Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization 6th Edition

Chapter Twenty-Four
Managing Risk off the Balance Sheet with
Loan Sales and Securitization

I. Chapter Outline
1. Why Financial Institutions Sell and Securitize Loans: Chapter Overview
2. Loan Sales
a. Types of Loan Sales Contracts
b. The Loan Sale Market
c. Secondary Market for Less Developed Country Debt
d. Factors Encouraging Future Loan Sales Growth
e. Factors Deterring Future Loan Sales Growth
3. Loan Securitization
a. Pass-Through Security
b. Collateralized Mortgage Obligation
c. Mortgage-Backed Bond
4. Securitization of Other Assets
5. Can All Assets Be Securitized?

II. Learning Goals

1. Understand the purposes of loan sales and securitizations.
2. Identify characteristics that describe the bank loan sales market.
3. Discuss factors that encourage and deter loan sales growth.
4. Describe the major forms of asset securitization.
5. Determine whether all assets can be securitized.

III. Chapter in Perspective

Rather than engaging in hedging activities to limit risk as discussed in the prior chapters,
FIs can also manage their risks via loan sales and asset securitization. Loan sales may
involve selling whole loans or parts of loans, while loan securitization involves
transforming portfolios or pools of loans into marketable securities. In selling or
securitizing loans, FIs are passing on the risk of asset transformation to others and
choosing to act as asset brokers instead. Because the broker function is generally less
risky than the asset transformation (or financing) function, sales and securitization may
reduce the rate of return to the selling FI unless a sufficient additional volume of
transactions can be generated. Nevertheless, sales and securitization allow the FI more
alternatives to tailor the risk return combination they choose to bear. Increasing the
emphasis on the loan brokerage function reduces the sensitivity of profits to the net
interest margin (NIM), and may help stabilize profitability because the NIM can fluctuate
dramatically as interest rates change (see Chapter 22). Related benefits may include
reduced capital and reserve requirements and better balance sheet liquidity.1 In
theory loan sales and securitization may also reduce the government’s deposit insurance
1
With fewer loans on the balance sheet there may be less need for deposit funding.

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liability. Indeed there is no particular theoretical reason why depository institutions

should be the primary providers of loan financing. With the passage of the FSMA we
can expect loan originating institutions to increasingly act as asset brokers as markets for
loan sales and securitization mature. However, securitization also led to the subprime
mortgage crisis. Mortgage companies and other originators encouraged homebuyers to
purchase more home than they could afford and many of the mortgages financing these
purchases were securitized and became collateral for mortgage backed securities. The
causes of the subprime crisis have been discussed elsewhere, but briefly, a combination
of low interest rates for an extended period of time leading to a long run of rising home
prices. The implicit government backing of the two mortgage agencies Fannie and
Freddie and the home price gains led to low risk premiums and excessive amounts of
mortgage credit. Originations made in 2005 and 2006 led to very high default rates.
Securitization led to reduced origination standards as lenders quickly sold and securitized
mortgages. Congressional pressure to increases affordable housing to lower income
segments also contributed. Warnings from both the Bush administration and former
Federal Reserve Chairman Alan Greenspan about the systemic risk in the mortgage
agencies, Fannie Mae and Freddie Mac were also ignored. As a result of the crisis the
Dodd-Frank Act of 2010 requires originators to keep 5% of loans originated when they
are securitized, although as of this writing lobbying efforts were attempting to create
broader exclusions to this rule.

IV. Key Concepts and Definitions to Communicate to Students

Loan securitization Financial distress

Correspondent banking Vulture fund

Highly leveraged transaction loans (HLT loans) Downsizing

Loan sales Brady bond

Sales with and without recourse Fraudulent conveyance

Loan participation Pass-through security

Assignment Fully amortized

LDC loan Prepayment risk

Collateralized mortgage obligation (CMO) Mortgage backed bonds (MBB)

Interest Only Securities Principal Only Securities

REMICs Sequential pay CMO

Planned Amortization Class CMO Negative Convexity

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Financial engineering Distressed loans

Collateralized Debt Obligations (CDOs) Subprime crisis

Collateralized Loan Obligations (CLOS) Syndicated loans

Sovereign bonds Performing sovereign loans

Nonperforming sovereigns

V. Teaching Notes

1. Why Financial Institutions Sell and Securitize Loans: Chapter Overview

Loan sales are the sales of individual loans in whole or in part; these sales may be with or
without recourse. A sale without recourse means the loan seller has no contingent
obligation to repay the loan to the loan buyer in the event of borrower default. Loan
securitization is the conversion of loans into marketable securities. This is usually
accomplished by placing the loans in a trust (or selling them to an FI who will do this)
and issuing (selling) marketable securities using the loans as collateral. The basics of
securitization are covered in Chapter 7 and readers should be familiar with that material,
although some of the same concepts are repeated in this chapter for clarity. Loan sales
and securitization can improve the FI’s risk return tradeoff by:
 reducing the credit risk the FI faces,
 improving the liquidity of the balance sheet and by
 reducing the regulatory burden imposed on traditional lending and deposit taking
activities.

2. Loan Sales
Loan sales have been a traditional activity of correspondent banking for over 100 years
in the U.S.2 Small banks often sell all or part of loans they have originated that are too
large for them to finance on their own, and large banks sell loan participations to smaller
banks. The market for buying and selling loans after origination is called the syndicated
loan market. This market has three type participants:
1. Market makers who commit capital to create liquidity and take outright positions
in the markets. These are primarily the large money center banks and investment
banks.
2. Institutions that actively participate in the market. These would include some
commercial and investment banks, insurers and specialized investment funds (see
below).
3. Occasional participants who either sell or buy loans as opportunities arise.
Examples would include smaller banks involved in correspondent relationships
purchasing pieces of large loans originated by bigger institutions, or the reverse
with the small banks selling shares in a loan to larger institutions.

