Chapter Twenty-

Five
Managing Risk off
the Balance Sheet
with Loan Sales and
Securitization

Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.
 Loan Sales and Securitization

 Loan
Loansalessalesand
andsecuritization,
securitization, thethepacking
packingand
andselling
sellingofof
loans
loansand andother
other assets
assets backed
backedby byloans
loans issued
issuedbyby the
theFI,
FI,
are
aremechanisms
mechanismsthat that FIs
FIshave
haveused
usedto tohedge
hedgetheir
their credit
credit
risk,
risk, interest
interest rate
raterisk,
risk, and
andliquidity
liquidityrisk
riskexposures
exposures
 Allowed
AllowedFI
FIasset
assetportfolios
portfoliostotobecome
becomemore
moreliquid
liquid
 Provided
Providedan
animportant
importantsource
sourceofoffee
feeincome
income
 Helped
Helpedreduce
reducethe
theeffects
effectsofofregulatory
regulatory“taxes”
“taxes”(e.g.,
(e.g.,capital
capital
requirements,
requirements,reserve
reserverequirements,
requirements,and anddeposit
depositinsurance
insurance
premiums)
premiums)ononFI
FIprofitability
profitability
 Loan
Loansales
salesinvolve
involvesplitting
splittingup
uplarger
larger loans
loansand
andloan
loan
portfolios,
portfolios, whereas
whereasloan
loansecuritization
securitizationinvolved
involvedthe
thegrouping
grouping
of
of smaller
smallerloans
loansinto
intolarger
largerpools
pools
© 2022 McGraw-Hill Education. 25-2
 Loan Sales

 Loan
Loansale
sale occurs
occurs when
whenan
anFIFI originates
originatesaaloan
loanand
andsells
sellsitit
with
withor
or without
without recourse
recourse to
toan
anoutside
outsidebuyer
buyer
 Recourse
Recourseisisthe
theability
abilityof
ofaaloan
loanbuyer
buyerto
tosell
sellthe
theloan
loanback
backto
to
the
theoriginator
originatorshould
shouldititgo
gobad
bad
 Large
Largepart
part of
of correspondent
correspondent banking
banking involves
involvessmall
smallFIsFIs
making
makinglarge
largeloans
loansand
andselling
selling(or
(or syndicating)
syndicating) parts
partsof of the
the
loans
loansto
tolarge
largeFIs,
FIs, who
whoininturn
turnoften
oftensell
sellparts
partsof
of their
their loans
loans
(called
(calledparticipations)
participations) totosmaller
smaller FIs
FIs
 Correspondent
Correspondentbanking
bankingisisaarelationship
relationshipbetween
betweenaasmall
small
bank
bankand
andaalarge
largebank
bankin inwhich
whichthe
thelarge
largebank
bankprovides
providesaa
number
numberof
ofdeposit,
deposit,lending,
lending,and
andother
otherservices
services
 Syndicated
Syndicatedloan
loanmarket
market isisthe
themarket
market for
for buying
buyingand
andselling
selling
loans
loansonce
oncethey
theyhave
havebeen
beenoriginated
originated
© 2022 McGraw-Hill Education. 25-3
 Loan Sales (Continued)

 Syndicated
Syndicatedloan
loanmarket
market can
canbe
besegmented
segmentedinto
intothree
three
categories:
categories:
1.1. Market
Marketmakers
makersare aregenerally
generallythe
thelarge
largecommercial
commercialbanks
banksthat
that
commit
commitcapital
capitalto
tocreate
createliquidity
liquidityand
andtake
takeoutright
outrightpositions
positionsin in
the
themarkets
markets
2.2. Active
Activetraders
tradersare
aremainly
mainlyinvestment
investmentbanks,
banks,commercial
commercialbanks,
banks,
and
andculture
culturefunds
funds
3.3. Occasional
Occasionalparticipants
participantsmay
maybe beeither
eithersellers
sellersor
orbuyers
buyersof ofloans
loans
 Syndicated
Syndicatedloan
loanmarket
market grew
grewrapidly
rapidlyin
inthe
theearly
early1980s
1980sdue
due
to
tothe
theexpansion
expansionin in highly
highlyleveraged
leveragedtransaction
transaction(HLT)
(HLT)
loans
loans to
tofinance
financeleveraged
leveragedbuyouts
buyouts (LBOs)
(LBOs) and
andmergers
mergersand
and
acquisitions
acquisitions(M&As)
(M&As)
 HLT
HLTloans
loansfinance
financeaamerger
mergerand
andacquisition;
acquisition;aaleveraged
leveraged
buyout
buyoutresults
resultsin
inaahigh
highleverage
leverageratio
ratiofor
forthe
theborrower
borrower
© 2022 McGraw-Hill Education. 25-4
Recent Trends in the Loan Sales
Market

