Residential mortgage securitisation in the Italian market
An expansion study for the ABC Bank
Non-confidential public version
Lennart Hiemstra
Amsterdam, august 2007 Rijksuniversiteit Groningen
Study: “Technische Bedrijfswetenschappen” at the Faculty of Management and Organisation Supervisor: drs. D. Tavenier
Assistant supervisor: dr. P.E. Kamminga
To protect confidential information this thesis has been edited. All references to the company involved have been
replaced with company “ABC”. Other links and clues to this company have been replaced with “--Removed from public thesis--“. The original version remains confidential and will not be published.
Summary
ABC bank is a specialized English merchant bank. One of its specialisations is Residential Mortgage Securitisation. ABC has expressed the wish to expand to new markets. After a short study Italy has been selected as a target for research. To facilitate similar future studies first a framework is developed that lists requirements a new country should fulfil. This framework will then be used to examine the possible entry of ABC on the Italian mortgage market.
A residential mortgage is a loan with a fixed or variable rate that is secured by a piece of real estate that can be repossessed in the event of a default. In a mature mortgage market several types of companies distribute mortgages; banks, insurance
companies and mortgage intermediaries. Acceptation criteria such as loan to value ratio are set when distributing mortgages.
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Funding mortgages is traditionally done by using deposits. This can however create a liquidity problem. An alternative is securitization of mortgages by issuing Residential Mortgage Backed Securities (RMBS). With securitisation assets are removed from the balance sheet by selling them to a separate entity. This entity finances this purchase by issuing securities. These securities are backed by the purchased assets and are rated by one or more rating agencies. The entity is a special purpose vehicle (spv) which is created only for this transaction.
A securitisation transaction separates specific asset risk from the risk associated with a company. In this way a company with a low credit rating can attract cheap debt for highly rated assets. The average asset risk is split into several tranches with
different risk-return levels, attracting investors with different risk appetites. Also liquidity is enhanced. These advantages can make mortgage financing by securitisation cheaper then direct financing.
The credit level of issued securities is enhanced by subordination. Junior notes are used to cover any losses, providing
protection for senior notes. The most senior notes in a residential mortgage transaction receive an AAA credit rating and make up over 90% of the securities issued.
A securitisation transaction starts with establishing a SPV. This SPV contracts several parties to ensure its safety and credit level. A trust company receives ownership and official management. A liquidity provider covers any short term liquidity mismatches and an interest swap is used to convert incoming fixed interest into a floating rate payable to investors. Assets are transferred from the originator to the SPV by means of a ‘true sale’ which makes the SPV bankruptcy remote from the
originator.
ABC’s concept of principal finance is based on securitising residential mortgages. ABC provides financing to business partners such as insurance companies and mortgage intermediaries. Servicing of mortgages is outsourced to specialised servicers. When sufficient mortgages are on ABC’s balance sheet a securitisation transaction is started. Afterwards ABC’s balance sheet is
‘empty’ again, providing room for new funding of mortgages. This is called ‘balance sheet velocity’ and provides basically unlimited funding to business partners.
The base of this concept is risk based pricing of mortgages. This means mortgage interest levels are based on a securitisation structure, where the risk level of underlying assets is the main component of the price column. The price structure is build up with a profit margin, securitisation expenses, pipeline risk, servicing fees, prepayment risk, credit spread and the relevant Euribor interest swap rate. The sum of these make up the mortgage interest rate as offered to the customer.
The credit spread is the compensation to investors for the risk they undertake by investing in these securities. This spread is based on the underlying mortgage portfolio. It is calculated by first creating a virtual mortgage portfolio with the expected characteristics, like average loan size and loan to value ratios. This virtual portfolio is then run through a model which
calculates the credit enhancement and resulting pricing. A similar model is used by rating agencies. The prepayment risk is the risk a mortgagee repays its mortgage sooner or later than expected. This results in a cash surplus or shortage, which must be invested or borrowed at mismatching interest levels. Expected prepayment behaviour is modelled and a swap is purchased to cover against deviations.
For this concept to work in another country certain requirements have to be met. The mortgage market must be of sufficient size and show growth potential. This market needs to be mature and distribution has to be possible through intermediaries. It also should be possible to outsource servicing. Next the securitisation market has to be developed and established. With these
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basic conditions in place ABC must also be able to operate competitively. Pricing of mortgages has to be at the top of the market to attract customers and business partners.
In part two of the thesis the Italian market is examined for these characteristics. The Italian mortgage market grows with 17- 20% per year with a 2005 volume of €238 Billion. The residential debt to GDP ratio is very low at 15%, showing potential for growth. Distribution through intermediaries is currently around 30%, coming from 10% only 4 years ago. The market is
dominated by low LTV mortgages with a variable interest rate.
The residential securitisation market is large and mature. In 2006 €19,6 Billion was securitised in 14 transactions. No
substantial legal or other boundaries exist on this market. Several servicers exist that are capable of professionally servicing a mortgage portfolio. Securitisation performance varies geographically and with the LTV ratio. Distribution should focus on the North of Italy and the default level of higher LTV mortgages can be priced in the transaction.
When pricing potential mortgages according to the risk-based pricing model a competitive price is calculated for mortgages with a floating interest rate. For most loan terms and LTV levels the cheapest mortgage can be offered. For fixed rates the price level is in the middle of the market, but floating rates make up 70% of the market.
Entering this market can be done by starting an Italian subsidiary, by purchasing a local bank or mortgage intermediary, or by setting up a joint venture. When starting originating mortgages it will take time before a sufficient volume is gathered to initiate a securitisation transaction. This can take one to two years.