2
Correspondent banking is the term used to characterize the relationship and the services large banks offer
to smaller banks.

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Loan sales grew rapidly in the 1980s due to the growth of levered buy outs (LBOs).
Banks provided financing for many of these LBOs via lending for so called highly
leveraged transactions or HLTs. HLTs are primarily loans to finance takeovers and
mergers where the resulting borrower has a high leverage ratio after the takeover.
Technically a HLT is a transaction that meets the following two criteria: 1) the loan is for
a buyout, acquisition or recapitalization and 2) one of the following: either the company’s
liabilities are doubled as a result and the leverage ratio is at least 50%, or the resulting
leverage ratio is at least 75%. In some of the HLTs, large banks divested parts of the
loans to smaller banks in order to spread the high risk of these transactions. The quantity
of loan sales tends to rise and fall through time with M&A and HLT activity.
Loan Sales Through Time
Year Billions $ % Distressed
1980 < $ 20
1989 285
1999 79
2008 510 7.8%
2009 474 29.4%
2010 413 20.5%
2011 409 8.4%
2012 395 5.7%
2013 517 3.9%
Source:
https://www.loanpricing.com/analysis/152-2/
The HLT market grew rapidly in the 1980s, tapered off in the early 1990s, grew again in
the boom years of the latter part of the decade, dropped in the early 2000s and began
growing again with the economy by the mid 2000s. Loan sales continued to grow in
2007 and 2008 before falling with the crisis. The HLT market suffered larger declines
but bounced back along with total loan sales. Distressed loan sales were very high
following the crisis years.

A bank loan sale occurs when the originating institution sells the loan to another party. If
the loan is sold without recourse the loan is removed from the balance sheet and the
bank has no further liability in the event of borrower default. The bank may or may not
retain the workout responsibility (collections and resolution of problem loans). Most
loan sales are without recourse. If the sale is with recourse, the loan seller removes the
loan from the balance sheet, but the seller records a contingent liability that must be
disclosed in the footnotes. There may be reserve and capital requirements for loans sold
with resource.

a. Types of Loan Sales Contracts

There are two types of loan sale contracts: participations and assignments. There are
technical differences in the two.

 Loan participations: A loan participation is buying a share in a loan, but the buyer
has only limited control and rights over the borrower. In particular, in a participation
the original loan agreement between the originating lender and the borrower remains

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intact after the sale. The loan buyer is thus not a direct claimant of the borrower, but
of the loan seller. The loan buyer has only limited control over any changes in the
loan contract. The loan buyer(s) can only vote on changes in the interest rate or
collateral backing, but other contractual changes that the buyer does not approve can
occur. Thus, the loan buyers are clearly in a subordinate position to the original
lender. For example if a borrower fails to repay the original loan, the loan seller, who
normally retains a part of the loan, may agree to renegotiated terms that the loan
buyers do not want. Moreover if the loan seller fails, the original borrower’s debt
may be netted against any claims (such as deposits at the failed FI) the borrower has
against the selling FI. This would reduce the amount the loan buyers could collect.
The loan buyer must thus monitor the creditworthiness of the borrower (or trust the
loan seller to do so) and monitor the creditworthiness of the loan seller. Direct loan
participations occur in less than 10% of U.S. loan sales.

 Loan assignments: An assignment of a loan is the purchase of a share in a loan

where the loan buyer is assigned or granted contractual control and rights over the
borrower. Assignments are used in over 90% of U.S. loan sales instead of
participations. In an assignment the loan buyer holds a direct claim on the borrower,
that is, the loan buyer obtains all rights upon purchase of the loan. In some cases the
original loan agreement will prevent assignment to certain parties or in certain
conditions. Loan buyers must be sure that the loan agreement does not contain
specific exclusions that limit their rights. Because of the complexity involved a loan
sale is not a quick, easy process. It may take several months to complete the sale of a
loan although most are completed within about two weeks.

b. The Loan Sale Market

There are three segments of the market, two are discussed in this section and the third is
discussed in part c):
 The short term segment is comprised of sales of one to three month loans. The
loans are normally secured by tangible collateral of the borrower and are of
investment grade. These loans are typically sold in units of $1 million and up and
are the traditional segment of the loan sale market. The rates on these loan sales are
closely tied to the commercial paper market, a competing source of short term
funds for well secured borrowers.

Teaching Tip: These characteristics keep the risk down. Many bankers, particularly at
smaller conservative institutions, are reluctant to invest in loans when they did not
conduct the credit evaluation. As a result, sales of well secured loans by creditworthy
corporations have been the traditional mainstay of the loan sale market.

 HLT loan sales: Loan sales grow with the volume of HLTs. This segment of the
market was insignificant before 1985 but grew with the increased interest in LBOs
and takeovers in the latter part of the 1980s. HLTs and other loans can be either
‘distressed’ (the borrower is having difficulty making the scheduled loan payments)
or ‘nondistressed.’ A distressed HLT loan is valued at less than 80¢ on the dollar
(the text mentions 90¢ rather than 80¢). HLT loans are usually long term, secured

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with collateral, floating rate and have strong covenant protections. Distressed loan
sales peaked at about 20% of loan sales in 2009 and 2010 before declining over the
next three years to a 2013 low of under 4%.