© 2022 McGraw-Hill Education. 25-5

 Types of Loan Sales Contracts

1.1. Participation
Participationin
inaaloan
loanisisthe
theact
actof
ofbuying
buyingaashare
sharein
inaaloan
loan
syndication
syndicationwith
withlimited
limitedcontractual
contractualcontrol
controland
andrights
rightsover
overborrower
borrower
 Holder
Holder(buyer)
(buyer)isisnot
notaaparty
partyto
tothe
theunderlying
underlying(primary)
(primary)credit
credit
agreement,
agreement,so sothe
theinitial
initialcontract
contractbetween
betweenthe
theloan
loanseller
sellerand
andthe
the
borrower
borrowerremains
remainsininplace
placeafter
afterthe
thesale
sale
 Loan
Loanbuyer
buyercancanexercise
exerciseonly
onlypartial
partialcontrol
controlover
overchanges
changesininthe
theloan
loan
contract’s
contract’sterms
terms
 Holder
Holdercan
canvote
voteon
ononly
onlymaterial
materialchanges
changesto
toloan
loancontract
contract
2.2. An
Anassignment
assignmentisisthe
thepurchase
purchaseofofaashare
sharein
inaaloan
loansyndication
syndication
with
withsome
somecontractual
contractualcontrol
controland
andrights
rightsover
overthe
theborrower
borrower
 All
Allownership
ownershiprights
rightsare
aretransferred
transferredon
onsale,
sale,meaning
meaningthetheloan
loanbuyer
buyer
holds
holdsaadirect
directclaim
claimon
onthe
theborrower
borrower
 U.S.
U.S.domestic
domesticloans
loansare
arenormally
normallytransferred
transferredwith
withaaUCC
UCCfiling,
filing,meaning
meaning
there
thereisisdocumentation
documentationof ofaachange
changeininownership
ownershipininwhich
whichthe
thebuyer
buyerhas
has
first
firstclaim
claimononthe
theborrower’s
borrower’sassets
assetsininthe
theevent
eventof
ofbankruptcy
bankruptcy
© 2022 McGraw-Hill Education. 25-6
 The Loan Sales Market
 U.S.
U.S.loan
loansales
salesmarket
markethas
hasthree
threesegments:
segments:
1.1. Traditional
Traditionalshort-term
short-termloans
loans
 Secured
Securedby byassets
assetsofofthe
theborrowing
borrowingfirm
firmororother
otherexternal
externalguarantors
guarantors
 Made
Madeto toinvestment-grade
investment-gradeborrowers
borrowersor orbetter
better
 Issued
Issuedforforaashort
shortterm
term(90(90days
daysororless)
less)
 Sold
Soldininunits
unitsof
of$1
$1million
millionand
andup
up
 Rates
Ratesareareclosely
closelytied
tiedtotocommercial
commercialpaper
paperrate
rate
2.2. Highly
Highlyleveraged
leveragedtransactions
transactions(HLTs)
(HLTs)loans
loans
 Secured
Securedby byassets
assetsofofthe
theborrowing
borrowingfirm
firm
 Have
Havelong
longmaturity
maturity(often
(oftenthree-
three-to
tosix-
six-year
yearmaturities)
maturities)
 Have
Havefloating
floatingrates
ratestied
tiedto
tothe
theLIBOR,
LIBOR,thetheprime
primerate,
rate,or
oraaCD
CDrate
rate
 Have
Havestrong
strongcovenant
covenantprotection
protection
 May
Maybebeeither
eitherdistressed
distressedor ornondistressed
nondistressed
3.3. Less
Lessdeveloped
developedcountry
country(LDC)
(LDC)loans
loansare
aremade
madeto
toaaless
less
developed
developedcountry
country(LDC)
(LDC)
© 2022 McGraw-Hill Education. 25-7
 The Buyers

