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Securitization: a Post Mortem

Erik Heitfield Federal Reserve Board erik.heitfield@frb.gov

The views expressed here are my own and do not reflect the opinions of the Federal Reserve Board of Governors or its staff.

Today’s Talk

Overview of securitization

Looking back

What went wrong?

Excessive complexity

Leveraged exposure to systematic risk

Model error

Looking forward

Alternatives to securitization

Securitization going forward

Overview

What is credit securitization?

Securitization is the pooling and tranching of credit risk

Assets of a securitization are a pool of fixed income securities with embedded credit risk such as

Corporate bonds & loans

Mortgages

Credit card receivables

Other structured products

Liabilities are structured in tranches ordered in terms of payment priority

Senior tranches bear least risk but carry lowest interest rate

Mezzanine tranches bear more risk in return for higher rate

Lowest tranche (equity) bears most risk and is often not traded

Assets Liabilities Super Senior Senior Mezzanine Equity
Assets
Liabilities
Super
Senior
Senior
Mezzanine
Equity

A taxonomy of securitization products

Assets

 

Whole Loans or Unstructured Bonds

Structured

Liabilities

Securities

Pass-through

Agency MBS CDX Indexes

ABX.HE Indexes

Structured

Non-agency MBS Corporate Bond CDO

ABS CDO CDO-squared

Goals of securitization

Separate debt funding from risk bearing

Senior tranche investors put up most of the capital to fund assets

Junior tranche investors bear most of the credit risk

Risk diversification

A single structured credit deal may be backed by hundreds or thousands of loans

Cash flows for large asset pools may be easier to predict

Tailor debt risk/return characteristics to market demand

Risk/return profile of structured securities is different from that of underlying collateral

Regulatory arbitrage

Financial institutions can move assets off balance sheet while continuing to be exposed to much of those assets’ credit risk

Rapid growth of new MBS…

Annual Issuance of Non-agency Residential Mortgage Backed Securities

$ billions (nominal) 1,400 Other Prime 1,200 Alt-A Subprime 1,000 800 600 400 200 0
$ billions (nominal)
1,400
Other
Prime
1,200
Alt-A
Subprime
1,000
800
600
400
200
0
2001
2002
2003
2004
2005
2006
2007
2008*

* Jan-Sep, Annualized Source: Inside Mortgage Finance

…Increasingly held by CDOs

Composition of CDO Collateral

High-Grade Cash-Flow/Hybrid CDOs

High-Grade Cash-Flow/Hybrid CDOs

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2001 2002 2003 2004
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2001
2002
2003
2004
2005
2006
2007*

CDO Vintage

* 2007 vintage includes deals completed through September Source: Standard and Poors

Mezzanine Cash-flow/hybrid CDOs

Mezzanine Cash-Flow/Hybrid CDOs

100% 90% 80% 70% Other 60% CDOs NIMS 50% Closed-end 2nds Alt-A 40% Subprime 30%
100%
90%
80%
70%
Other
60%
CDOs
NIMS
50%
Closed-end 2nds
Alt-A
40%
Subprime
30%
20%
10%
0%
2001
2002
2003
2004
2005
2006
2007*

CDO Vintage

* 2007 vintage includes deals completed through September Source: Standard and Poors

Other CDOs NIMS Closed-end 2nds Alt-A Subprime
Other
CDOs
NIMS
Closed-end 2nds
Alt-A
Subprime

MBS valuations plunge

AAA ABX.HE Indexes

110 100 90 80 70 60 50 40 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08
110
100
90
80
70
60
50
40
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08

Source: MarKit

2006:H1 2006:H2 2007:H1 2007:H2
2006:H1
2006:H2
2007:H1
2007:H2

ABS CDO credit ratings collapse…

Share of CDO notes downgraded to Caa or lower, by initial grade and vintage

Percent 90 80 2007 Vintage 70 60 2006 Vintage 50 40 30 20 10 0
Percent
90
80
2007 Vintage
70
60
2006 Vintage
50
40
30
20
10
0
Aaa
Aa
A
Baa

Source: Moody's

Initial Rating

…and so does CDO issuance

Global CDO issuance

$ Billions 200 180 Unstructured Collateral 160 (corporate bonds, loans, etc.) 140 120 Structured Collateral
$ Billions
200
180
Unstructured Collateral
160
(corporate bonds, loans, etc.)
140
120
Structured Collateral
(MBS, other ABS and CDOs)
100
80
60
40
20
0
05-Q1
05-Q2
05-Q3
05-Q4
06-Q1
06-Q2
06-Q3
06-Q4
07-Q1
07-Q2
07-Q3
07-Q4
08-Q1
08-Q2

Source: Securities Industry and Financial Markets Association

What went wrong?