Teaching Tip: The junk bond market grew rapidly in the 1980s as takeovers of
increasingly larger firms occurred. Banks were unable or unwilling to provide the
necessary financing to fund the large takeovers. Michael Milken and his firm Drexel
Burnham saw an opportunity and successfully created a secondary market for junk bonds
(below investment grade bonds). Junk bond financing allowed the takeovers of firms
previously considered too large to acquire.

Loan buyers:
Vulture funds: These are specialized funds that invest in distressed loans and bonds.
These funds are often operated by investment banks. They can be actively managed; loan
purchasers of distressed funds are often able to dictate favorable terms that can result in
high rates of return. Other funds passively diversify their holdings instead, being content
with the higher promised yield on distressed loans. The active funds sometimes pressure
borrowers to restructure debts and/or sell off assets. These investors are looking for a
quick return on their capital, and unlike a bank lender, are usually not interested in
building long term relationships with the borrowers.

Investment banks: Investment banks invest in HLT loans because of their expertise in
analyzing M&A activity and their role in junk bond financing (a related product, see the
Teaching Tip above).

Commercial banks: Banks have historically been interested in buying loans to

circumvent interstate banking prohibitions (perhaps due to the desire to remain fully
invested in loans in periods of weak local loan demand), generate better geographic
diversification of their loan portfolio and develop correspondent banking relationships.
Small banks have often had to sell large loans to avoid loan concentration limits. This
market has been shrinking with the demise of interstate banking prohibitions and the
large number of bank mergers. Correspondent banking relationships are also less
important today. Finally there are increasing concerns about the moral hazard involved
in loan sales. Originating institutions may sell problem loans and keep the good ones.3
The moral hazard problem was evident in the securitization of subprime mortgages.

Foreign banks: Foreign banks are the dominant buyer of U.S. domestic loans. Loan
sales allow them to participate in U.S. loans without incurring the cost of branching.

Closed End Bank Loan Mutual Funds: Some mutual funds both purchase and originate
loans.

Insurance Companies, Pension Funds & Nonfinancial Corporations: Large insurers

and pensions buy a significant amount of loans and a few corporations purchase loans.

3
This problem can be partially resolved by requiring the selling institution to keep a significant portion of
the loan, as is usually the case and as is now required under the 2010 Dodd-Frank law.

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The loan sellers include:

Money center banks: These are the primary loan sellers
Small banks
Foreign banks
Investment banks (generally limited to HLTs)
Hedge funds (generally in HLTs)
U.S. government and agencies, including Housing and Urban Development (HUD)

c. The Secondary Market For Lesser Developed Country (LDC) Debt

A third segment of the loan sale market is the sale of LDC loans (see Chapter 19). The
major players in this market are large U.S. and foreign commercial and investment banks.
LDC loans are the highest risk component of the loan portfolio and only the largest banks
have LDC loans. Many of the problem LDC loans made throughout the 1980s and 1990s
were restructured as Brady bonds. A Brady bond is a bond that was created via a swap
for a distressed LDC loan (see Chapter 6). The bonds were fixed rate, whereas most LDC
loans are variable rate. The bonds were more liquid than the loans, but they were of
lower value than the original loan amount. The swap allowed the lender to eliminate any
further losses by selling the bonds. Many bonds of emerging countries had good
performance in the early 2000s. Brazil’s economic growth, Mexico’s credit rating
upgrade, and Russia’s debt restructuring encouraged investors and resulted in growing
interest in these markets. Low U.S. yields undoubtedly helped as well. The experience
of Argentina’s creditors has not been as promising and growing unrest in other South and
Central American countries will continue to contribute to the riskiness of this region.

In recent years three market segments of sovereign debt have emerged:

 Sovereign bonds (government issued debt)
 Performing loans which are sovereign loans that are collecting interest and principal
 Deep discount nonperforming loans which are sovereign loans that are not currently
collecting interest and principal

d. Factors Encouraging Future Loan Sales Growth

 Sales without recourse eliminate the credit risk faced by the originating institution.
 Sales may still generate fee income for the loan seller. The bank can retain the
servicing contract (processing term payments) for which it receives a fee, and the
lender normally charges a loan origination fee. By creating and selling more loans,
the FI can report higher current earnings than by financing the loans and reporting
interest income through time.
 The ability to sell the loans improves the liquidity of the bank’s loan portfolio. This
may allow the bank to hold fewer liquid assets and invest more in higher earning
assets.
 Most loans carry a substantial risk weight in calculating the required amount of
capital. If the loans are sold without recourse the amount of capital a FI must hold
can be reduced and additional growth in total assets may be possible for a given level
of capital.
 Loans sold without recourse do not have any reserve requirements. If loans are
routinely sold, the FI does not need as large a deposit base to fund its activities. With

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the smaller deposit base, its required reserves will be reduced.

e. Factors Deterring Future Loan Sales Growth

 Corporations are increasingly using the commercial paper market to fund short
term financing needs. This reduces the quantity of high grade loans available for sale.
 Loan customers may not like having their loan sold, taking it as a sign the bank does
want its business.
 Some high profile fraudulent conveyance proceedings may limit the popularity of
loan sales. Fraudulent conveyance means that a loan sale was conducted improperly
or illegally according to the terms of the original loan agreement. In particular,
fraudulent conveyance is the transfer of assets at less than fair value made while a
firm is insolvent. This activity is prohibited to protect the interests of creditors. In
2011 the Federal Housing Finance Agency (FHFA) sued Bank of America, J.P.
Morgan Chase, Goldman Sachs and Citigroup alleging the banks had misstated the
value of the mortgages sold to the housing agencies, Fannie Mae and Freddie Mac.
The Justice Department also filed a complaint against Bank of America for problems
with loans sold to the same agencies. Most of these loans were originated by
Countrywide which was taken over by Bank of America.

