pass-through market | |
| Finally, it will present the trading and relative value of the multiclass mortgage pass-throughs | |
| An appendix at the end of this chapter will provide detailed explanations on the reasons for prepayment, prepayment risk, and the calculation of prepayment rate | |
| Prepayment of Mortgage Pass-Throughs | |
| The Need for Multiclass Securities | |
| Collateralized Mortgage Obligations | |
| Real Mortgage Investment Conduits | |
| Variety of REMIC Classes | |
| The Rise, Collapse, and Recovery of REMICS | |
| Trading and Relative Value | |
| Appendix: Analysis of Prepayment and Prepayment Rate | |
| Private-Label Mortgage Pass-Throughs | |
| Private-label mortgage pass-throughs (hereafter, private-label pass-throughs) began to play a significant role in housing finance in the beginning of the 2000s | |
| They are called “private-label” because neither the underlying mortgages nor the securities themselves are insured or guaranteed by a government agency | |
| For this reason, private-label pass-through transactions are necessarily structured with credit enhancement and always issued in multiple securities with a wide range of credit classes | |
| This chapter will first present the development of the private-label pass-through market | |
| It will then describe the structure of private-label pass-throughs with an example of a typical transaction | |
| The description will consists of (1) analysis of the characteristics of the underlying mortgages and (2) illustration of the credit enhancement mechanism of the typical transaction | |
| This chapter will also explain the unique prepayment pattern, discuss the criteria of credit ratings, examine the historical performance of credit ratings, and present the trading and relative value of private-label pass-throughs | |
| An appendix will be provided at end of the chapter to discuss the significance of mortgage default and housing price appreciation on the credit performance of private label pass-throughs | |
| The Growth of the Private Label Pass-throughs Market | |
| A Typical Transaction | |
| The Cash Flow Structure-Mechanism of Credit Enhancement | |
| Credit Rating Criteria | |
| Performance of Credit Ratings | |
| Prepayment Pattern | |
| Trading and Relative Value | |
| Appendix: Default and Housing Price Appreciation | |
| Subprime Mortgage-Backed Securities | |
| Subprime mortgage-backed securities made their capital-market debut only in the late 1980s, but became one of the fastest growing sectors of the asset securitization market in the late 1990s | |
| Actually, before their debacle in late 2006, subprime mortgages were generically referred to as “home equity loans” (HELs) among the participants in the residential mortgage market | |
| In fact, HELs were originally second-lien mortgages originated for homeowners to borrow against the accumulated equity on their houses | |
| However, as originations expanded quickly with a rapid pace of securitization, HELs began to represent more subprime mortgages than a true second-lien mortgages secured by the home equity | |
| A subprime mortgage refers to a borrower who has in the recent past became delinquent on paying interest on the consumer loan or even defaulted on the loan | |
| By contrast, a prime mortgage describes a borrower who has an unblemished credit history | |
| From a cash flow point of view, a subprime mortgage is no different from a prime mortgage | |
| They are all single-family mortgages | |
| In the securitization market, however, subprime mortgage-backed securities are viewed as a part of the ABS, not RMBS, market | |
| This arbitrary distinction, gradually established during the 1990s, was made primarily because the origin of subprime mortgages was HELs, which were not full fledged first-lien mortgages. | |
| This chapter will discuss the evolution of the subprime mortgage market, features of subprime mortgages, and the varying characteristics of subprime mortgage securities | |
| While the discussion in this chapter will focus on the credit aspect of subprime mortgage securities, it will briefly cover HELs as a financing instrument secured by the home equity | |
| More important, this chapter will use two subprime mortgage transactions issued in different time periods as examples to illustrate the changing credit quality of the underlying pools and the various structural features of subprime mortgage securities | |
| It will also analyze the unique prepayment pattern and trading convention of subprime mortgage securities | |
| An analysis on the causes of the collapse of the subprime mortgage securities market and remedies for the market recovery will be provided in Chapter 14 | |
| Evolution of the Subprime Mortgage Market | |
| Features of Home Equity Loans | |