It can be concluded that expansion to the Italian mortgage market can be feasible for ABC. The mortgage market is large and growing, securitisation is possible. Mortgage pricing leads to a competitive offer. Distribution through intermediaries is possible, partners yet have to be searched for. The best entry strategy will have to be decided upon by ABC.
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Contents
1 Introduction ... 12
1.1 ABC Bank ... 12
1.2 History ... 12
1.3 Strategic Business Units ... 12
1.4 Real Estate Securitisati on ... 13
1.5 Moti ve for research ... 14
2 Research design ... 17
2.1 Problem Statement ... 17
2.2 Research Goal ... 17
2.3 Research steps ... 18
2.4 Data sources ... 20
3 Residential Mortgages ... 23
3.1 Introduction ... 23
3.2 Mortgage characteristics ... 24
3.2.1 Loan term ... 24
3.2.2 Interest rate ... 24
3.2.3 Tax ... 25
3.3 Funding ... 25
3.4 Distribution ... 26
3.5 Acceptation criteri a ... 27
3.5.1 Loan to Value... 27
3.5.2 Debt-to-income... 28
3.6 Servicing ... 29
4 Securitisation ... 30
4.1 Introduction ... 30
4.1.1 Overview ... 30
4.1.2 History of securi tisation ... 31
4.2 Types of securitisations ... 32
4.2.1 Asset backed securities ... 32
4.2.2 Future-flow financing ... 32
4.2.3 W hole business securitisation ... 32
4.2.4 Synthetic securitisation ... 33
4.3 Structure ... 34
4.3.1 True sale ... 38
4.3.2 Credit enhancement ... 38
4.4 Benefits of securi tisation ... 39
4.4.1 Issuer benefits ... 40
4.4.2 Investor benefits ... 41
4.4.3 Social and economic benefits... 41
4.5 Residential Mortgage Based Securitisation ... 42
4.5.1 Introduction ... 42
4.5.2 The Origi nation phase ... 43
4.5.3 The Structuring Phase ... 43
4.5.4 The Distribution Phase ... 44
4.5.5 Servicing ... 45
4.5.6 Prepayment ... 46
4.5.7 Interest Swap ... 49
4.5.8 Rating Agencies ... 49
5 ABC’s concept of principal finance ... 52
5.1 Introduction ... 52
5.2 Activities at RES ... 52
5.2.1 Origination ... 53
5.2.2 Portfolio Management ... 54
5.2.3 Securitisation ... 56
5.3 Pricing ... 56
5.3.1 Expenses ... 58
5.3.2 Pipeline risk ... 58
5.3.3 Servicing fees ... 59
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5.3.4 Prepayment risk ... 59
5.3.5 Credit spread ... 61
5.3.6 Conclusion pricing ... 66
5.4 ABC’s core competence ... 67
6 Framework for Risk Based Pricing in a new market 71 6.1 Introduction ... 71
6.2 Residential mortgage market ... 72
6.2.1 Market si ze and growth ... 72
6.2.2 Housing market ... 72
6.2.3 Tax deductibili ty ... 73
6.2.4 Legal status of mortgage ... 73
6.2.5 Distribution structure ... 74
6.2.6 Banking market ... 74
6.3 Securitisation market ... 74
6.3.1 True sale ... 75
6.3.2 Investor trust ... 75
6.3.3 Servicing ... 75
6.4 Pricing ... 76
7 Italian residential mortgage market... 78
7.1 Residential mortgage market ... 78
7.2 Banking market ... 78
7.2.1 Concentration ... 79
7.2.2 Foreign Banks ... 80
7.2.3 English Banks ... 81
7.2.4 Market Entry ... 81
7.3 The Mortgage market ... 82
7.3.1 Housing ... 82
7.3.2 Historical development ... 82
7.3.3 Mortgage Volumes ... 85
7.3.4 Mortgage History ... 86
7.3.5 Underwriting ... 91
7.3.6 Legal ... 91
7.3.7 Performance ... 92
7.3.8 Funding ... 94
7.4 Possibilities for ABC ... 94
8 RMBS market... 96
8.1 General information ... 96
8.1.1 RMBS market ... 96
8.1.2 Typical features ... 97
8.2 Origination ... 97
8.3 Structures ... 98
8.4 Performance ... 98
8.5 Servicing ... 99
8.6 Legal ... 100
8.7 Taxes ... 101
9 Pricing ... 102
9.1 Introduction ... 102
9.2 Credit Spread ... 103
9.2.1 Mortgage pool creation ... 103
9.2.2 Credit risk pricing ... 104
9.3 Prepayment risk ... 110
9.4 Expenses ... 111
9.5 Pipeline risk ... 112
9.6 Servicing fees ... 112
9.7 Final Pricing ... 112
9.8 Conclusion pricing ... 115
10 Entering Italy ... 117
10.1 Entry mode ... 117
10.2 Time ... 119
10.3 Exit ... 119
11 10.4 Conclusion ... 119
11 Conclusion... 121 12 Bibliography... 123 13 Appendices ... Error! Bookmark not defined.
To protect confidential information this thesis has been edited. All references to the company involved have been
replaced with company “ABC”. Other links and clues to this company have been replaced with “--Removed from public thesis--“. The original version remains confidential and will not be published.
1 Introduction 1.1 ABC Bank
ABC Bank NV (ABC) is a specialized merchant bank situated in London. Its activities are concentrated in North-West Europe, consisting of loan and intermediate finance, advisory services and structured and risk management products to mid-sized corporates and institutional investors. ABC has a worldwide distribution network effectuating their business model of regional origination with global distribution. In Figure 1.1 key performance figures for ABC Bank are given for the years 2003 to 2005.