Teaching Tip: Suppose a bank is technically insolvent but is still operating. Bank
managers have an incentive to sell loans at fire sale prices in order to raise cash to
keep the institution afloat as long as possible. Alternatively, suppose a corporation is
insolvent. Its banker may attempt to sell any loans the bank has with the corporation
at discounted prices to limit its losses. The loan buyer may be unaware of the
corporation’s insolvency and would be purchasing a claim that is different than
represented by the selling bank. Notice that both these problems stem from
information asymmetry between the parties.

3. Loan Securitization (Also see Chapter 7)

In 2013 there were $1,954.7.3 billion in U.S. mortgage related securities issued by
agency and non-agency sources according to SIFMA.

In 2013 agency mortgage backed securities outstanding (MBS) totaled $5,905.6 billion or
83.9% of the total. Agency CMOs were $1,134.0 or about 16.1% of the total. Non-
Agency MBS were $1,681.9 or about 19.28% of the total outstanding.4 The Non-Agency
MBS market includes issuers involved in the bulk of the subprime market. According to
Thomson Financial, international securitization volume dropped by about 92% in the first
quarter of 2008 as compared to the same time period in 2007. This was the smallest
volume at the time since 1996.5 In 2010 mortgage related issuance was $1,746.8 billion.
Almost 98% of total issuance was by government agencies in 2010 and through May of
2011, so the private securitization market had not recovered by spring of 2011. In 2013
about 95% of MBS issuance continued to be agency backed. 6

4
All data are from the Securities Industry and Financial Markets Association (SIFMA) website.
5
See http://banker.thomsonib.com Debt Capital Markets
6
SIFMA website data

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Although at first securitization was largely limited to mortgage loans, other loan types are
now being securitized and many new institutions had entered the securitization business
before the subprime crisis.

The subprime mortgage crisis

Mortgage delinquencies increased dramatically in the last quarter of 2006 and remained
high throughout 2007. Foreclosure filings increased 93% in July 2007 over July 2006.
The delinquencies caused severe problems in the mortgage backed securities markets.
Losses from the decline in value of subprime mortgages and the securities that have these
loans as collateral are estimated at $400 billion. Financial institutions and government
agencies that invested in MBS saw the value of their holdings plummet. The largest
commercial and investment banks wrote off about $130 billion in loans. Citigroup,
Merrill Lynch and Morgan Stanley wrote off about $40 billion combined. Bank of
America and Wachovia wrote off $3 billion and $1.2 billion respectively while UBS took
looses of $10 billion. Two Bear Stearns hedge funds failed due to mortgage related
losses, eventually bringing the parent firm down with them. In February 2008 MBIA, a
bond and mortgage insurer reported a $2.3 billion loss related to mortgages it insured.
Eventually Lehman Brothers, Merrill Lynch, Wachovia, IndyMac, Citigroup, AIG,
Countrywide, GMAC and others either failed or were bought/bailed out. Global losses
from the crisis and the ensuing recession are in the trillions.

FNMA and FHLMC were quasi government agencies that are heavily involved in the
mortgage markets and securitization. These agencies reported losses of $9 billion in the
second half of 2007 related to the market for subprime MBS. In February 2008
regulators raised the caps on the size of jumbo mortgages FNMA and FHLMC could
purchase. In March 2008, regulators allowed both institutions to reduce their capital from
30% to 20%, both moves were attempts to add to liquidity in the ailing mortgage
markets, particularly for jumbo mortgages. The moves were expected to add up to $200
billion of liquidity in the mortgage markets and enable FNMA and FHLMC to purchase
or guarantee about $2 trillion in mortgages in 2008. Both institutions went bankrupt and
had to be placed in government conservatorship in September 2008. As of February
2011 the two agencies had cost taxpayers $133.7 billion net of funds paid back to the
government.7 However in 2012 and 2013 both entities made solid profits and have repaid
$66 billion of the funds received in 2008. The Treasury now expects a net profit of $50
billion. The return to profitability has made it more difficult to reform these institutions.

a. Pass-Through Security
With a mortgage pass-through security, after origination mortgages may be placed in a
pool held by a trustee and then mortgage pass-through securities may be sold to the
public. The pool organizer passes through all mortgage payments (less a servicing fee)
made by the homeowners, including prepayments, to the holders of the pass-through
securities on a pro-rata basis. Payments are thus monthly and are variable based on how
many homeowners pay off their mortgages early. The pool organizer and/or the
government usually provide insurance for the mortgages in the pool. Before the financial
crisis default risk was not generally a worry for a government backed pass-through
7
See FMCC at www.Bedford Report.com.

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security holder (such as a GNMA pass-through). These securities do carry substantial

prepayment risk.

Teaching Tip: Privately Issued Pass-Throughs or PIPs are pass-throughs created without
government or quasi government involvement. Before the subprime crisis there were a
growing number of private mortgage pass-through issuers. They typically securitize
nonconforming mortgages that do not qualify for government insurance nor have
appropriate loan to value ratios.

