PREDATORY STRUCTURED FINANCE
http://www.doanlaw.com/pdf/Securitization.pdf
Paper Summary
Starts with history of american mortgages right from the building societies of 19th Century and then private thrift trusts and then thrifting as a business , and then to mortgaging and then the recession of 1890s and then the early securtization of mortgages of those times and then depression and then FHA setup which gave way for government assurances and thus underwriting.Thus started the days for motivation towards clean lines credits , but yet until the 1970-80s not much was there for predatory securitization of mortgages.Much of the mortgages were government sponsored .
In 1934 Congress created the Federal Housing Administration (“FHA”) tasking it with offering government guaranteed insurance to home mortgage lenders.For loans that met FHA’s underwriting criteria, the government agreed to pay mortgage lenders the difference between the price fetched by a repossessed home and its outstanding loan balance.In the 30s along with GSEs fannie mae was setup and paving way for more underwriting but in a more professionalized fashion.Fannie Mae’s function was to act as an assignee by purchasing FHA’s “nonconventional” insured loans.Not only was a qualifying mortgage guaranteed, but the lender, if it chose, could assign the loan to Fannie Mae for cash, quickly recouping its investment plus a premium.Though much of criteria for primes remained strict fannie mae did introduce the markets towards mortgage securitization.
In 1968 Congress partitioned Fannie Mae into two separate organizations. The Government National Mortgage Association.64 Ginnie Mae, as it became known, continued to purchase nonconventional FHA and VA insured mortgages.Fannie Mae became a private federally chartered corporation whose primary function would be to purchase conventional home mortgages from private lenders. At this point Fannie Mae still held home mortgages in its own portfolio, and in turn borrowed money in its own name to finance its operations. The hope was that this new private incarnation of Fannie Mae would provide a reliable low cost source of funds for lenders wishing to offer conventional non-government insured mortgages.In 1970, Congress created Freddie Mac to serve a similar role as Fannie Mae.A short time later, a fundamentally new method of obtaining funds for mortgage loans developed: securitization.Rather than holding mortgages themselves, both Ginnie Mae and then Freddie Mac began issuing mortgage backed securities that “passed through” interest income to investors.The agencies would purchase home mortgages, deposit large numbers of them in “pools”, and sell participations in the pools to investors on Wall Street. With these new pass-through investment vehicles, investors could hold a share of large (and diversified) number of mortgages insured by the government in the case of Ginnie Mae, or guaranteed by the large stable government sponsored enterprises (“GSEs”) in the case of Freddie Mac and Fannie Mae (who also began securitizing shortly thereafter).Because the agencies now
guaranteed the principal and interest income of their securities even when mortgagors defaulted, investors saw the securities as a low risk investment even without the assurances of a rating organization, such as Standard and Poors or Moody’s.
Like the GSEs, purely private institutions saw the potential benefits of pooling home mortgages into mortgage-backed securities and soon began attempting to channel capital into home mortgage lending in similar ways.Private financiers wanted to mobilize capital to serve this enormous potential demand for credit.Also as GSEs invested in mortgages with specific middle class oriented policy objectives in mind, they would not purchase unusually large (“jumbo”) mortgages, mortgages with variable interest rates (“ARMs”), home equity loans, or—most importantly for our purposes—subprime mortgages.Unmet demand in these market segments left enticing (and large) niches for private investors.
In 1977 Bank of America and Salomon Brothers (with some limited cooperation from Freddie Mac) moved to take advantage these potential markets by issuing a security where outstanding loans were held in trust, with investors as beneficiaries.The trust itself was entirely passive — it had no employees or assets aside from the home mortgages themselves.Participations in this trust are generally recognized as the first mortgage back securities issued by the private sector—now called “private label” mortgage-backed securities.
Initially, investment in these “securitized” mortgages suffered from legal and pricing problems stemming in part from the novelty of the new method of finance.The first crucial innovation facilitating securitization was the development of pricing models that could estimate the present value of the right to receive a portion the revenue from a pool of loans. Because mortgage backed securities issued by the government sponsored enterprises held an implicit federal guarantee, investors felt comfortable in using the face value of those securities to make investment decisions.