1.2 History
--Removed from public thesis--
Figure 1.1. Key performance figures for ABC Bank NV, 2003-2005.
--Re moved from public thesis--
1.3 Strategic Business Units
--Removed from public thesis--
Figure 1.2 ABC Organisation Chart. Source: ABC document ABC Organisation Chart, 1-11-2006
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--Removed from public thesis--
1.4 Real Estate Securitisation
The research for this thesis will take place in the Strategic Business Unit Real Estate Securitisation (RES). Access to the capital markets is used to finance activities in real estate. Assets are originated with the purpose of refinancing them in the capital markets. This business model RES is utilising is called “Principal Finance”. Refinancing is done by securitisation, a technique of structuring illiquid assets into tradable bonds. Securitisation will be extensively dealt with in
Chapter 3.
RES operates around three asset classes; Residential Mortgages, Commercial Mortgages and non-real estate securitisation. The experience gained in mortgage securitisation is used to securitise other asset classes than mortgages, like business loans. This is where the non-real estate business unit is active. Commercial mortgages are originated and securitised, or securitised as a service for a third party, by one business unit. Recently this business unit is reshaped into a joint venture with the commercial real estate business unit from corporate finance. A recent high-profile deal is --Removed from public thesis--
Residential mortgages are originated by the origination business unit. When on ABC’s balance sheet the Residential Mortgage Structuring team structures the mortgages and securitises them, creating room for new origination. A recent deal performed for a third party is --Removed from public thesis--. The business model of residential mortgages will be explained in chapter 4.
The Residential Mortgage Structuring team is the initiator of this research.
Figure 1.3 Real Estate Securitisation Organisational Chart.
Source: ABC document ABC Organisation Chart, 1-11-2006
--Removed from public thesis--
1.5 Motive for research
Recently a (--edit for public thesis--) renewed focus was given to growth. All SBUs are expanding their businesses. RES is looking for international expansion of securitisation activities into new European countries. Opportunities are sought in new countries to use the extensive experience RES has in mortgage origination and financing. Recently studies have been
undertaken to enter the X(edited) and Y(edited) residential mortgage market.
--Removed from public thesis--
The largest Western European mortgage markets are the UK (€1243 Bil), Germany (€1157 Bil), The Netherlands (€518 Bil), France (€432 Bil), Spain (€385 Bil), Italy (€197 Bil), Denmark (€174 Bil) and Sweden (€147 Bil). (See figure 1.4) After
consideration of the banking markets, mortgage financing practices and growth opportunities the decision was made by ABC to focus research on Italy.
With 58 million inhabitants Italy has the fourth largest population in Europe with the sixth largest residential mortgage market measuring almost 200 billion euro. The residential debt to GDP ratio stands at 15% which is one of the lowest in Europe, showing potential for growth. Part two of this thesis will focus on research on this market.
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The management of RES wants to structure the way in which new markets are explored. Previous studies were done on an ad hoc basis. The approach to market research from these studies has not been documented. Now every new research has to be set up again from scratch. To improve and speed up future research a second goal of this research will be to provide ABC with a framework on which to test new markets.
Figure 1.4: 2005 largest mortgage markets in Western Europe Sources: EMF, Housing Statistics, Fitch, Standards and Poors
Population (Million)
Mortgage market (€M)
RMBS Volume (€B)
RMBS
# Deals
Residential Debt / GDP
UK 60 1243 72.5 41 73%
Germany 82 1157 2.4 4 52%
Netherlands 16 518 25.9 19 111%
France 60 432 4.9 6 26%
Spain 41 385 28.2 27 46%
Italy 58 197 9.8 11 15%
Denmark 5 174 0.1 1 90%
Sweden 9 147 0.3 1 53%
Belgium 10 88 0.0 0 31%
Ireland 4 77 1.8 1 53%
This table summarises research on the European mortgage and securitisation market. The volume and number of Residential Mortgage Based Securitisation (RMBS) deals is an indicator of the maturity of the securitisation market in a country. The residential debt vs. gross domestic product ratio tells us about the relative size of the mortgage market. A high ratio signals a mature market where the use of mortgages is widespread and mortgage are of a high value compared to the value of the house.
(Loan to value ratio).
The decision to focus research on Italy was made by eliminating this list top-down. The German market --Removed from public thesis--. The France market was seen as very protective and to difficult to enter. The Spanish and Italian markets then both had potential. The Spanish market faced the most competition, and ABC management had other interests in Italy which would make a good combination with mortgage finance. The decision then was made by RES management to research the Italian mortgage and securitisation market.
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2 Research design
In this chapter the design of the research will be set out. In the previous chapter it is made clear where the research takes place and what the motive from ABC is for this investigation. Now we will formalise the objectives into a problem statement and research goal according to scientific practises.1 Research steps taken towards the solution will be explained and the total research summarised in a conceptual model. This provides structure in creating, and reading, the rest of the thesis.
2.1 Problem Statement
ABC wants to enter new markets using her experience in originating and securitising residential mortgages. Out of a longlist of European countries Italy has been selected as having the most potential. It is not known if expansion with ABC’s model of risk-based pricing to the Italian residential mortgage market is feasible. In the near future more countries will be looked upon to expand into, but there is no standardised method to evaluate new markets.
2.2 Research Goal
The goal of this research is to advice ABC on the possibilities the Italian market has for risk-based pricing. It should be possible to easily repeat this research for other countries ABC later on might be interested in. This goal is formalised in a research objective and a research question.
Research Objective
Create a framework on which new markets for ABC’s model of risk-based pricing can be tested. Use this framework to research the Italian mortgage and securitisation market. Find out if the ABC’s model is competitive and feasible in this market.