The advantages of securitization:

Suppose a DI has just originated 1000 thirty year single family FHA mortgages at a 9%
rate with an average loan amount of $100,000. The DI charges a 1% origination fee to
offset processing costs. If processing costs are 0.5% then net fee income is $500,000.
After securitization the DI may retain about 35 basis points in fee income for processing
the mortgage payments. If the cost of such processing is 10 basis points, the DI nets 25
basis points of the payment amount or (0.0025  $804.62 / month  12 months  1000
mortgages) = $24,138.60 per year. The discounted present value of the annual net fee
income using a 9% interest rate over 30 years for simplicity is $247,991.8 Total
originating and servicing fee income is thus estimated at $747,991 = ($500,000 +
$247,991).
The FI can avoid the following costs and investments by securitizing the mortgages:
 Capital requirement (See Chapter 14) = $100,000  1000  0.50  0.08 =
$4,000,000.9 If having to raise equity capital increases the weighted average cost of
capital by 50 basis points, then the cost of the additional equity investment can be
estimated as 0.0050  $4 million = $20,000 per year. The total present value of this
annual cost for the 30 years using the 9% rate for simplicity is $205,473.
 If the remaining funding is in the form of transactions deposits with a 10% reserve
requirement then the reserve requirement on these accounts that can be avoided is
found as $96,000,000 / (1 – 0.1) = $106.67 million or $10.67 million dollars of
noninterest earning reserves at the Fed must be held to back the deposits.10 The
present value of lost interest income on this amount over 30 years if these funds
would have been invested in liquid assets earning 5% comes to $10,165,476.89.11
 Annual deposit insurance premiums (assuming a cost of 27 basis points) of $106.67
million  0.0027 = $288,009. In recent years this considerably overestimates the
cost of actual insurance premiums levied for most institutions. The present value of
this cost at 9% is $2,958,904.
 Total costs avoided are $205,473 + $10,165,477 + $2,958,904 = $13,329,854

8 ?
In reality the mortgages will be prepaid long before the maturity and the fee income will be less
than this.
9 ?
I assumed the SF mortgages have a 50% risk weight and I assumed an 8% minimum capital ratio
requirement similar to the text. See Chapter 13 for details on mortgage risk weighting.
10
For simplicity we assume a zero % rate of return on deposits at the Fed, although this is no longer
strictly true the rate earned is very low.
11
The amount invested in required reserves declines each year as the mortgages are amortized, the capital
required declines also. I used a spreadsheet to calculate the lost interest on the required reserves using the
declining reserve requirements each year. I did not account for prepayments. I ignored the declining
capital requirement in the capital cost calculation because the cost was relatively small to begin with.

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Adding up the costs avoided and the fee income allows one to see why securitization has
grown in popularity.

Teaching Tip: These numbers are very rough guidelines of the costs involved. I
constructed them from common sense, but they may not be realistic guides to actual
costs. Instructors use them at your peril!

Securitization can reduce repricing and funding gap problems (interest rate risk)
because a long term fixed rate asset is removed from the balance sheet. The process can
also be used to reduce liquidity risk. The reduction in liquidity risk occurs because the
loans are now saleable and if the FI wishes to invest in the real estate markets mortgage
backed securities that are also liquid can replace the loan investments.

Prepayment Risk
Most mortgages are set up as fully amortized loans where there will be no remaining
balance at the end of the 30 year or 15 year maturity. However, most mortgages are also
prepaid (paid off in full prior to maturity). GNMA and other pass-throughs have little or
no default risk, but they have substantial prepayment risk (see Chapter 7). Prepayments
increase in falling interest rate environments and leave the pass-through holder with a
shorter maturity instrument than expected. The duration is reduced by prepayments so
the price gains anticipated from falling rates are not as large as predicted, but the lost
reinvestment income from having to reinvest at lower rates does occur. This can
substantially reduce the investor’s realized rate of return over time. The dollars of
interest earned each month can decline fairly rapidly as interest rates drop and
prepayments increase. The reduction in total expected cash flows over the life of the
pass-through dampens the increase in price associated with the interest rate drop, but the
future value of the reinvestment income declines due to the lower reinvestment rate and
the lower amount of interest that will be received.

b. Collateralized Mortgage Obligation (CMO)

The CMO was created in 1983 by FHLMC and what was then the investment bank First
Boston as a means of repackaging prepayment risk. CMOs are created by repackaging
mortgage payment streams, or more typically, by repackaging payments on pass-
throughs. The innovation of the CMO is to offer different classes or ‘tranches’ that offer
different degrees of prepayment protection.12 The simplest form of CMO is a sequential
pay CMO (see below). This is a profitable activity for CMO backers because the CMO
investor has a better idea of the prepayment risk they face; consequently, they are willing
to pay more for a CMO than a pass-through, ceteris paribus.

CMOs are a hybrid between a pass-through and a bond. With a sequential pay CMO,
separate classes are created with different levels of prepayment protection. Suppose a
sequential pay CMO with a total pool value of $150 million has three classes, A, B and C
with principal amounts of $50 million per class. The Class A CMO holder would receive
all the initial principal payments (on the entire pool), including all prepayments on the
entire pool. These payments would reduce the Class A holders principal. Initially, Class
12
CMO tranches can also be set up for credit enhancement.

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B and C holders would receive no principal payments until all of the principal of Class A
holders have been paid. Likewise, Class C is not affected by any prepayments until Class
B holders have been paid. The multiple classes allow investors to better choose the level
of prepayment risk desired.

