Note on Securitisation Revenues and Writedowns

What is Securitisation Securitisation is made up of four core business lines: ABS The term ABS covers securitisations of: auto loans student loans credit card loans home equity loans (typically second loans on a property or home improvement loans) equipment or infrastructure projects whole businesses (ie the future income of part or all of a company) The latter two categories tend to be the most complex and generate the highest fees. RMBS These are securitisations based on residential mortgage loans. Historically this segment has been markedly different on each side of the Atlantic. In the US the the market has been made up of: Agencies securities issued by US agencies (mainly Freddie Mac and Fannie Mae), but syndicated by investment banks. This product sits outside of securitisation groups at some banks and is instead aligned with the US Treasury desk Private Label RMBS here home buyers take out a mortgage through a mortgage broker (brokers range from one man companies to banks themselves), a financial institution initially finances the loan, but loans are often traded between banks or are bought by investment banks before being securitised. The loans are then serviced by specialist companies. The main categories are: o pass-throughs, o collateralized mortgage obligations (CMOs). These are typically issued through a specialized conduit called a REMIC o CDOs of residential mortgages. These are similar to CMOs but have more relaxed rules on collateral and may include instruments such as credit default swaps. These quite distinct from CBOs, CLOs and CSOs which are more properly credit products. In Europe homebuyers have tended to go to a bank or mutual society for a mortgage.

These institutions have tended to hold the loans on their own balance sheet financing them from deposit accounts or, more riskily, through the money markets, or covered bonds. Covered bonds have some similarities with securitisation in that they are bonds backed by mortgages (or in some cases public debt). The crucial difference is that the institution issuing them has to ensure that the net interest income from the pool of loans is always sufficient to pay the bond holders the credit risk therefore effectively remains with the bank rather than the holder of the covered bond. In most banks they are traded with European supra and agency bonds. Historically some financial institutions have used RMBS to finance their mortgage lending, but this was not the norm. However, from around 2004 the US style private label model started to creep in, with the advent of specialist sub-prime mortgage companies. Some investment banks quickly moved to capture part of this new market. CMBS These are more akin to RMBS, but with the underlying mortgage being secured on commercial property. This property typically falls into one of the following categories: Offices (such as 30 St Mary Axe) Industrial sites Retail sites (usually shopping malls) Residential apartments or multifamily buildings

The securitisations take one of three forms: Securitisations to finance developments by property companies themselves (such as Prologis or St George) CMO securitisations based on a pool of loans bought by a bank or other financial institution Commercial real estate CDOs these are brought to market in a similar way to CMOs but have more relaxed rules on collateral quality.

Conduits These are special purpose entities set up by investment banks in order to pool the short term financing needs of a number of corporate clients. The conduit issues commercial paper to provide financing for the corporates. The credit risk of this paper is effectively based on the pool of corporates. The conduit therefore is a vehicle to gain greater scale and lower financing costs that the corporate clients could achieve on their own. Corporate clients pay fees to the bank responsible for the conduit. Location of Securitisation businesses in Banks Securitisation is an activity that can sit in many different places in a bank:

It can be linked to debt origination (as is the case at GS for example) It can be in fixed income trading (as is the case at CS) It can even be split across the two (at DBK CMBS is part of banking and RMBS and ABS is part of sales and trading)

When analyzing the market we decided it was decided that for consistency all origination activity would be a primary activity, whether it is: agented - ie the bank gets a fee for arranging the securitisation of a client's assets, or principal - In principal deals the bank is securitising loans that it has bought onto its own balance sheet and is making money from: o the credit spread between the interest paid in on the original loans and the interest paid out to the holders of the ABS, RMBS or CMBS paper. This is risk free ONCE the securities have been placed - there is a time lag as you need to build up a good sized pool of loans before they can be securitised. o the gross interest payments on any paper that they either fail to place or choose to hold. In this case the entire credit risk of the loans rests with the bank.

With this approach the secondary securitisation part of the business only covers the secondary trading of and ABS, CMBS or RMBS securities after they have been issued. Writedowns Turning now to the securitisation writedowns. Why did they occur? The answer is that they were almost entirely due to principal securitisation activity. As the US housing market crashed so defaults on residential mortgages increased. This led to real or theoretical losses from two direct sources: any bank holding mortgage loans on their own balance sheet (these would be loans that were being warehoused while a pool of the right size was being built to then be securitised) had to mark-down the value of those loans (as they were held on a mark to market accounting basis and the probability of default was now much higher, plus some would have actually defaulted. This was mainly a driver of writedowns in 2007. The chart below show defaults on US sub-prime and prime mortgages (as you can see prime mortgages which were supposedly credit-worthy borrowers became much more likely to default).