 For
Forthe
thenondistressed
nondistressedmarket
marketand
andthe
thetraditional
traditionalU.S.
U.S.domestic
domestic
loan
loansales
salesmarket,
market,there
thereare
areseven
sevenmajor
majorbuyers:
buyers:
1.1. Investment
Investmentbanksbanksarearethe
thepredominant
predominantbuyersbuyersof ofloans
loansbecause:
because:
2.2. Vulture
Vulturefunds
fundsarearespecialized
specializedinvestment
investmentfundsfundsestablished
establishedto to
invest
investinindistressed
distressedloans,
loans,often
oftenwithwithan
anagenda
agendathatthatdoes
doesnot
not
include
includehelping
helpingthethedistressed
distressedfirmfirmsurvive
survive
3.3. Other
Otherdomestic
domesticbanks,
banks,especially
especiallysmallsmallbanks,
banks,may mayfind
findthe
thesales
sales
market
marketuseful
usefulas asaaway
waytotoregionally
regionallydiversify
diversifytheir
theirloan
loanportfolios
portfolios
4.4. Foreign
Foreignbanks
banksremain
remainthe
thedominant
dominantbuyerbuyerof ofdomestic
domesticU.S.U.S.loans
loans
5.5. Insurance
Insurancecompanies
companiesand andpension
pensionfundsfundsareareimportant
importantbuyers
buyersofof
long-term
long-termloans
loans
6.6. Closed-end
Closed-endbank bankloan
loanmutual
mutualfunds
fundsareareleveraged
leveragedmutual
mutualfunds
funds
that
thatinvest
investinindomestic
domesticU.S.
U.S.bank
bankloans
loans
7.7. Nonfinancial
Nonfinancialcorporations,
corporations,primarily
primarilythethefinancial
financialservices
servicesarms
armsofof
the
thevery
verylargest
largestU.S.
U.S.and
andEuropean
Europeancompanies,
companies,buy buyloans
loans
© 2022 McGraw-Hill Education. 25-8
 The Sellers

 Sellers
Sellersof ofdomestic
domesticloans
loansand andHLTHLTloans
loansinclude
includethe thefollowing:
following:
1.1. Major
Majormoney
moneycenter
centerbanks
bankshave havedominated
dominatedloan loanselling
selling
2.2. Small
Smallregional
regionalororcommunity
communitybanks banks sell
sellloans
loansto todiversify
diversifycredit
credit
risk,
risk,though
thoughthey
theyarearenot
notaamajor
majorplayer
playerin inthe
theloan
loansales
salesmarket
market
3.3. Foreign
Foreignbanks
bankssell
sellloans
loansfromfrombranch
branchnetworks
networks(e.g.,
(e.g.,the
the
Japanese-owned
Japanese-ownedbanks banksin inCalifornia)
California)ororloans
loansoriginated
originatedinintheir
their
home
homecountry
countryininU.S.
U.S.loan
loansales
salesmarkets
markets
4.4. Investment
Investmentbanks
banksact actasasloan
loansellers
sellerseither
eitheras aspart
partof
oftheir
theirloan
loan
origination
originationactivities
activitiesororasasactive
activetraders
tradersin inthe
themarket
market
5.5. U.S.
U.S.government
governmentand anditsitsagencies
agencies have
haveshown
shownan anincreased
increased
willingness
willingnesstotoengage
engagein inloan
loansales
salesininrecent
recentyears
years
 Aided
Aidedby
bypassage
passageofofDebt
DebtCollection
CollectionImprovement
ImprovementAct Actof
of1996,
1996,
which
whichauthorizes
authorizesfederal
federalagencies
agenciestotosell
selldelinquent/defaulted
delinquent/defaultedloans
loans
© 2022 McGraw-Hill Education. 25-9
 Secondary Market for Less
Developed Country (LDC) Debt
 Since
Sincethe
themid-1980s,
mid-1980s,aasecondary
secondarymarket
marketfor
fortrading
tradingLDC
LDCdebt
debt
has
hasdeveloped
developedamong
amonglarge
largecommercial
commercialand
andinvestment
investmentbanks
banks
in
inNew
NewYork
Yorkand
andLondon
London
 Volume
Volumeof oftrading
tradinghas
hasgrown
growndramatically,
dramatically,from
fromaround
around$2
$2billion
billionper
per
year
yearinin1984
1984to toover
over$6
$6billion
billiontoday
today
 Three
Threemarket
marketsegments
segmentsinclude
includethe
thefollowing:
following:
1.1. Sovereign
Sovereignbonds
bonds(i.e.,
(i.e.,government-issued
government-issueddebt)debt)
2.2. Performing
Performingloans
loansare
areoriginal
originalor
orrestructured
restructuredoutstanding
outstandingsovereign
sovereign
loans
loanson
onwhich
whichthe
thesovereign
sovereigncountry
countryisiscurrently
currentlymaintaining
maintaining
promised
promisedpayments
paymentsto tolenders
lendersor ordebt
debtholders
holders
3.3. Nonperforming
Nonperformingloans
loansreflect
reflectthe
thesecondary
secondarymarket
marketprices
pricesfor
forthe
the
sovereign
sovereignloans
loansof
ofcountries
countrieswhere
wherethere
thereare
areno
nointerest
interestor
or
principal
principalpayments
paymentscurrently
currentlybeing
beingmade
made
© 2022 McGraw-Hill Education. 25-10
 Future Loan Sales Growth