Example of payments on a Sequential Pay CMO:

Suppose the mortgages in the pool have a 9% interest rate and further suppose the CMO
makes monthly payments. It could make quarterly or semiannual payments as well. The
mortgage holders make their scheduled monthly payments; if there are defaults the pool
organizer will make the scheduled payment:
Month 1 Amount paid into pool in Month 1: $2 million
Beginning Interest Due
Class Balance & Paid Actual Principal reduction End Balance
A $50,000,000 $375,000 $2 mill - $1,125,000 =$875,000 $49,125,000
B $50,000,000 $375,000 $50,000,000
C $50,000,000 $375,000 $50,000,000
Total $1,125,000

Month 2 Amount paid into pool in Month 2: $3 million

Beginning Interest Due
Class Balance & Paid Actual Principal reduction End Balance
A $49,125,000 $368,437 $3 mill - $1,118,437 =$1,881,563 $47,243,437
B $50,000,000 $375,000 $50,000,000
C $50,000,000 $375,000 $50,000,000
Total $1,118,437

Only Class A holders are initially affected by prepayments or any principal payments.
Once Class A principal is totally retired, Class B holders will begin to receive all
principal payments, including prepayments. CMOs sometimes have as many as
seventeen classes. Class A may have an expected maturity of 2 to 3 years, Class B may
have an expected maturity of 5 to 7 years, and Class C may have a typical expected
maturity of 8 to 10 years or more. Buyers of Class A bonds are seeking short duration
mortgage investments and are typically purchased by FIs with shorter time horizons,
including thrifts, banks and P&C insurers. Class B bonds have some prepayment
protection; these appeal to longer term investors such as banks, pension funds and life
insurance companies. Class C securities are generally desirable investments for
institutions seeking long term investments and are primarily held by pension funds and
life insurers. Each class is usually quoted at a markup over the appropriate maturity
Treasury rate. Thus mortgage investments offer a higher promised rate than
comparable maturity Treasuries with typically little or no additional default risk. Actual
promised rates depend upon expected prepayment patterns. Higher prepayments result in
shorter maturities. Pool organizers often can sell CMO claims for more total value than
similar pass-throughs because some investors are usually willing to pay more for the
additional prepayment protection.

The Z class
CMOs usually have a Z class which is different from the other classes. The Z class is a
residual claim on the mortgage pool. Initially the Z class receives no payments, but its
face value increases at a stated coupon rate. Once the principal on all other classes have

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been fully paid, Z class investors begin to receive both interest and principal payments. Z
class investments are long duration and are thus risky. Faster prepayments will start
payments to the Z class investor sooner. An investor faces uncertainty when payments
will begin and how many payments will be received. Typical investors are institutions
such as hedge funds that are seeking long duration investments with higher risk and
return.

REMICs
The IRS normally rules that issuers that securitize and issue securities with multiple debt
classes are engaging in a taxable activity. If the IRS taxes the interest payments on the
mortgage backed securities CMOs could not offer competitive returns. To circumvent
this problem Congress created the Real Estate Mortgage Investment Conduit (or
REMIC) trust that was specifically exempt from IRS taxation. Most CMOs are placed in
REMICs and the industry often uses the terms interchangeably.

Other Types of CMOs:

1. Interest Only and Principal Only securities
Mortgage pools can be used to create mortgage pass-through strips such as interest
only and principal only securities. The interest only (IO) and principal only (PO) strips
are special types of CMOs. The IO provides the holder a pro-rata claim to all interest
payments made on the pool of mortgages. The PO provides the holder a pro-rata claim
on all principal payments made on the pool. An IO can exhibit negative convexity
because as interest rates fall, prepayments rise and the total amount of interest accruing to
these securities falls. Lower rates raise the present value of the cash flows, but the lower
overall cash flows can result in a decline in the value of the IO when rates fall. The
converse also holds. If the prepayment effect dominates the IO will exhibit negative
convexity, if the present value effect dominates it will not, so the net result depends on
changes in prepayment behavior as interest rates move. The text indicates that when
interest rates are above the coupon rate on the mortgages the IO will act more like a
standard security. This is not strictly true as IOs and POs are priced according to an
expected level of prepayments, as one would expect in an efficient market.
Nonstandard price changes can still occur because a change in rates would change the
probability of prepayments. The prepayment effect however is more likely to dominate
when rates are below the coupon rate. IOs that are expected to exhibit negative convexity
can be used by FI’s desiring to hedge against rising interest rates. Since IOs are
investments that provide cash flows, these may be more acceptable to managers than caps
or futures positions.

POs exhibit greater volatility than an equivalent maturity bond. As interest rates fall
and prepayments increase, the present value of the cash flows will rise, increasing the
value of the PO and cash payments to the PO holder are accelerated, further increasing
the value of the PO. The converse is also true. In this case, the present value and
prepayment effects both work in the same direction to increase the PO’s volatility relative
to a standard bond. POs may appeal to investors who want a potentially higher rate of
return than a standard bond offers without facing additional default risk. POs may also
be useful for FIs who wish to increase the interest rate sensitivity of their assets. For

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instance, POs may be useful hedging investments for institutions with a negative duration
gap or positive repricing gaps.