Excessive complexity

Leveraged exposure to systematic risk

Sensitivity to modeling error

Complexity

Tasman CDO

$300 million mezzanine-hybrid CDO 2

Deal date: January 11, 2007

Lead Underwriter: UBS

Capital Structure: 7 debt classes maturing in March 2047

Assets: 64 CDO notes of various types

Tasman CDO – Liabilities

 

Issue

 

Class Name

Amount

($MM)

Initial

Rating

A1S Senior Secured

$164

Aaa

A1J Senior Secured

$30

Aaa

A2 Senior Secured

$58

Aa2

A3 Secured Deferrable

$20

A2

B Mezzanine Secured Deferrable

$12

Baa2

C Mezzanine Deferrable

$4

Ba1

U.S Subordinated

$12

NR

Maturity: 03/21/2047

A1S Senior Secured

55%

A1J Senior Secured — 10%

A2 Senior Secured

19%

A3 Secured — 6.66%

B & C Mezzanine Secured

5.33%

U.S Subordinated — 4%

Tasman CDO – Assets

TASM TASM (CDO2) (CDO2)
TASM TASM (CDO2) (CDO2)
CAMBER-8 CAMBER-8 (CDO2) (CDO2) 0.72% 0.72% PINE-5 PINE-5 (CDO2) (CDO2) 0.004% 0.004% Merrill Merrill Lynch
CAMBER-8 CAMBER-8
(CDO2)
(CDO2)
0.72% 0.72%
PINE-5 PINE-5
(CDO2) (CDO2)
0.004% 0.004%
Merrill Merrill Lynch Lynch Loan Loan
Other Other
(Home (Home Equity) Equity)
Debt Debt Notes Notes
0.005% 0.005%
(Home Equity) Equity) Debt Debt Notes Notes 0.005% 0.005% AQUARIUS-4 AQUARIUS-4 (CDO2) (CDO2) 0.58% 0.58% 62
AQUARIUS-4 AQUARIUS-4 (CDO2) (CDO2) 0.58% 0.58%
AQUARIUS-4 AQUARIUS-4
(CDO2) (CDO2)
0.58% 0.58%
62 62 Other Other CDO CDO Notes Notes 98.7% 98.7%
62 62 Other Other
CDO CDO Notes Notes
98.7% 98.7%
MAY-5 MAY-5 (CDO2) (CDO2) 0.94% 0.94% AQUARIUS-5 AQUARIUS-5 Other Other (CDO2) (CDO2) Debt Debt Notes
MAY-5 MAY-5
(CDO2) (CDO2)
0.94% 0.94%
AQUARIUS-5 AQUARIUS-5
Other Other
(CDO2) (CDO2)
Debt Debt Notes Notes
0.19% 0.19%

Tasman CDO – Assets

Direct Indirect 0% 20% 40% 60% 80% 100%
Direct
Indirect
0%
20%
40%
60%
80%
100%

CDOCLO Other ABS Corporate CMBS Prime/Midprime Alt-A Subprime Second HELOC

CLOCDO Other ABS Corporate CMBS Prime/Midprime Alt-A Subprime Second HELOC

Other ABSCDO CLO Corporate CMBS Prime/Midprime Alt-A Subprime Second HELOC

CorporateCDO CLO Other ABS CMBS Prime/Midprime Alt-A Subprime Second HELOC

CMBSCDO CLO Other ABS Corporate Prime/Midprime Alt-A Subprime Second HELOC

Prime/MidprimeCDO CLO Other ABS Corporate CMBS Alt-A Subprime Second HELOC

Alt-ACDO CLO Other ABS Corporate CMBS Prime/Midprime Subprime Second HELOC

SubprimeCDO CLO Other ABS Corporate CMBS Prime/Midprime Alt-A Second HELOC

SecondCDO CLO Other ABS Corporate CMBS Prime/Midprime Alt-A Subprime HELOC

HELOCCDO CLO Other ABS Corporate CMBS Prime/Midprime Alt-A Subprime Second

Note: “Indirect” exposure tabulated at three-level depth.

Tasman CDO – Performance

Tranche Credit Ratings (21 Notch Scale)

Aaa 20 15 Baa 10 Caa 5 0 1/11/07 1/30/08 3/07/08 6/16/08 7/09/08 Entered accelerated
Aaa
20
15
Baa
10
Caa
5
0
1/11/07
1/30/08
3/07/08
6/16/08
7/09/08
Entered accelerated repayment on March 17, 2008

A1SA1J A2 A3 B C

A1JA1S A2 A3 B C

A2A1S A1J A3 B C

A3A1S A1J A2 B C

BA1S A1J A2 A3 C

CA1S A1J A2 A3 B

Leveraged exposure to systematic risk

Pooling assets does not reduce systematic risk

Performance of collateral assets depends on two types of risk factors

Idiosyncratic factors unique to each asset (e.g., quality of a firm’s management, homeowner’s individual financial condition)