 Factors
Factorsencouraging
encouragingfuture
future  Factors
Factorsdeterring
deterringfuture
futureloan
loan
loan
loansales
salesgrowth:
growth: sales
salesgrowth:
growth:
 Fee
Feeincome
income––Originating
Originatingand and  Access
Accessto tothe
thecommercial
commercial
quickly
quicklyselling
sellingloans
loanscan canboost
boost paper
paper(CP)(CP)market
market––Firms
Firmshave
have
an FI’s reported income
an FI’s reported income less
less need to rely on bank loansto
need to rely on bank loans to
Liquidity finance short-term expenditures,

Liquidityriskrisk––FI FIcan
canmitigate
mitigate finance short-term expenditures,
aaliquidity problem by selling with
withfewer
fewerloan
loanoriginations
originations
liquidity problem by selling
some generally
generallyresulting
resultingininfewer
fewerloans
someof ofits
itsloans
loansto tooutside
outside loans
investors being
beingsold
sold
investors
Capital  Customer
Customerrelationship
relationshipeffects

Capitalcosts
costs––FIs FIscan
canboost
boost effects
capital-to-assets ––Loan
Loansales
salescan
canharm
harmrevenues
capital-to-assetsratio ratioby by revenues
reducing generated
generatedby bythe
theFI
FIasascurrent
reducingassets
assets(via(vialoan
loansales)
sales) current
rather and
andpotential
potentialfuture
futurecustomers
ratherthan
thanboosting
boostingcapital
capital customers
Reserve take their business elsewhere
take their business elsewhere

Reserverequirement
requirement––
Represents  Legal
Legalconcerns
concerns––Fraudulent
Representsaaform formof oftax
taxthat
that Fraudulent
adds conveyance
conveyance is oneexample
is one exampleof ofaa
adds to the cost of fundingthe
to the cost of funding the
loan portfolio legal
legalconcern
concernhampering
hamperinggrowth
growth
loan portfolio
© 2022 McGraw-Hill Education. 25-11
 Loan Securitization:
Pass-Through Security
 Pass-through
Pass-throughsecurities
securities offer
offerinvestors
investorsan aninterest
interestininaapool,
pool,
created
createdbybyFIs
FIspooling
poolingmortgages
mortgagesand andother
otherloans
loansthey
theyoriginate
originate
 Though many different types of loans (and other assets) on FI’s
Though many different types of loans (and other assets) on FI’s
balance
balancesheets
sheetsare
arecurrently
currentlybeing
beingsecuritized
securitizedas
aspass-
pass-
throughs,
throughs,the
theoriginal
originaluse
useofofthis
thistype
typeof
ofsecuritization
securitizationisisaaresult
result
of
ofgovernment-sponsored
government-sponsoredprograms
programsto toenhance
enhancethetheliquidity
liquidityof
of
the
theresidential
residentialmortgage
mortgagemarket
market
 Pass-through
Pass-throughmortgage
mortgagesecurities
securities“pass
“passthrough”
through”promised
promisedpayments
payments
by
byhouseholds
householdsofofprincipal
principaland
andinterest
intereston
onpools
poolsof
ofmortgages
mortgagescreated
created
by
byFIs
FIsto
tosecondary
secondarymarket
marketinvestors
investorsholding
holdingan
aninterest
interestininthese
thesepools
pools
 Three
Threegovernment
governmentagencies
agenciesor orgovernment-sponsored
government-sponsored
enterprises
enterprisesare
aredirectly
directlyinvolved
involvedininthe
thecreation
creationof
ofmortgage-
mortgage-
backed
backedpass-through
pass-throughsecurities:
securities:
 Ginnie
GinnieMae
Mae(GNMA),
(GNMA),Fannie
FannieMae
Mae(FNMA),
(FNMA),and
andFreddie
FreddieMac
Mac(FHLMC)
(FHLMC)