Both IOs and POs can be used to hedge balance sheet interest rate exposures. These are
examples of financial engineering.
2. Planned Amortization Class CMO
An alternative to a sequential pay CMO is the planned amortization class (PAC) CMO.
The basic PAC CMO has two classes:
 The PAC or Planned Amortization Class:
For a range of Prepayment Speeds, for example, 80% of standard to 250% of
standard, the maturity of the PAC and the principal and interest payments
received will not change. That is, payments will be according the original
planned amortization schedule. PAC investors have a higher degree of certainty
of the cash flows they will receive and the maturity of their investments than
investors in pass-throughs.
 The “Companion Class.” (The text uses the term “Support Class” instead)
The Companion Class receives all prepayments as long as prepayment speed stays
within the given range. If the prepay speed moves outside the standard range,
prepayments are shared between the PAC and Companion Class.

Other types of CMOs exist. The websites of FHLMC and FNMA can provide more
examples.

c. Mortgage-Backed Bond (MBB) (See Chapter 7)

The MBB is different from a pass-through and a CMO in that the MBB does not remove
the mortgages from the balance sheet. MBBs are also standard bonds that have
mortgages as collateral. There is no ‘passing through’ of mortgage payments
(transformed or not) with MBBs. Thus MBBs do not offer the FI the main advantages of
securitization discussed above that resulted from removing the mortgages from the
balance sheet. They also leave the issuing FI with substantial prepayment risk because
the bonds require fixed coupon payments to be paid regardless of the level of
prepayments. The FI will receive the promised principal, but they must reinvest the
principal at lower interest rates while still paying the higher promised bond interest rate.
As a result, most MBBs have to be overcollateralized in order to receive a high quality
credit rating. MBBs are advantageous to investors in that the bondholders have no
prepayment risk (unless the bonds are callable). MBBs may be advantageous to the FI
because the bond issue can be used to fund the mortgages and the bond issue will have a
similar maturity to the mortgages’ expected maturity, thus reducing the repricing and
duration gap problems. The text indicates that this advantage to the FI comes at
increased risk to the FDIC because the pledged assets backing the mortgage bonds may
not be available to insured depositors in the event of FI failure. The MBB may also
actually reduce the FI’s liquidity because now the pledged mortgages cannot be sold;
moreover the FI must pledge more mortgages than bonds issued so overall liquidity can
be reduced. Due to these disadvantages, MBBs are the least used form of securitization.

Teaching Tip: With a pass-through security, the investor bears all of the prepayment risk.

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With a non-callable mortgage backed bond the issuer bears all of the prepayment risk.
With a CMO the prepayment risk is shared between the issuer and the investors and the
investors can choose their desired level of prepayment protection by choosing between
the different CMO classes.
Teaching Tip: The Paulson reform plan put forth in spring 2008 suggested that regulators
encourage the use of mortgage backed bonds rather than other forms of securitization
because it makes banks maintain capital to back the mortgages. Securitization has
removed the loans from the balance sheet and may have encouraged banks to create
excessive amounts of mortgage credit to less creditworthy borrowers.

4. Securitization of Other Assets

Other assets are now being securitized (2014 Q1data): 13
Asset Billions of
dollars
Automobile loans $168.3
Credit card receivables (called CARDs) 129.4
Equipment loans 22.3
Housing Related 96.5
Other (Structured Settlements, SBA, etc.) 713.5
Student loans 225.0
Total $1,355.0

In total, $1,355 billion of non-first mortgage related asset backed securities were
outstanding in 2013.

5. Can All Assets Be Securitized?

There are three reasons that securitization occurred first for mortgage loans. First, they
are highly standardized. Second, government mortgage insurance has limited the
need for buyers of mortgage backed securities to engage in individual credit risk
investigations. Before 2007 homes also generally maintained their collateral value.
Third, mortgages are long term so the costs of securitization can be efficiently spread
through time. Lack of these characteristics would seem to be the major limiting factors in
securitization of other loan types. Standardization can be achieved at the origination
level to some extent and pooling can lead to additional standardization. Third party
participants may be willing to insure against default risk, or securities buyers may be
willing to bear the default risk. In some cases such as for credit card loans, the pooling of
large numbers of borrowers and the ability to charge sufficiently high interest rates to
offset higher loss rates can overcome the default risk problem. As familiarity grows and
the costs to securitize fall, shorter term loans may be able to be securitized if sufficient
economies of scale can be achieved, perhaps by high volume. Nevertheless the terms and
risks of many loans are unique. Ultimately it is the ability to accurately assess and
measure the level of risk of the pool that may limit securitization. The more
heterogeneous the loans of a given type and the more uncertain the collateral values are
absent insurance, the more difficult it will be to successfully securitize a given loan type.

13
Data are from The Securities Industry and Financial Markets Association (SIFMA) website.

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Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations

(CLOs)14
CDOs are a type of securitization that can take many forms.15 In its simplest form the
pool organizer purchases a pool of assets and using the pool as collateral issues different
claims or ‘tranches’ to CDO investors. The tranches have different levels of security.
The senior tranche has a prior claim on principal and interest earned by the assets and is
usually setup so that it is overcollateralized and will have a AAA rating. A basic CDO
strategy is similar to the bond investment strategy, ‘riding the yield curve.’ The assets are
typically longer term than the liabilities. When the term structure is upward sloping this
will provide part of the profit margin to the CDO organizer who usually is an equity
investor in the CDO. These are called Arbitrage CDOs. CDOs that are used to remove
assets from the balance sheet are called Balance Sheet CDOs. See the simple example
below of a Cash Flow CDO but be aware that many variations exist.16
Example CDO
Assets Liabilities & Equity
Medium & Long Term Debt Senior Tranche
Bank Subordinated Debt Asset Backed Commercial Paper
Mortgage Backed Securities Junior Tranche
Medium Term Notes
Equity Tranche
Residual cash flows

As the yield curve flattened in the mid-2000s profit margins were squeezed and more
CDOs began to add riskier securities to the asset pool; some added subprime mortgages.
When subprime defaults and past dues began to increase, the security of senior tranche
holders quickly evaporated and CDO organizers had difficulty persuading investors to
refinance in the asset backed commercial paper tranche.