Exhibit 9

Residential Delinquencies

Updated May 29, 2009

Residential Delinquencies by loan number

35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%
35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%

Source: National Delinquency Survey, Mortgage Bankers Association, CMSA. Delinquency figures are based on loan counts (not dollar balances) and includes loans that are 60+, 90-day delinquent in addition to loans in process of foreclosure. Figures are seasonally adjusted by MBA using Census Bureau's X-12-ARIMA seasonally adjusted program. REO is not included. For the first quarter 2008, National Delinquency Survey data covered about 45.0 million loans 1-4 unit residential properties.

any bank that held RMBS securities on its balance sheet (either because they chose to hold them or had failed 2008 CMSA - Commercial Mortgage Securities Association, all rights reserved. to sell them when carrying out the original securitisation) had to mark down the value of these securities and show the reduced value as a loss (even though they were unrealised losses). For interest you might like to note that the LEH 10-Q report covering the second quarter of 2008 shows that at May 2008 LEH at group level had $72bn of ABS, CMBS and RMBS on its balance sheet. Some indices for US mortgage backed securities are shown below - note how jumbo MBS are the first to loose value and become almost worthless, and how the value of AAA goes down by 10-20% and BBB 30%. As an aside you can see that agency MBS retain their value, but only because of the guarantees provided by the agencies themselves. It is these guarantees that will take the agencies to verge of bankruptcy and lead to intervention by the US government.
US MBS Pricing

Q 39 8 Q 19 9 Q 39 9 Q 10 0 Q 30 0 Q 10 1 Q 30 1 Q 10 2 Q 30 2 Q 10 3 Q 30 3 Q 10 4 Q 30 4 Q 10 5 Q 30 5 Q 10 6 Q 30 6 Q 10 7 Q 30 7 Q 10 8 Q 30 8 Q 10 9

All residential

Prime

Subprime

After the residential market faltered the commercial market also went into decline. Investment banks have therefore put in writedowns on both loans themselves and securities held. However, the scale and duration of CMBS problems has been much more short-lived as the chart below shows.
Exhibit 13

CMBS Spreads and Swap Spreads Monthly

Updated August 10, 2009

CMBS spread over swaps

1200

1200

1050

1050

900

900

750
basis points

750

600

600

450

450

300

300

150

150

0
Au g D 96 ec Ap 96 Au r 97 g D 97 ec Ap 97 r Au 98 g D 98 ec Ap 98 Au r 99 g D 99 ec Ap 99 Au r 00 g D 00 ec Ap 00 Au r 01 g D 01 ec Ap 01 Au r 02 g D 02 ec Ap 02 Au r 03 g D 03 ec Ap 03 Au r 04 g D 04 ec Ap 04 Au r 05 g D 05 ec Ap 05 Au r 06 g D 06 ec Ap 06 Au r 07 g D 07 ec Ap 07 A r0 D ug 8 ec 0 8 Ap 20 r 2 08 00 9

Gap

Swap Spread

CMBS Aaa Spreads Treasurys (10-year)

Source: Morgan Stanley. Generic AAA spreads from August 1996 to December 2004; Super Senior AAA from January 2005 to present.
2008 CMSA - Commercial Mortgage Securities Association, all rights reserved.

Writedowns due to Monolines In many structures monolines provided a key role in enhancing the rating of the securities issued by providing credit guarantees. Indeed, when looking at the chart below it can be seen that they insured over 50% of all CDO based securities issued this covers residential CDOs, commercial CDOs and Cash CDOs (the latter falls outside the scope of this note.
CDO structures issued and the percentage insured by monolines

However, as the creditworthiness of RMBS and CMBS fell so the insured liabilities of the monolines grew to the extent that their own viability was doubted. This can be seen by looking at the share price and CDS spread of MBIA (one of the largest) on the chart below.
MBIA Share price and CDS spread

Source: Euromoney

The loss of faith in the monolines in turn led to doubt being placed on the value of the insurance or credit guarantees that they had provided on securities. Investment banks, again working on mark to market accounting, therefore added writedowns based on the additional loss that would be incurred if the monolines failed. Public reporting of revenues and writedowns When it comes to the public reporting of securitisation revenues as well as any losses/writedowns banks take slightly differing strategies. However, in general: fee revenue is reported under debt underwriting gains due to principal activity is reported in fixed income sales and trading losses and writedowns are reported against fixed income sales and trading

In order to align all securitisation revenues and losses/writedowns we move any booked against fixed income sales and trading up to the primary securitisation section. All elements of the origination based securitisation businesses are therefore in the same place making valid comparisons between banks possible.

Tricumen August 2009