Securitization
Chapter 28
Financial Institutions Management, 3/e
By Anthony Saunders
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Introduction

Securitization: Packaging and selling of
loans and other assets backed by securities.
• Many types of loans and assets are being
repackaged in this fashion including royalties
on recordings ( David Bowie, Rod Stewart).
• Original use was to enhance the liquidity of the
residential mortgage market.
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Securitization

Government National Mortgage Association
(GNMA)
• Sponsors MBS programs and acts as a
guarantor.
• Timing insurance.

FNMA actually creates MBSs by
purchasing packages of mortgage loans.
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Freddie Mac

Federal Home Loan Mortgage Corporation
• Similar function to FNMA except major role
has involved savings banks.
• Stockholder owned with line of credit from the
Treasury.
• Sponsors conventional loan pools as well as
FHA/VA mortgage pools.
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Incentives and Mechanics of PassThrough Security Creation

Example:
• Create a mortgage pool from one-thousand,
$100,000 mortgages (Results in $100 million).
• Each mortgage receives credit risk protection
from FHA.
• Capital requirement: $4 million.
• Must issue more than $96 million in liabilities
due to reserve requirements. (+ FDIC premia).
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Further Incentives
Gap exposure
 Illiquidity exposure
 Default risk by mortgagees

• Phoenix, AZ in 1980s.

Default risk by bank/trustee
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Effects of prepayments

Good news effects
• Lower market yields increase present value of
cash flows.
• Principal received sooner.

Bad news effects
• Fewer interest payments in total.
• Reinvestment at lower rates.
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Prepayment effects

Prepayments result of sales or refinancing.
• Since prepayment affects the cash flows to
MBS, pricing models require estimates of the
prepayment rates.
• Methods:
» Option pricing approach.
» Public Securities Association approach.
» Empirical approach.
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Option Model Approach
Use option pricing theory to figure fair yield
spread of pass-throughs over Treasuries.
 Fair price on pass-through decomposable
into two parts

• PGNMA = PTBOND - PPREPAYMENT OPTION

Option-adjusted spread between GNMAs
and T-bonds reflects value of a call option.
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Collateralized Mortgage Obligation
(CMO)

CMO structure
• Prepayment effects differ across tranches
(classes).
• Z-Class CMO.
• Improves marketability of the bonds.
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Mortgage-Backed Bonds (MBBs)
Normally remain on the balance sheet.
 Regulatory concerns.
 Other drawbacks to MBBs.

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Innovations in Securitization

Pass-through strips
• IO strips
» Negative duration.
• PO strips

Securitization of other assets
• CARDs
• Various receivables, loans, junk bonds, ARMs.
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