Some CDOs were used to remove assets from the balance sheet as discussed under
securitization benefits above. Some were formed because the organizer hoped to earn the
difference between the interest earned on the assets and the interest paid to tranche
holders. This type is termed an arbitrage CDO. If the underlying asset portfolio is
predominantly loans it is termed a Collateralized Loan Obligation or CLO. If the
collateral is asset backed securities or mortgage backed securities it is called a ‘structured
finance’ CDO. A special type of CDOs called synthetic CDOs sell credit default swaps
(CDS) rather than invest in securities. Finally CDO2 are CDOs that invest in other
synthetic or cash CDOs rather than securities.

14
Information is drawn from Securities Industry and Financial Markets Association website and from
“CDOs in Plain English: A Summer Intern’s Letter Home,” Nomura Fixed Income Research, September
13, 2004, Nomura Securities International.
15
You may also hear the term SIV. A Structured Investment Vehicle (SIV) is a type of CDO that is more
actively managed and does not have a maturity date.
16
The term Cash Flow CDO means the CDO has purchased securities as assets. A Synthetic CDO
is one with credit default swap (CDS) payments as the asset. The term Hybrid CDO is used when the
CDO has both standard assets and CDS payments as assets.

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CDOs are yet another form of securitization that contributed to the credit crunch when
problems developed in the subprime mortgage markets. These instruments are
complicated and difficult to value, especially the more exotic forms. It is doubtful that all
investors understood the risks they faced. CDOs are structured based on correlation
analysis of security prices in normal markets and even small changes in the underlying
security values can result in declines in credit quality of even senior tranches. In the
credit crunch asset correlations all increased toward +1. Under most CDO contracts,
collateral declines from dropping asset values can force CDO managers to change
investment policies to restore collateralization levels. This in turn can force asset sales
and in the markets managers faced in 2007 these sales led to additional declines in asset
values. CDO issuance rose from only $10 billion in 1995 to over $500 billion in 2006.
After the financial crisis issuance in 2010 was a mere $8.7 billion although the market
recovered substantially in 2012 and 2013 when $64.3 and $90.2 billion were issued. In
2013, there were $711,170.9 million of CDOs outstanding globally.

Using CDOs allows banks to create more mortgages which are then placed into a CDO
structure. As we found out in 2007 and 2008, the banks still had responsibility for these
mortgages even though they were not required to hold capital to back them since they had
been shifted off the balance sheet. Should these complex investment vehicles be banned?
Innovations such as these that allow risk sharing probably provide net benefits to society,
but regulators must move more quickly to understand the risks involved from financial
engineering before a crisis occurs.

VI. Web Links

http://www.federalreserve.gov/ Website of the Board of Governors of the Federal

Reserve

http://www.loanpricing.com/ The Loan Pricing Corporation’s website

http://www.sifma.org/ The Securities Industry and Financial Markets

Association website. The SIFMA was created from
the merger of the Securities Industry Association
and The Bond Market Association.

http://www.ginniemae.gov/ GNMA’s website, at this site the browser can learn

about GNMA pass-throughs and REMICs.

http://www.fanniemae.com/ The Federal National Mortgage Association website

http://www.freddiemac.com/ The Federal Home Loan Mortgage Corporation

website

http://www.fdic.gov/ The Federal Deposit Insurance Corporation website

has net charge off rates for banks and thrifts.

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http://www.occ.treas.gov/ Office of Comptroller of the Currency

http://www.bis.org/ Bank of International Settlements website: The BIS

collects data about derivatives usage and
promulgates risk based capital requirements
including requirements for derivatives usage.

http://www.isda.org/ International Swaps and Derivatives Association is

a global trade association for the derivatives
industry.

http://www.americanbanker.com/ ABA website

http://www.wsj.com/ Website of the Wall Street Journal Interactive

edition. The web version of the well known
financial newspaper can be personalized to meet
your own needs. Instructors can also receive via e-
mail current events cases keyed to financial market
news complete with discussion questions.

VII. Student Learning Activities

1. Go to FHLMC’s website and read about the process of selling mortgages to

FHLMC. How are accounts classified? After the account is classified what is
required to sell mortgages to FHLMC?

2. Go to Fannie Mae’s website under their general product information learn

about TACs PACs and sequential pay CMOs or REMICS as they are usually called.
What are the major differences? In particular, how do the risks of the types differ?

3. At Fannie Mae’s website find out what the terms floaters and inverse floaters
mean. Also what are the major risks of REMICS? Identify and explain each.

4. At the FDIC’s website find the most recent amount of loans sold with
recourse by type of loan. Which type is largest? As a percentage of loans (per type)
how many loans are sold with recourse?

5. Go to the Loan Pricing Corporation’s website. What is the LSTA/LPC Mark-

to-Market Pricing Service? How can this service help FIs that wish to sell their loans?

6. At the SIFMA website find the excel file for Global CDO Issuance. Looking
at the CDO Type section, describe what happened to CDO issuance each year from
2005 to the present? Explain the pattern you find.

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