© 2022 McGraw-Hill Education. 25-12

Pass-Through Mortgage Security

© 2022 McGraw-Hill Education. 25-13

Summary of a GNMA Pass-
Through

© 2022 McGraw-Hill Education. 25-14

 Prepayment Risk on GNMA Pass-
Throughs
 Mortgage
Mortgageloan
loansecuritization
securitization
 Reduces
Reduces(or
(orremoves)
removes)thetheregulatory
regulatorytax
taxburden,
burden,interest
interestrate
rate
risk
riskexposure,
exposure,and
andliquidity
liquidityrisk
riskexposure
exposurethat
thatFIs
FIsface
facewhen
whenthey
they
issue
issuemortgages
mortgages
 Introduces
Introducesaanew
newrisk
risk––prepayment
prepaymentriskrisk––to
tothe
thepass-through
pass-through
security
securityholder
holder
 Prepay
Prepaymeans
meansto topay
payback
backaaloan
loanbefore
beforeits
itsmaturity
maturityto
tothe
theFI
FIthat
that
originated
originatedthe
theloan
loan
 Most
Most fixed-rate
fixed-ratemortgages
mortgagesare
arefully
fullyamortized
amortized
 Full
Fullamortization
amortizationisisthe
theequal,
equal,periodic
periodicrepayment
repaymenton onaaloan
loan
that
thatreflects
reflectspart
partinterest
interestand
andpart
partprincipal
principalover
overlife
lifeof
ofthe
theloan
loan
 Propensity
Propensitytotoprepay
prepaymeans
meansrealized
realizedcoupons/cash
coupons/cashflows
flowson
on
pass-through
pass-throughsecurities
securitiescan
canoften
oftendeviate
deviatesubstantially
substantiallyfrom
from
state
stateor
or expected
expectedcoupon
couponflows
flowsininaano-prepayment
no-prepayment world
world
© 2022 McGraw-Hill Education. 25-15
Prepayment Risk on Pass-
Through Securities

© 2022 McGraw-Hill Education. 25-16

 Collateralized Mortgage
Obligations (CMOs)
 Collateralized
Collateralizedmortgage
mortgageobligation
obligation(CMO)
(CMO) isisaamortgage-
mortgage-
backed
backedbond
bondissued
issuedin
inmultiple
multipleclasses,
classes, or
or tranches
tranches
 Innovated
Innovatedin in1983
1983bybyFHLMC
FHLMCand andCredit
CreditSuisse
SuisseFirstFirstBoston
Boston
 Makes
Makesmortgage-backed
mortgage-backedsecurities
securitiesmoremoreattractive
attractiveto toinvestors
investors
by
byrepackaging
repackagingcash cashflows
flowsfrom
frommortgages
mortgagesand andpass-through
pass-through
securities
securitiesin inaadifferent
differentfashion
fashionto toattract
attractdifferent
differenttypes
typesofof
investors
investorswith
withdifferent
differentdegrees
degreesof ofaversion
aversionto toprepayment
prepaymentrisk risk
 Pass-through
Pass-throughsecurity
securitygives
giveseach
eachinvestor
investoraaproprorata
ratashare
shareof of
any
anypromised
promisedand andprepaid
prepaidcash
cashflows
flowson onaamortgage
mortgagepool,pool,
whereas
whereasCMO CMOisisaamulticlass
multiclasspass-through
pass-throughwith withseveral
several
different
differentbond
bondholder
holderclasses
classes(i.e.,
(i.e.,tranches)
tranches)differentiated
differentiatedbyby
the
theorder
orderininwhich
whicheach
eachclass
classisispaid
paidoffoff
 Type
Typeof ofderivative
derivativesecurity
securitywith
withmortgages
mortgagesas asthe
theprimary
primaryasset
asset
 Serves
Servesto todistribute
distributeororreduce
reduceprepayment
prepaymentrisk risk
© 2022 McGraw-Hill Education. 25-17
 Creation of CMOs