| Varying Characteristics of Pools of Subprime Mortgages | |
| Examples of Transactions | |
| Unique Prepayment Pattern | |
| Performance of Credit Ratings | |
| Trading and Relative Value | |
| Commercial Mortgage Backed Securities | |
| The commercial mortgage-backed securities (CMBS) market is one of the youngest sectors of the asset securitization market | |
| While it already existed in the mid-1980s, the market only began to develop rapidly after the mid-1990s | |
| From 1985 to 2009, issuance of CMBS totaled $1,230 billion with the yearend 2009 outstanding balance amounting to $700 billion | |
| From the cash flow structural point of view, a CMBS is no different from that of a RMBS discussed in the previous chapters | |
| However, the underlying assets (commercial mortgages) for CMBS are vastly different from those for RMBS with respect to the underwriting criteria of the underlying mortgages, the securing properties, and the sources of the cash flow to service the mortgages | |
| In addition, and more important, the commercial mortgages on average have markedly higher incidences of default than prime residential mortgages | |
| From that perspective, for credit rating purposes, the credit support levels for CMBS are substantially higher than those of private-label mortgage securities but lower than those of subprime mortgage securities. | |
| This chapter will first present a brief history on the development of the CMBS market | |
| Then, it will compare features of commercial mortgages with those of residential mortgages | |
| Like the previous chapters, an example of a representative transaction will be used to illustrate the salient cash flow structure and credit enhancement of a CMBS | |
| The incidence of default, which is a particularly important factor that contributes to the prepayment of commercial mortgages, will be discussed along with the empirical evidence of default frequency and loss severity | |
| This discussion will be followed by a review of the performance of credit ratings of CMBS | |
| Finally, it will present the relative value and trading of CMBS | |
| History of the Commercial Mortgage-Backed Securities Market | |
| The Origination of a Commercial Mortgage | |
| Defaults and Losses of Commercial Mortgage Loans | |
| A Typical CMBS Transaction | |
| Performance of Credit Ratings | |
| Trading and Relative Value | |
| Asset-Backed Securities | |
| As mentioned in the introductory chapter, asset-backed securities, in a narrower sense, include securities backed by non-residential and non-commercial mortgage assets, such as credit card receivables and automobile loans | |
| These securities started to grow rapidly in the late-1980s | |
| This chapter will describe two most important types of ABS: credit card receivable-backed securities (credit card ABS) and auto loan-backed securities (auto ABS) | |
| In many ways, the cash flow structure and credit enhancement of other ABS resemble either those of the credit card or auto ABS | |
| To avoid repetition, this chapter will discuss only the two important ABS | |
| For credit card ABS, this chapter will first describe the underlying collateral, the different types of issuers, and unique transaction parameters | |
| Then, it will present an example of a typical transaction to illustrate the transaction parameters, the cash flow pattern of credit card receivables, and the specific credit enhancement mechanism | |
| For auto ABS, this chapter will also discuss the major types of issuers, the cash flow of auto loans, and the unique features of credit enhancement | |
| The prepayment aspect of auto loan ABS, which is different from the payment of RMBS will also be discussed | |
| The final section will present the performance of credit rating performance and relative value of the two ABS | |
| The Growth of the ABS Market | |
| Credit Card Receivable-Backed Securities | |
| Auto Loan ABS | |
| Performance of Credit Ratings | |
| Trading and Relative Value | |
| Collateralized Debt Obligations | |
| For all securitized transactions discussed in the previous chapters, the underlying assets are residential mortgages, commercial mortgages, or consumer loans (credit card receivables and auto loans) | |
| The cash flows of these assets are sold primarily by their originators to investors for funding through an SPE | |
| In all cases, the SPE is just a shell, owning the pool of underlying assets as the only asset and having the securities it issued as the only liability | |
| This SPE is a neutral trust in the sense that it has no one managing the pool of underlying assets as an investment portfolio | |
| There is only the trustee-appointed servicer, who collects the cash flow generated from the underlying assets and passes the cash flow through the SPE to investors | |