Systematic factors shared by all assets (e.g., macro environment, aggregate home price appreciation)

Pooling assets limits importance of idiosyncratic risk

Law of Large Numbers implies that loss rate for a pool of securities is less volatile than the loss rate for an individual security

But pooling assets does not diminish systematic risk

Systematic risk factors induce correlations in losses across securities

Loss rate for a large pool of securities has less dispersion overall, but systematic factors play a bigger role

Large asset pools may not be safer under systematic stress conditions

pools may not be safer under systematic stress conditions Loss Exceedance Probabilities (%) Num. of Loss

Loss Exceedance Probabilities (%)

Num. of

Loss

Loss

Loss

Bonds

> 5%

> 10%

> 15%

 

Unconditional

 

20

18.6

6.3

2.0

200

16.3

3.1

0.5

 

Systematic Stress*

 

20

67.2

 

39.4 16.5

200

81.2

 

37.5 11.6

* Assumes 99 th percentile draw of systematic risk factor

Senior tranches are sensitive to macro shocks

Senior tranches are always safer than junior tranches of the same CDO

Expected Losses (%) for Simulated CDO Tranches

 

Unconditional

Stress Condition

 

Tranche

Expected Loss

Expected Loss*

Ratio

Collateral

   
 

Pool

3.5

11.7

3.4

3

- 6%

10.4

72.0

6.9

6

- 9%

3.6

39.8

11.5

9 - 12%

1.2

20.4

16.6

12 - 100%

0.0

0.5

35.5

* Stress condition assumes 99 th percentile draw of systematic factor.

But credit performance of senior tranches is more sensitive to systematic shocks

Ratio of Stess Expected Loss to Unconditional Expected Loss Simulated CDO of 200 Mezzanine Bonds

40 35 30 25 20 15 10 5 0 Collateral Pool 3-6% Tranche 6-9% Tranche
40
35
30
25
20
15
10
5
0
Collateral Pool
3-6% Tranche
6-9% Tranche
9-12% Tranche
12-100% Tranche

Heitfield -- Federal Reserve Board

Stress EL assumes 99th percentile draw of a systematic risk factor.

22

Model risk

Senior tranche risk metrics are more sensitive to model errors…

Simulated CDO tranche probability of default (PD), expected loss (EL), and conditional expected loss (EL 0.99 ) as a function of collateral default probability parameter (π) and asset correlation parameter (ρ).

default probability parameter ( π ) and asset correlation parameter ( ρ ). Heitfield -- Federal

…so senior tranches are harder to evaluate given limited data

senior tranches are harder to evaluate given limited data Simulated distribution of CDO tranche probability of

Simulated distribution of CDO tranche probability of default (PD), expected loss (EL), and conditional expected loss (EL 0.99 ) given historical data on the performance of 20 cohorts of 400 collateral bonds.

Conclusions

To a large degree, the potential for dramatic falls in ratings and valuations was “baked in” to the securitization process

Complexity of exotic resecuritization deals made it difficult to evaluate risk exposures

Pooling assets and structuring liabilities ensured that senior tranches would perform well under most circumstances, but would all fall together

Credit rating and valuation models depended on limited data – could not accurately assess the likelihood of future losses

Looking Forward

Regulators and market participants are working to address identified problems

Originators, underwriters, and sponsors created increasingly complex structured products, but did not always supply investors with sufficient information on the assets backing them

Rating agencies underestimated the risk of RMBS and complex resecuritization products

Financial regulators did not adequately distinguish between structured and unstructured credit exposures

Investors, attracted to higher yields, relied on credit ratings, ignored exposure to systematic risk

Alternatives to structured MBS are expanding

Alternatives to structured MBS are expanding Figure extracted from Best Practices for Resi dential Covered Bonds

Figure extracted from Best Practices for Residential Covered Bonds, US Treasury Dep.

Covered bonds

US regulators are promoting use of covered bonds to finance mortgage lending (July 2008)

FDIC clarified receivership treatment of covered bonds

Treasury articulated best practice standards for covered bonds

Covered bonds offer an alternative funding source for banks

More flexible than deposits

Cheaper than unsecured bank-issued bonds

Unlike securitization, covered bonds do not transfer credit risk

If collateral assets perform poorly, bank equity-holders bear first losses, not covered bond investors

Collateral performance only affects bond returns if the issuing bank defaults

Effects on bank balance sheets

No direct effect on assets – pledged collateral stays with the bank

May increase risk to FDIC, uninsured depositors, and unsecured bond-holders

May make it easier for banks to manage liquidity

Will securitization come back?

Greater emphasis on transparency and standardization

Example: standardization of credit default swap terms and central clearing of CDS contracts

Rating agencies and other gatekeepers have become much more conservative

Some structured finance products including resecuritizations such as ABS CDOs and CDO 2 may no longer be viable