Credit Default Swaps for Dummies: Part III - Securitization

In Part I of Credit Default Swaps for Dummies we explained what a single name CDS is.  In Part II of Credit Default Swaps For Dummies we explained how a CDS Index works.  In this section we will (try) to explain how securitization works.  This is a precursor to explaining synthetic CDOs and why they are so hard to price.

Say you are a savings and loan bank.  You take deposits from customers and you lend these deposits to people who want to buy houses.  Over the life of the residential home loan the borrower will pay you back the principal on the loan plus interest.  Your business is going great but you find that you have more demand for loans than you have deposits.  You could try to borrow funds in another manner - say by issuing certificates of deposit (CDs) but there are limits to what you can do there.  You are limited by the equity value of the bank as to how much you can borrow and lend.  You could issue loans to borrowers and then try to sell the individual loans off to another bank but that can be very time consuming considering that the purchasing bank is not familiar with the borrower.  What you need is a way to package up those home loans and sell them off en-masse.

Enter securitization.  You (the bank) form a Special Purpose Vehicle (SPV) which is a entity legally separate from the bank.  The SPV issues debt to investors and uses the funds from that sale to purchase a pool of home loans from you (the bank).  Over time as the home buyers pay back principal and interest those cash flows go to the SPV and are distributed to the investors (debt holders) in the SPV.  Any sort of debt can be securitized in this way.  Securitizations of mortgage related debt are typically known as Mortgage Backed Securities (MBS).  If the mortgages are residential they are known as RMBS and if they are commercial mortgages then they are known as CMBS.  If we are securitizing non-mortgage assets (like credit card debt, college loans, car loans, etc) they are known collectively as Asset Backed Securities (ABS).

The big advantage of this type of structure is if there are many borrowers in the pool of loans and the events of default are uncorrelated between borrowers then by the Law of Large Numbers the realized default rate on the pool should approach the population mean default rate.  This reduces the need to monitor each borrower.  Also instead of one person holding all of those loans the SPV can sell its debt off in small chunks so that many many investors can each own a small interest in a diversified pool of loans.  So for example I would not want to take the risk of making one large loan to one borrower but I would be fine with making a small loan to large pool of borrowers since I can gauge the approximate default rate on the pool.

The downsides of this type of structure is (1) post securitization the originating bank will not have ongoing exposure to the borrowers so they may be less careful about who they loan to in the first place (2) by securitizing the loans the bank is no longer responsible for monitoring (3) it is more difficult to adjust terms of the loan when the loan is owned by a large pool as opposed to if it were owned by a single bank.  All three of these problems reared their heads during the recent sub-prime debt crisis.

The structure that we describe above specified that the SPV payed out the principal and interest cash flows to its investors - but we did not specify how they get payed out.  The most simple structure is a pass-through security.  In this case each investor gets a share of any repayed interest and principal proportional to their investment in the SPV.  Cash flows "pass through" the SPV directly and proportionally to investors.

In practice though the SPV can issue multiple classes of debt where each class has a claim on different portions of the cash flows. When the underlying pool is made up of residential mortgages this structure is known as a Collateralized Mortgage Obligation (CMO).  When the underlying pool contains non-mortgage debt the structure is known as a Collaterized Debt Obligation (CDO).

Four Popular CMO Structures

The most simple CMO structure is the sequential pay structure.  In this structure the SPV creates multiple classes of debt; call them A,B,C,D,...Z.  An initial amount of principal is allocated to each class.  When borrowers start paying back principal initially 100% of the principal payments (and prepayments) are allocated to the A class.  After the principal of the A class is fully payed off then the B class starts receiving all principal payments (and prepayments).  After the principal of the B class is fully payed off then all principal payments (and prepayments) go to the C class...This pattern continues until all principal is paid off and the Z class is retired.  As we move through time each class receives interest payments proportional to the amount of principal still outstanding for that class.

Why would you want to structure a bond like this?  It allows lenders to provide funds to the mortgage market but gives them some control over when those loans will be paid off.  Say you are a lender who wants to lend for five years.  If you look at the entire universe of 30 year fixed rate mortgages most will be payed off at more than five years but a few will be payed off faster.  How do you target getting payed back in five years?  If you want to loan fairly short term then you purchase an A class.  If you want to lend long term then you purchase a Z class.  Because the CMO pools a large number of mortgages the percent of the CMO that gets payed off in the first five years should mimic the population average (so says the Law of Large Numbers).

The sequential pay structure works well so long as interest rates stay fairly constant...however if after the CMO is issued interest rates fall we can run into a problem called prepayment risk.  When a lender makes a mortgage loan to a homeowner he expects to receive a fixed interest rate and principal payments for the term of the loan.  However if interest rates were to fall substantially then the homeowner could choose to refinance his mortgage at the lower interest rate and pay off the principal of the original mortgage loan.  This leaves our lender with cash to loan again but interest rates are now lower.  Some lenders would be willing to loan to the mortgage market but want to avoid prepayment risk.  To solve the problem of prepayment risk two types of structures were created; IO-POs and PACs. 

In the IO-PO structure the SPV issues two different classes of debt IO (Interest Only) and PO (Principal Only).  All interest payed to the SPV goes to the investors holding the IO class of debt and all principal payed to the SPV goes to investors holding the PO class of debt.  If interest rates fall substantially then homeowners refinance their loans and pay off their principal to the CMO pool early.  This turns out  be good for the PO class.  Why?  Because the POs were not getting any interest payments anyways.  They want to get their money back as soon as possible so they can loan it again.  But it is bad for the IOs - because they bought their class of bonds with the expectation of getting a sequence of interest payments - and since the principal got paid off early the IOs are not going to get all the interest that they expected.  This makes the price of IO and PO classes extremely sensitive to the level of interest  rates.

A better solution for the prepayment problem is called a Planned Amortization Class (PAC).  In the  PAC structure the SPV creates two classes of debt; a PAC class and a companion (aka support) class.  Each class is allocated an initial principal amount.  The PAC is promised a fixed series of cash flows.  The companion class absorbs all prepayments (up to some level).  Each class receives interest on the portion of her principal still outstanding.  In return for distributing the prepayment risk in this manner the PAC receives a lower yield than a straight pass-through would and the support class receives a higher yield than a straight pass-through would.

A fourth type of CMO is referred to as credit tranching.  Credit tranching was created to solve the following problem.  Some lenders may have cash to lend to the mortgage market but they do not want to be exposed to potential homeowner mortgage defaults.  In the credit tranche structure the SPV issues multiple classes of debt with a hierarchical structure (super-senior, senior, mezzanine, junior, equity, etc..).  Each class of debt gets allocated a share of principal. The most junior class of debt will absorb all defaults until the principal of that class is depleted.  After the principal of the most junior class is exhausted then the next most junior class will absorb all defaults until the principal of that class is depleted and so on.   The lower is a class in the hierarchy the higher the yield that it will receive but the more default risk it will be exposed to.  The most senior tranches will be exposed to very little default risk but in return they receive the lowest yield.

CDOs have analogous structures but the underlying pools are non-mortgage debt (credit cards, auto loans, corporate debt, school loans, etc..).  One type of CDO of particular interest is created by credit tranching a pool of corporate debt.  We will look at this case more in depth in the next section.

If my explanations were still a bit unclear, this presentation gives some examples.  Here is another presentation of similar material.