First, academics and investment analysts came up with satisfactory pricing models.91 Some of the early pricing models relied on public records of FHA mortgage histories.As mortgage-backed securities
became more complex, Wall Street spent millions of dollars refining these models & generally researching ways to estimate the value of pools of home mortgages.Ultimately investment analysts and academics succeeded in creating models which gave investors sufficient confidence to create tradeable securities.
A second innovation was the development of risk and term partitioned securities.Instead of directly passing through loan payments to investors, the income created by loans in the pool was divided into different income streams suited to the time and risk preferences of investors.Thus, investment bankers learned to tailor securities to the needs of different investors, making investment in mortgage backed securities desirable to a broader range of potential investors.Partitioned mortgage securities divide the income of mortgage pools into different “tranches” or “strips” each of which can be purchased by investors.Examples are principle-only tranche and interest only tranche.
Mortgage pool trustees also learned to tailor tranches to appeal to investors that prefer investing at a variety of maturation levels.For instance, insurance companies often know beforehand when the window will close on customer claims against a given insurance policy.These insurance companies may be particularly interested in a mortgage-backed security tranche with maturation dates designed to coincide with the closing of the insurance company’s policy liability window.Similarly, stripped mortgage backed securities with short term
maturations allow banks to invest in securities that match their short term deposit liabilities.Sometimes this is called ‘time tranching’ away from ‘credit tranching’ wherein interset risk is borne out!
A final development facilitating a private label home mortgage securitization market,was the introduction of rating agencies and credit enhancements.After doing due diligence, ratings agencies issue a credit rating on each tranch signaling to potential investors the likelihood that a particular instrument will pay interest and principle according to its terms.In order to receive investment grade credit ratings on some tranches of the mortgage pool, credit rating agencies usually require the issuer to augment the reliability of those tranches through “credit enhancements.”Credit enhancements are contractual arrangements that increase the likelihood that a particular participation in the pool of loans will pay out according to its terms.
Two basic types of credit enhancement: internal and external.
- internal: Tranching by seniority,turbo-structure wherein investors purchase a promised pay out on a tranche that is less than the aggregate assets of the underlying mortgages(A turbo structure is secured by more collateral than would be necessary to pay on-time if none of the underlying mortgages underperform)
- external credit enhancement: can take the form of insurance, letters of credit, or contractual guarantees.One limitation of this strategy is that, other things being equal, the credit rating given
to the mortgage-backed securities will only be as high as the third party enhancer’s credit rating.
Nevertheless, the potential rewards from home mortgage securitization are such that many companies, including some with outstanding credit ratings, have been willing to insure or guarantee senior tranches.
These developments in the private label home mortgage backed securities market facilitated a rapid increase in securitization.Expanding far beyond home mortgages, Wall Street now securitizes credit card debt, automobile loans, commercial loans, equipment leases, and loans to developing countries.Indeed receivables from virtually any income producing asset can securitized,including physician and hospital accounts, oil exploration, lawsuit settlement proceeds, entire business ventures, or even baseball stadiums. One firm famously led the way in intellectual property securitization by issuing “Bowie Bonds” with future royalties expected from pop-musician David Bowie’s music portfolio.Much of this
new credit was extended to borrowers with problematic credit histories.
Initially, a mortgage broker identifies a potential borrower through a variety of marketing approaches including direct mail, telemarketing, door-to-door solicitation, and television or radio advertising.The originator and broker together identify a loan which may or may not be suitable to the borrower’s needs.In determining the interest rate and other pricing variables, the broker and the originator rely on one or more consumer credit reporting agencies that compile database of information about on past credit performance, currently outstanding debt, prior civil judgements, bankruptcies.Consumers are given a credit score, often based on the statistical models of the Fair Issacson & Co, a firm that specializes in evaluating consumer repayment.Some brokers fund the loan directly using her own funds or a warehouse line of credit, while other brokers act as an agent using the originator’s capital to fund the loan.In any case, the originator establishes its right
to payment by giving public notice of the mortgage through recording it with a county recorders office.