 CMOs
CMOsare areusually
usuallycreated
createdby
byplacing
placingexisting
existingpass-throughs
pass-throughs
in
inaatrust
trust off-the-balance-sheet
off-the-balance-sheet
 May
Mayalso
alsobe
becreated
createdby
bypackaging
packagingand
andsecuritizing
securitizingwhole
whole
mortgage
mortgageloans
loans
 Trust
Trust issues
issuesCMOs
CMOsin inthree
threeor
or more
moredifferent
different classes,
classes, each
each
with
withaadifferent
different level
levelof
of prepayment
prepayment risk
risk
 Class
ClassAACMOCMOholders
holdershave
havethetheleast
leastprepayment
prepaymentprotection,
protection,
and
andare
areof
ofgreat
greatinterest
interestto
toinvestors
investorsseeking
seekingshort-duration
short-duration
mortgage-backed
mortgage-backedassets
assetstotoreduce
reducethe
theduration
durationof
oftheir
their
mortgage-related
mortgage-relatedasset
assetportfolios
portfolios
 After
Afterall
allClass
ClassAACMOs
CMOshavehavebeen
beenretired,
retired,remaining
remainingcash
cashflows
flows
(after
(aftercoupon
couponpayments)
payments)are areused
usedtotoretire
retire Class
ClassBBbonds
bonds
 Class
ClassBBholders
holdershave
havehigher
higherprepayment
prepaymentprotection
protectionthan
thanClass
ClassAA
 Class
ClassCCholders
holdershave
havethe
themost
mostprepayment
prepaymentprotection,
protection,and
andare
are
attractive
attractivetotoinsurance
insurancecompanies
companiesand
andpension
pensionfunds
funds
© 2022 McGraw-Hill Education. 25-18
The Creation of a CMO

© 2022 McGraw-Hill Education. 25-19

 Creation of CMOs (Continued)
 Issuing
IssuingCMOs
CMOsisisoften
oftenequivalent
equivalentto toengaging
engagingin indouble
double
securitization
securitization
 Sum
Sumof ofthe
theprices
pricesatatwhich
whichCMO CMOclasses classescan canbe besold
soldnormally
normally
exceeds
exceedsthat thatof
ofthe
theoriginal
originalpass-through
pass-through
 Gains from repackaging come from the way CMOs restructure
Gains from repackaging come from the way CMOs restructure
prepayment
prepaymentrisk riskto
tomake
makeititmore moreattractive
attractiveto todifferent
differentclasses
classes
of
ofinvestors
investors(i.e.,
(i.e.,each
eachclass
classhas hasaaguaranteed
guaranteedor orfixed
fixedcoupon)
coupon)
 CMOs
CMOscan canhave
havemore
morethanthanthe thethree
threeclasses classesdiscussed
discussedearlier
earlier
 Issues of up to 17 different classes have been made
Issues of up to 17 different classes have been made
 CMO issues often contain a Z class (standing for “zero”) as the
CMO issues often contain a Z class (standing for “zero”) as the
last
lastregular
regularclass;
class;ZZclass
classhas hascharacteristics
characteristicsof ofboth
bothaazero-
zero-
coupon
couponbond bond(no(nocoupon
couponpayments
paymentsfor foraalong
longperiod)
period)and
andaa
regular
regularbond
bond
 Another special CMO class is a planned amortization class
Another special CMO class is a planned amortization class
(PAC),
(PAC),designed
designedto toproduce
produceconstantconstantcash cashflows
flowswithin
withinaarange
range
(or
(orband)
band)of ofprepayment
prepayment rates
rates
© 2022 McGraw-Hill Education. 25-20
 Mortgage-Backed Bonds