| To the extent that the servicer manages the cash flow, it is only in the manner of allocating it for the purposes of maturity and credit tranching | |
| Collateralized debt obligations (CDOs) are also a product of asset securitization | |
| However, CDOs are different from all the previously discussed asset securitization in many aspects | |
| Most significant, the underlying assets of CDOs are managed as an investment portfolio by the sponsor (or sponsor-designated portfolio manager), who creates the SPE that issues the CDO securities to investors | |
| Also, CDOs have heterogeneous underlying assets that contrast sharply with the homogeneous assets of RMBS, CMBS, and ABS | |
| In fact, there are many types of CDOs that they are different among themselves | |
| This chapter will first introduce the market development of CDOs | |
| It will then discuss the following topics: (1) the basic concept of a CDO, (2) the various types and structures of CDOs, (3) the motivation of issuing and the incentives in investing in CDOs, (4) the credit rating of CDOs, and (5) the trading and relative value of CDOs | |
| Basic Concept and Market Development of CDOs | |
| CDOs Are Not Mutual Funds | |
| Different Structural Types of CDOs | |
| Motivations of Issuing and Incentives of Investing in CDOs | |
| Credit Ratings of CDOs | |
| Standard & Poor's CDO Evaluator | |
| Trading and Relative Value | |
| The Collapse and Recovery Prospects of the Asset Securitization Market | |
| During the heydays of subprime mortgages in the mid-2000s, there were already concerns about their inherently high credit risk | |
| Unfortunately, the market paid no attention to these concerns and the party of originating vast amount of subprime mortgages continued | |
| In mid-2006, amid the hiking of interest rates by the Federal Reserve and the leveling of housing prices, there were abundant signs of subprime mortgages experiencing higher-than-anticipated delinquencies and defaults | |
| By early 2007, several leading originators suffered heavy financial losses for having originated voluminous non-performing subprime mortgages and declared bankruptcy | |
| By the end of 2007, the subprime mortgage market collapsed | |
| It ultimately brought down the asset securitization market | |
| The subprime mortgage market was doomed to collapse for one fundamental reason: deteriorating mortgage underwriting standards | |
| The escalating interest rates and the burst of the housing price bubble in early 2007 only hastened and exacerbated the unavoidable disaster of subprime mortgages | |
| Most unfortunate, the securitization process, which by itself is a neutral financing method of bridging investors and borrowers, spread widely the negative impact of subprime mortgages onto the entire financial market | |
| The financial crisis slowed down economic activities and caused a severe economic recession | |
| None of the intermediaries in the securitization process can escape blame for the collapse of the subprime mortgage securities market | |
| This chapter will examine the causes of market failure by reviewing some of the necessary elements for developing an asset securitization market, which were discussed in the introductory chapter | |
| It is ironic that the long matured U.S | |
| market would fall precisely because it had forgotten the very fundamentals that nurtured its growth in the first place | |
| After the review, actions that would revitalize the market will be discussed | |
| The experience of the past four decades strongly suggests that the U.S | |
| economy needs a healthy asset securitization market to finance steady growth | |
| How the Market Collapsed | |
| Prospects for Recovery | |
| Asset Securitization in Asia-Pacific | |
| “Imitation is the sincerest form of flattery.” For the U.S | |
| asset securitization market, the ultimate complement is in the volume and speed with which advanced and emerging capital markets adopted this financing method | |
| European countries started to pattern after the innovative financing technique of asset securitization in the late 1980s | |
| In the meantime, Japan and Australia in Asia-Pacific also practiced in earnest asset securitization as a creative means to satisfy the financing needs of consumers and businesses | |
| The asset securitization products also satisfied the investor demands for a variety of innovative investment instruments | |
| This chapter will provide a brief review of the asset securitization market in Japan, Australia, Taiwan, and China | |
| Asset Securitization in Japan | |
| Asset Securitization in Australia | |
| Asset Securitization in Taiwan | |
| Asset Securitization in China | |
| Table of Contents provided by Publisher. All Rights Reserved. |
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