1 De Leeuw, bedrijfskundige methodologie
Research Question
What are the requirements to successfully compete on a new market using ABC’s model of risk-based pricing and does the Italian mortgage and securitisation market meet these requirements?
2.3 Research steps
In order to reach these goals a number of steps need to be taken. The research is divided into two parts, where the first part will focus on investigating what the requirements exactly are for successful entry to a new market. These requirements then can be used again in future feasibility studies. The second part will be a feasibility study into entry on the Italian mortgage market using these requirements.
The first part will look into ABC’s model of risk based pricing. This model consists of mortgages and securitisation, so these two topics have to be dealt with first. This will be done in the chapter “Residential Mortgage Based Securitisation”. We will look into literature on mortgage based securitisation and use practical information from the field. With this foundation in place steps can be taken to look into ABC’s model as used in The United Kingdom. The first part of the thesis can then conclude in building a framework of requirements the model needs to operate successfully. This framework should be reusable for research in other countries.
In part two the Italian market will be researched using the framework developed in part one. According to the steps in the model, the Italian residential mortgage market will be described in chapter 6, concluding with an analysis for ABC’s
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possibilities here. Next the RMBS market will be researched, also ending with options for ABC. When these topics are
combined pricing can be calculated for ABC’s model of risk-based pricing. This will be compared with local competition to see if these prices are competitive. In the conclusion will be summarised if the framework’s requirements are met and if expansion to Italy is feasible for ABC. In the last chapter I will look into the actual entry into Italy. What are the advantages and
disadvantages of possible entry modes.
This study can be summarised schematically in a conceptual model. All research objects are given as well as the relation these subjects have with each other.
Figure 2.1 Conceptual Model
2.4 Data sources
Academic literature on the subject of mortgage securitisation will be used in constructing the framework. The work of Fabozzi and Modigliani has set the standard for securitisation literature. Next research from business administration will be used to evaluate entry possibilities in a new market.
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Practical information will play a major role. Business reports from securitisation specialists and national bodies like the
national banks are used next to reports from rating agencies and industry organisations. Especially data on the Italian market is gathered from these sources
Next to these secondary sources primary data will be retrieved from interviews with ABC employees and with market specialists.
Part I
Working towards a framework of requirements for entry into new markets of ABC’s mortgage finance model.
In the first part of this thesis I will explain ABC’s model of principal finance and analyse how new markets can be evaluated.
To explain this model, I will start with a chapter about residential mortgages. The mortgage market, mortgage characteristics, funding and distribution will be examined.
Next, mortgage securitisation will be explained. The history of securitisation, types of securitisations and the structure of a transaction will be explained.
The knowledge introduced in these two chapters is used to explain ABC’s model of principal finance and risk based pricing. I will look into the capabilities of ABC and see if there are core competences that make this company unique in this market.
With the model analysed we can look into the requirements for a new market. What should be analysed and which conditions have to be met when starting this business in a new country.
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3 Residential Mortgages
In this chapter mortgage finance, securitisation and the combination of these items into residential mortgage backed
securitisation (RMBS) are explained. Some aspects of securitisation will be dealt with in the chapter of RMBS although they might also apply to different forms of securitisation.
3.1 Introduction
“A mortgage is a loan that is secured by an underlying asset that can be repossessed in the event of default.”2 The terms mortgage and mortgage loans are used intertwined. A mortgage is the legal device used to secure the asset, but is used to
designate the debt secured by the mortgage, being a mortgage loan. I will follow general practise and use both terms to refer to the secured debt.
In residential mortgages the underlying asset is a residence, in contrast to commercial mortgages with for example offices or shops as collateral. The collateral serves as a guarantee to the lender in case of non-payment reducing the risk-level and the price of the loan. A mortgage loan is for a larger amount and lower interest fee then otherwise would be lend to the person or company.
Traditionally mortgages were level-payment fixed-rate and not fully amortizising over time. Also banks had the right to ask for full repayment on short notice, even if the mortgagor was on its payment schedule. During the Great Depression in the USA banks liquidated their loans and forced borrowers to repay, although they were unable to do so. This forced people into
2 Fabozzi 2006
bankruptcy leading into a deepening of the economic crisis and motivated change in the mortgage system in the years after. In the 1930s fully amortizising products, mortgage insurance and governmental agencies to protect both borrowers and lenders came into existence. The market for mortgages has since grown to be one of the pillars under a modern countries economy. In many countries a mortgage is the most common way to finance the purchase of a house.
3.2 Mortgage characteristics
Mortgages are defined along several key characteristics. The seniority of the loan in case of a default is dictated by the lien status. A first lien mortgage has the first claim on the proceeds of forced liquidation of the asset. The second lien only has access to the proceeds after the first lien loan is fully repaid. A second lien mortgage can for example be used to liquefy a rise in the market value of the property. Proceeds from the second lien loan then can be used for personal expenditures or home improvement. When a first lien mortgage does not cover the purchase price of the real estate sometimes a second lien loan is taken out for the remaining part. In the mortgage market the majority of first lien mortgages are not supplemented by a second lien mortgage.
3.2.1 Loan term
At origination the term for the loan is set. The most common loan term is 30 years. However, terms of 5, 10, 15 or 20 years are possible too. The amortization schedule is based upon this term. With a shorter term loan buyers build equity more quickly and have larger monthly payments. The monthly mortgage payment is inversely related to the term of the loan. In the basic form the mortgage normally is repaid at the end of the term.
3.2.2 Interest rate
Mortgages exist in a wide variety. The interest rate can be flexible, following the market rates, or fixed for a certain period.