 Mortgage-
Mortgage-(asset-)
(asset-)backed
backedbonds
bonds(MBBs)
(MBBs)are arebonds
bonds
collateralized
collateralizedby byaapool
poolofofassets
assets
 MBBs
MBBsdiffer
differfrom
frompass-throughs
pass-throughsand andCMOs
CMOsin intwo
twokey
keyareas:
areas:
 Mortgage backing MBBs normally remain on the balance sheet
Mortgage backing MBBs normally remain on the balance sheet
 Cash flows on mortgages backing the bond are not necessarily
Cash flows on mortgages backing the bond are not necessarily
directly
directlyconnected
connectedto tointerest
interestand
andprincipal
principalpayment
paymenton onthe
theMBB
MBB
 FI
FIissues
issuesan anMBB
MBBto toreduce
reducerisk
risktotothe
theMBB
MBBholders,
holders,who
whohave
haveaa
firm
firmclaim
claimto toaasegment
segmentof ofthe
theFI’s
FI’smortgage
mortgageassets
assets
 Costs
Costsof ofMBB
MBBissuance:
issuance:
 MBBs tie up mortgages on the balance sheet for long periods,
MBBs tie up mortgages on the balance sheet for long periods,
thus
thusdecreasing
decreasingthe theasset
assetportfolio’s
portfolio’sliquidity
liquidity
 FI is subject to any prepayment risk on the underlying mortgages
FI is subject to any prepayment risk on the underlying mortgages
 FI continues to be liable for capital adequacy and reserve
FI continues to be liable for capital adequacy and reserve
requirement
requirementtaxestaxesbybykeeping
keepingmortgages
mortgageson onthe
thebalance
balancesheet
sheet
© 2022 McGraw-Hill Education. 25-21
 Securitization of Other Assets

 Major
Majoruse
useof
ofsecuritization
securitizationvehicles
vehicleshas
hasbeen
beento
topackage
packagefixed-
fixed-
rate
rateresidential
residentialmortgage
mortgageassets,
assets,but
butthese
thesetechniques
techniquescan
canandand
have
havebeen
beenused
usedfor
forother
otherassets,
assets,including
includingthe
thefollowing:
following:
 Automobile loans
Automobile loans
 Credit card receivables
Credit card receivables
 Small-business loans guaranteed by the Small Business
Small-business loans guaranteed by the Small Business
Administration
Administration
 Commercial and industrial loans
Commercial and industrial loans
 Student loans
Student loans
 CDOs/CLOs
CDOs/CLOs
 Equipment loans
Equipment loans
 Junk bonds
Junk bonds
 Adjustable-rate mortgages
Adjustable-rate mortgages
© 2022 McGraw-Hill Education. 25-22
U.S. Asset-Backed Securities
Outstanding, 1985-2018

© 2022 McGraw-Hill Education. 25-23

Can All Assets be Securitized?

 Can
Canall
allassets
assetsand
andloans
loanseventually
eventuallybe
besecuritized?
securitized?
 Conceptually,
Conceptually,yes,
yes,sosolong
longas
asdoing
doingso
soisisprofitable
profitableororthe
the
benefits
benefitsto
tothe
theFI
FIfrom
fromsecuritization
securitizationoutweigh
outweighits itscosts
costs
 With
Withheterogeneous
heterogeneous loans,
loans, itit isisimportant
important to
tostandardize
standardize
the
thesalient
salient features
featuresof
of loans
loans
 Default
Defaultrisks,
risks,ififsignificant,
significant,must
mustbe
bereduced
reducedby
by
diversification
diversification
 Expected
Expectedmaturities
maturitiesmustmustbebereasonably
reasonablysimilar
similar
 FIs
FIshave
havebeen
beenable
ableto
toissue
issuethe
thefollowing
followingsecuritization
securitization
packages:
packages:
 CLOs
CLOsare arecollateralized
collateralizedloan
loanobligations
obligations containing
containinghigh-
high-
quality,
quality,low-default
low-defaultrisk
riskloans
loans
 CDOs
CDOsare arecollateralized
collateralizeddebt
debtobligations
obligationscontaining
containingaa
diversified
diversifiedcollection
collectionofofjunk
junkbonds
bondsororrisky
riskybank
bankloans
loans
© 2022 McGraw-Hill Education. 25-24
Benefits versus Costs of
Securitization

© 2022 McGraw-Hill Education. 25-25