Then, in a typical conduit the originator will quickly transfer the loan to a subsidiary of an investment banking firm.This subsidiary which is alternatively called the securitization sponsor, or seller, then transfers the loan and hundreds of others like it into a pool of loans.This pool of loans will become its own business entity, called a special purpose vehicle (“SPV”).Aside from the mortgages, the SPV has no other assets, employees, or function beyond the act of owning the loans. Under the agreement transferring the loans into the pool, the SPV agrees to sell pieces of itself to investors.In designing the SPV and its investment tranches, the seller typically works closely with a credit rating agency that will rate the credit risk of each tranche.The credit rating agency investigates credit risk of the underlying mortgages as well as the risks posed from pooling the mortgages together
Inquiry as to the former, known as “mortgage risk”, focuses
above all upon borrower net equity over time—which is to say, the risk that foreclosure on a defaulting mortgage will not recoup invested funds.Evaluation of “pool risk” looks at factors such as the size of the loan pool and the geographic diversity of underlying mortgages.Credit ratings on each tranche are essential, since they obviate the need for each individual investor to do due diligence on the underlying mortgages in the pool.The rating agency will typically require some form of credit enhancement on some tranches to assign them higher investment ratings.The seller also arranges to sell the rights to service the loan pool to a company which will correspond with consumers, receive monthly payments, monitor collateral, and when necessary foreclose on homes.Sometimes the originator retains servicing rights which has the advantage of maintaining a business relationship with homeowners.But often servicing is done by a company specializing in this activity.Increasingly, pooling and servicing agreements allow for several different servicing companies with different debt collection roles. A master servicer may have management responsibility for the entire loan pool. Similar to a subcontractor in construction, the master servicer may subcontract to subservicers with a loan type or geographic specialty.The pooling and servicing agreement may also allow for a special servicer that focuses exclusively in loans that fall into default or have some other characteristics making repayment unlikely.Some servicing agreements require servicers to purchase suborinated tranches issued from the mortgage pool in order to preserve the incentive to aggressively collect on the loans.
Many securitization deals sellers and trustees agree to hire a document custodian to keep track of the mountains of paperwork on loans in the pool .A related role is commonly played by a unique company called Mortgage Electronic Registration System, Inc.The mortgage is often recorded with the county property recorder’s office under MERS, Inc.’s
name, rather than the originator’s name—even though MERS does not solicit, fund, service, or ever actually own the loan. MERS then purports to remain the mortgagee of record for the duration of the loan even after the originator or a subsequent assignee transfers the loan into an SPV for securitization. MERS justifies its role by explaining that it is acting as a “nominee” for the parties.
Altogether, these businesses have created an extremely powerful and lucrative device for marshaling capital into home mortgage loans.
Securitization can decrease the information costs for investors interested in investing in home mortgages.Also, securitization allows loan originators to make great profit from origination fees by leveraging limited access to capital into many loans.Even
lenders with modest capital can quickly assign their loans into a securitization conduit, and use the proceeds of the sale to make a new round of loans.These advantages have increased consumer access to purchase money mortgages, home equity lines of credit, and cash-out
refinancing. And while, in general, this is a positive development for American consumers, it has had profound and less beneficial consequences for some borrowers.
In the parlance of mortgage lending industry, “prime mortgages” are generally those that qualify to be resold to Fannie Mae or Freddie Mac.Both GSEs have strict automated underwriting standards, use widely accepted financial models, require standardized documentation, and pay similar prices for all the loans they purchase.All of these factors stabilize and homogenize prime mortgage loans allowing the secondary market to treat prime loans like a commodity, rather than long term, tenuous financial relationships.In contrast, “subprime” mortgages are typically—though by no means always—made to borrowers with problematic credit histories that do not meet the guidelines of the GSEs.
Unlike prime loans where access to the secondary market is guarded by the playit-safe GSEs, the secondary subprime market is filled with aggressive investors and businesses looking to maximize their profits by any possible means.
One advantage of non-uniform underwriting in the subprime market is the ability to penetrate into markets not served well by prime lenders.Both of these factors tend to lower the borrower’s risk profile as evaluated by the GSES’s automated underwriting guidelines Similarly, many subprime borrowers want to finance non-traditional housing stock, including especially manufactured homes, which are often located on leased real estate.Moreover,
subprime borrowers often lack strong relationships with depository institutions, and thus tend to be more amenable to alternative marketing strategies, such as direct mail, telephone solicitation, email spam, internet advertizing, and even door-to-door sales. These characteristics have facilitated the commercial practices and contract terms that too often create ethically and legally questionable loans.The result has been a steady stream of consumer horror stories from this segment of the mortgage market and widespread accusations of “predatory lending.