This can vary usually from 1 year to 30 year and anything in between. At the end of a fixed rate period the lender has the
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option to settle a new fixed rate, switch to a floating rate or redeem the mortgage and refinance somewhere else. On all mortgages interest has to be paid and the loan value repaid, but several options exist on how to do this. A lenders choice will depend on their current and expected future financial situation. Monthly payments can increase over time, decrease or stay constant. Another possibility often is not to repay any principal until maturity of the loan. In countries with a high degree of interest tax deductibility it is often profitable not to repay any principal during the term of the loan. This especially leads to a wide range of mortgage products.
3.2.3 Tax
In The United Kingdom a wide range of products exist. The catalyst for product development has been the tax regime that promotes home ownership. Over a period of 30 years interest payments may be deducted from income tax. This has led to a situation where it is profitable to postpone repayment of the mortgage. Suppliers of mortgages have developed different product to maximise this tax advantage. This tax deduction of interest differs per country. Some countries have abolished it during the past decade. This has drastic consequences on the housing market and on the economics of a country. House prices can drop and the financial stability of people can change overnight creating a downturn in the economy. In English politics the question of interest deductibility is a very delicate issue.
3.3 Funding
Funding basically means where the mortgage lenders get the money to lend to their customers in the form of a mortgage loan.
A wide variety of sources and methods exist for retrieving funds. The dominant and oldest one is the use of deposits placed by consumers with the bank as savings or current accounts. Here however a funding mismatch occurs. Deposits are short term loans, consumers can retrieve them on short notice. These are used to fond long term assets, the mortgages. This mismatch can lead to liquidity problems when many consumers withdraw their savings. --Removed from public thesis-- Deposits also are often offered on variable rate. This can increase the cost of providing long term fixed mortgage loans. A geographical
mismatch can also occur, when in one part of a country saving balances are high and demand for mortgages low, and in another part of the country, not served by the same bank, demand for mortgages is high but sufficient savings accounts are lacking.
The two other main sources of funding are Covered Bonds and Mortgage Backed Securities. Covered bonds have a long history as source for mortgage funding. These are debt instruments secured by a pool of mortgage loans. In event of default investors have a preferred claim over this collateral, making it a save instrument to invest in.3 Mortgage Backed Securities are debt instruments issued by setting up a securitisation transaction. Unlike with covered bonds the collateral is transferred off balance to a separate entity. The technique of securitisation will be dealt with in the next chapter.
3.4 Distribution
Traditionally mortgages were only issued by banks. Someone looking to obtain a mortgage would go to his or hers home bank and apply there. The banks would use its deposits or issue bonds and fund the mortgages. In many countries this is still largely the case. In The United Kingdom however, as in the US and several other countries, a complicated web of mortgage
distribution has developed. For a start distribution of mortgages to consumers and funding mortgages have been separated. Now only certain banks and insurers perform both these roles. Mortgages are marketed and distributed by numerous parties for different reasons. Banks still originate mortgages through their offices, but also through agents. Insurers also originate, often using mortgages to cross-sell insurance to the new customer. Customers are attracted with a cheap mortgage and in the
application process are convinced to take out several insurances or other products. Banks also use cross-selling, for example towards savings accounts or credit cards. Mortgage brokers, often in the form of national chains, act as an agent for different lending institutes. For every customer they try to find the best mortgage provider. Their independence however can be
questioned since their revenues come from a fee paid by the lender for every successful application. Examples of these are --
3 European covered bond council
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Removed from public thesis--. Internet also plays an important role, as well in information provision and broker function. All parties that have a role somewhere between the client and the funder are called mortgage intermediaries.
Factors affecting market
Property pricing is an influential factor in demand for mortgages. High house prices force people to borrow more since they are less able to finance a purchase. Also the amount borrowed rises so a larger part of income will be used for mortgage payments.
Supply and demand on the housing market affects pricing. A housing shortage leads to higher pricing. This in time makes people less inclined to move to a new home, increasing shortage again. Especially young people buying their first house are affected by higher prices. Their desired houses are occupied by people unable to move on to larger housing. Also government regulations and town planning can drag behind market demand.
3.5 Acceptation criteria
When a person applies for a mortgage the distribution agent has several criteria the client has to fulfil. These criteria are to make sure that the borrower will be able to pay back the loan. This involves the borrower’s personal circumstances as well as the underlying collateral. Especially the ratio between the value of the residence and the loan amount, called the Loan-to-Value ratio, is checked.
3.5.1 Loan to Value
In case of default the residence will have to be sold to redeem the mortgage. If the outstanding mortgage amount is larger than proceeds of the sale the lender will not be fully paid and incurs a loss. To prevent this loans are evaluated by their loan-to- value ratio (LTV). The LTV is an indicator of the amount to be recovered from a loan in the event of a default. A LTV of 80%
is generally regarded as safe for the lender. In The United Kingdom mortgages are distributed with a LTV of up to 130% LTV.
Internationally this is considered quite high. An important distinction to be made is how value is determined. This can be the value of the property at execution, the current market value or the purchase price as paid by the borrower. Especially the execution value, or foreclosure value, is quite a bit lower than the market value. This is about 85% of market value due to the time pressure and types of buyers when sold by execution auction. In The United Kingdom LTV is generally seen as the loan- to-foreclosure value, technically the LTFV.
Next to the amount to be recovered in case of default the LTV is also an indicator of the borrower’s willingness to pay. In a low LTV loan the borrower has put equity in the house. In case of default this equity will be lost, so the borrower will do his best to prevent this from happening. In a highly leveraged loan, indicated by a high LTV, little or no equity from the borrower is present so the incentive to prevent default is smaller. Several sources exist that show a high positive correlation between LTV ratio and default ratios. Especially in the high LTV area, above 80% this link is strong.4
The value of the residence can be determined in different ways. Usually the purchase price is taken. In higher priced houses the value is determined by a special agent. He visits the house and compares it with similar houses in the neighbourhood.
3.5.2 Debt-to-income
The second big criterium on which a loan is granted is the ability of the borrower to keep paying interest and principal. The part of the income that has to be used for mortgage payments is expressed as the Debt-to-Income ratio (DTI). An important distinction here is whether other possible loan payments are taken in account. This can for example be automobile loans and credit card payments. The DTI considering only payments concerning interest, principal, homeowners insurance and property
4 Fabozzi, Fitch
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tax is called the front ratio.5 The back ratio adds other debt payments to the total payments. In The United Kingdom a DTI of 20-30% is common, using the front ratio. However, when the borrower also has large other debts these are taken into account as well. In most countries the maximum is 35%.
3.6 Servicing
Servicing is the term used for all administrative operations necessary supporting a mortgage. This involves collecting monthly payments from mortgagors and forwarding these to the owner of the loan; reminding mortgagors when payments are overdue;
recording principal balances; starting foreclosure procedures when applicable; keeping an escrow balance for tax and
insurances and furnishing tax information to mortgagors when necessary.6 For this special servicing companies exist. In The United Kingdom market leader in servicing is --Removed from public thesis--. They manage all client contact and collect payments. These payments are immediately passed on to the owner of the mortgages. Payment of a servicer is usually calculated as a percentage of the mortgage. Servicing can also be performed be the originating company. In many countries banks keep servicing their portfolio after it is sold.
5 Fabozzi
6 Fabozzi and Modigliani ‘92
4 Securitisation 4.1 Introduction
To explain the process of securitisation I will begin with the, according to Kravit, Mayer, Brown & Platt, most common
definition: “Securitisation consists of the pooling of assets and the issuance of securities to finance the carrying of the pooled assets.” Of course, securitisation is much more than this. This chapter will try to cover the important aspects of modern day securitisation. First I will give an overview of securitisation in general by explaining the process, its history, the different forms and the benefits associated with securitisation. Next, I will focus on residential mortgage based securitisation.
4.1.1 Overview
Securitisation started in the 1970’s and has gained popularity ever since. It is used by financial institutions and businesses alike to realize the present value of a cash generating asset. Numerous types of assets can be securitised. When an asset generates a stable and predictable cash flow the possibility of securitisation exists. Asset classes that are actively securitised are among others, residential and commercial mortgage loans, trade receivables, auto loans, corporate loans, credit card receivables, student loans and whole businesses. These assets have in common a stable and predictable stream of payments.
These are used to make interest and principal payments on the debt securities issued. The basic concept of securitisation is applicable to almost any asset that has a predictable future flow of revenues. One of the most exotic securitisations has been David Bowie’s 1997 sale of future royalties income for $55 million (CNNmoney august 2003)
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Securitised assets generate a lump sum for the originator in stead of payments spread out over time. Securitised assets are split into two categories, mortgage-based securities (MBS) and asset-backed securities (ABS) for all non-mortgage assets. When assets are corporate loans or bonds, the bonds are named Collateralised Debt Obligations (CLO), with Collateralised Bond Obligations (CBO) for bonds and Collateralised Loan Obligations for corporate loans.
4.1.2 History of securitisation
Mortgage-backed securitisation started in the 1970’s in the USA. Before this whole loans were traded for some time. This primary market however was relatively illiquid. Mortgage lender had trouble buying and selling whole loan mortgages in time and at acceptable prices. Trading loans involved a lot of paperwork and detailed operations, making it an expensive business.
In 1970 the Government National Mortgage Association (GNMA), also called Ginnie Mae, guaranteed the first mortgage pass- through securities that pass the principal and interest payments on mortgages through to investors (Cowan, 2003). This was a major breakthrough in the secondary mortgage market. The issuance of bonds backed by a pool of government guaranteed mortgages created a liquid secondary market, making it much more attractive to investors and lenders. The government backed guarantee made these bonds about as safe as government bonds, however, with a wider spread than government bonds. Since the 1970’s this market has grown to over $3.6 trillion at the end of 2006 (Bond Market Association). The first MBS
transactions were all based on residential mortgages. Later commercial real estate was used to issue commercial mortgage based securities. With the continued development of this market new asset classes like equipment leases and credit card receivables were introduced.
4.2 Types of securitisations
4.2.1 Asset backed securities
The largest class of securities is that of asset backed securities. These securities are backed by a pool of assets. These assets can be very diverse; credit card receivables, residential and commercial mortgages, real estate, equipment leases, auto loans, trade receivables, corporate loans and debt obligations and possibly new asset types that are continuously looked in. In these classes, mortgage securities make up a segment on their own, called Mortgage Backed Securities. All securities backed by assets other than mortgage are called Asset Backed Securities. Figure 4.1 shows the classes of Asset Backed Securities.
4.2.2 Future-flow financing
Backed by specific cash flows generated in the normal course of business of a company or government. This can be export receivables, government tax income, settlement fees. This type of securitisation is somewhat exotic, specific structures are set up for every transaction.
4.2.3 Whole business securitisation
Securitisation backed by the revenue stream of an entire company, or whole business. This can be seen as an asset backed security, where the asset is one complete company. However, not the company itself is backing the security, but its future cash flow is.
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4.2.4 Synthetic securitisation
Not a real securitisation, but the effects of a securitisation transaction or imitated by a combination of structured finance and credit derivative techniques. The purpose is to transfer the risk associated with the assets, without actually transferring the assets themselves.
Figure 4.1 Types of Asset Backed Securities
4.3 Structure
A securitisation structure starts with assets being originated by a company and funded on that company’s balance sheet. This can be done by buying an entire portfolio of assets, or by originating these assets one at a time, for example through
distribution agents. These assets generate a cash flow, for example credit cards payments, lease payments, company profits in the case of a whole business securitisation, or interest and principal payments on mortgages. The originating company, referred to as the “Originator”, then arranges for a new separate entity to be set up, called a “Special Purpose Vehicle” or “Special
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Purpose Entity” (SPV or SPE). This SPV is legally separate from the originator; ownership is usually in the hands of a specialized trust company. The originator sells the pool of assets to this SPV. The SPV finances this purchase by issuing bonds. An underwriter sells these bonds to institutional investors and makes sure a liquid secondary market is maintained. The cash flow generated by the assets is used to pay interest and principal on these bonds. The bonds usually are tranched in
different classes with varying maturities and risk levels, using credit enhancement. All risk associated with these assets is structured in tranches with different risk levels. Investors now can choose the level of risk-return that fits their needs, and trade in these bonds. In contrast, the original assets have only one single level of risk and were relatively illiquid. The
securitisation transaction has now established three goals. The first being separating the assets from their originator and thus separating their risk levels. When pricing these assets any risk associated with the originator is separated. Only the risk associated with the assets themselves is regarded. The second goal is increased financing efficiency by splitting the single average risk-return level into several levels as demanded by the market. This is schematically shown in figure 4.2. Third the illiquid assets have been transformed into liquid bonds tradable on the secondary market. Due to this efficiency and liquidity increase and risk separation an arbitrage exists between payments received from the assets and payments made to the
bondholders, creating a profit for the originator.
Figure 4.2 a basic securitisation structure
Ass et s
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Figure 4.3 risk-return (source: ABC presentation; edited)
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Obligors Investors
Interest Sw ap Liquidity provider Credit enhancement
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The balance of a SPV consists of Assets in the form mortgages, and Liabilities in the form of securities sold to investors. The average risk level of the mortgages is split into securities with different risk levels. Investors can choose AAA notes with a low risk and low return to BBB notes or the first loss, with a high risk and return.
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4.3.1 True sale
It is crucial that the sale of assets to the SPV is legally regarded as a “true sale”. Ownership of the assets and its cash flows has to be transferred fully to protect the SPV and its newly acquired assets from any claims against the originator. The SPV has to be bankruptcy remote from the originator. In case of an originator bankruptcy the SPV’s assets cannot be used to satisfy any creditors claim on the originators assets. Also, the originator is protected from any investors claim against the SPV. Now a possible bankruptcy of the SPV is solely linked to the performance of the underlying assets. This isolation of financial assets is the most distinguishing feature of securitisation. In traditional methods of financing, like issuing bonds, payment performance depends on an entire company where securitisation isolates the performing assets from the issuing company.
The SPV finances this purchase by issuing bonds which are sold to institutional investors. These investors are looking for a secure investment. Separating the assets from the originator removes any credit risk associated with the originator and leaves only risk based on the assets and on the securitisation structure. In order to improve the credit risk profile of notes issued, the structure is supported by credit enhancements. These are supplied by internal sources in structuring the transaction, or, for a fee, by a third party.
4.3.2 Credit enhancement
Credit enhancement raises the securities credit profile above that of the originator and the underlying assets. Securitisation is effective because of credit enhancement. This is how the risk level of assets is adjusted to fit different investor needs.
Tranching is the most effective and popular way of credit enhancement. Bonds issued by the SPV are split into different risk- levels, or classes. The riskier a bond is the more interest is paid. In this way different investors with varying appetites for risk
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are served. Notes are structured in classes from A to E, F or another lower letter. An A class note represents the least risk and is called a senior note. The lowest note is the first loss piece. Any losses incurred by the SPV are passed on to the note holders start at the lowest, or junior, note, hence the first loss piece. All income is distributed from the top note holder downwards, starting with Class A notes. This is called the “waterfall structure” since the flow of money from the top notes to the bottom notes resembles a waterfall. Every structure has its specific payment policy, usually according to this waterfall model. The class A notes have the least chance of defaulting and often make up over 90% of the value of securities issued.
In order to give investors an insight in the risk level of each class of notes and in the underlying portfolio, rating agencies are asked to give a rating to the notes. The three most influential rating agencies are Moody’s, Standard & Poors and Fitch. When an originator is structuring a securitisation deal usually two or three of the raters are called in to rate the tranches. They do this according to a model called the residential mortgage default model. This will be explained in a next chapter.
Other forms of credit enhancement are over collateralization, excess spread and a reserve fund. This fund is drawn when losses start to occur. Excess spread can exist between incoming and outgoing cashflows, to cover first losses. When the value of collateral exceeds that of securities issued this is called over collateralisation.
4.4 Benefits of securitisation
The process of securitisation is an efficient use of capital. It can have numerous advantages to different parties involved. These benefits can be seen from the issuer point of view and from the investors point or as general social and economic benefits.
4.4.1 Issuer benefits
Issuer benefits are making assets liquid, efficient and lower cost financing, improving financial ratios and more flexible and adaptable financing.
Illiquid financial assets can be transformed into tradable capital market instruments. An issuer can trade away these former illiquid assets and use the proceeds for new origination activities. A static balance sheet with illiquid assets becomes flexible with a higher asset turnover.
Compared to traditional financing such as bank loans and debt securities securitisation is cheaper and more efficient.
Securitisation gives an issuer the ability to issue securities with a higher credit rating than the issuers own rating. Even companies without a rating now can access the capital markets. This offers cheaper debt then would be possible with debt backed by the issuer’s ability to pay back debt. Next this alternative to traditional financing offers issuers the option of
diversifying their financing sources. This makes the issuer less dependent on its financing institutions and creates price tension between the suppliers of capital.
The removal of asset from the issuer’s balance sheet by securitisation can help improve various financial ratios. Capital is freed, while the return on this capital is still realised, so return on capital employed increases with this transaction. Leverage, the ratio between equity and debt, is lowered by repaying debt previously used to finance the assets. This also helps to comply with risk-based capital standards. Financial institutions in Europe are to follow the Basel Accords. These state among other things that financial institutions must finance assets of a certain risk level with at least 8% of Tier 1 capital (* Tier 1 capital is an institutions core capital, primarily equity). In order to comply, banks must either attract more capital or free up assets.
Since attracting tier 1 capital is expensive, disposing of assets has become the most attractive way of complying with the Basel accords. When assets are removed from a balance sheet and the institution is already compliant, the 8% tier 1 capital involved is freed up to use as cover on other assets. (Source Basel accords)
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4.4.2 Investor benefits Yield premium
Investors benefit from securitisation fore mostly from the higher return offered. Compared to government bonds of the same maturity, ABS rated AAA offer higher returns while rated at the same risk level. This makes ABS a profitable alternative to government bonds. The yield premium makes ABS especially attractive to pension funds and insurers, offering a safe and liquid investment with a generous return. Pension funds are one of the largest investors in these securities.
Asset backed securities also offer investors the possibility of investing in specific asset classes, without the accompanied risk in associated companies. An investor looking to invest in for example residential mortgages could invest in a corporate entity operating on the mortgage market. The investor now attracts the wanted risk associated with investing in mortgages, but also the unwanted risk associated with investing in the corporation itself. By investing in mortgage backed assets, only risk associated with the underlying assets, mortgages, is attracted.
Next securitisation techniques offer an almost limitless number of options on maturity, risk level, payment structure and terms.
Securities can be tailored to exactly meet the investor’s specific needs. Also compared to a direct investment in the underlying assets traded bonds are much more liquid, offering flexibility in investments to the investor. This variety and flexibility of ABS attracts a much larger base of investors otherwise would be possible.
4.4.3 Social and economic benefits
A number of social and economic benefits have arisen in markets where securitisation practises are widely spread.
Financing on the primary markets, to for example potential home-owners has become more accessible and cheaper. The benefits to investors have led to an increased supply of capital available to the primary markets, leading to easier access for consumers. Because of competition between lenders on the primary market the price advantage of securitisation has partly been transferred to the market. This has led to for example mortgages with lower rates than previously possible.
Geographic disparities in the demand and supply of credit are also reduced. A local lender now can access the worldwide capital market, while previously having to rely on local banks and other regional suppliers of capital.
Efficient securitisation markets have helped the
Securitisation has introduced the disciplinary working of the capital market in pricing and valuation into individual credit granting institutions. It helps to allocate scarce capital to its most efficient use. From a regulatory point of view securitisation helps diversify concentrated risk away to the broader capital market, thus reducing the risk to individual institutions and the systematic risks within financial systems.
4.5 Residential Mortgage Based Securitisation
4.5.1 Introduction
Financing mortgages is increasingly done by Residential Mortgage Backed Securitisation (RMBS). In this structure mortgages are financed be securitizing them and selling the resulting bonds to institutional investors.
A mortgage securitisation transaction consists of three phases; the origination phase, the structuring phase and the distribution phase. In figure 4.4 a securitisation structure is pictured.
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4.5.2 The Origination phase
During the origination phase the originating company establishes a portfolio of mortgages. This can be done by cooperating with distribution parties, as explained in the mortgage chapter. On the English mortgage market an extensive value chain exists from the party that markets a mortgage towards the client to the financial institution that finances the mortgages. The ending point of this value chain is the starting point of a securitisation transaction. Some originators keep this distribution chain in- house, while others use distribution agents like mortgage brokers. A large bank for example can both market, sell and fund their mortgages. It can take up to several years to build a portfolio large enough to initiate a securitisation transaction. It is also possible to quick-start a business or quickly expand in a market by buying a portfolio of mortgages from a third party.
With the portfolio on the balance sheet the origination phase is concluded and the real securitisation process starts with the structuring phase.
4.5.3 The Structuring Phase
In the structuring phase the SPV is set up to operate like an “auto-pilot”. The setting up the transaction, or structuring it, is called the structurer. Often this is the same as the originator. The structurer creates an independent company, the SPV. It contracts a trust company to manage and own the SPV. In legal terms, the trust company has full control and responsibility over this SPV. However, in practice all contracts between the SPV and third parties are set up in a way that no later
management is needed. The trust party usually only steps in when the SPV gets into financial distress. The goal of the
structuring phase is to create a SPV with the lowest possible risk of defaulting on its obligations. At the end of the structuring phase rating agencies are called in to rate the risk level of the bonds issued by the SPV.
4.5.4 The Distribution Phase
The securitisation transaction ends with the distribution phase; here bonds are distributed to investors. When the originator is a bank with a regular securitisation programme the originator will distribute the bonds itself. Investor presentations are held during a ‘road show’ covering multiple countries. Here investors are presented with the characteristics of the particular
transaction, rating methods and, especially, of the characteristics of the underlying mortgage portfolio. Afterwards negotiations start for the sale of the bonds. When the originator does not sell the bonds itself an underwriter is used. This party underwrites the bonds and handles sales to investors. It also takes up risk associated with this sale.
After bonds are sold, the transaction is monitored by the rating agencies and investor reports are issued to inform investors of the current status of the structure, including payment schedules, interest risks, prepayment behaviour and other issues that might affect the value of their bonds.
Figure 4.4 securitisation phases
