Securitization is designed to reduce the risk of bankruptcy and thereby obtain lower interest rates from potential lenders. A credit derivative is also sometimes used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors. As a portfolio risk backed by amortizing cash flows and unlike general corporate debt the credit quality of securitized debt is non-stationary due to changes in volatility that are time and structure dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss. Securitisation in the USA
Securitisation has evolved from its tentative beginnings in the late 1970s to a vital funding source with an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3,455 billion in the US and $652 billion in Europe Residential Mortgage Backed Securities (RMBS) in the USA
In the USA Securitisation of residential mortgages is the mother of all securitizations and is in the form of Residential mortgage-backed securities (RMBS) which generally pass through securities or bonds based on cash flows from residential home loans, as opposed to commercial real estate loans. Background
The RMBS or mortgage pass through market originated in the United States with the active support of Government agencies. The three US Government agencies engaged in promoting securitisation with their guarantees are Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), and Federal Home Loan Mortgage Corporation (FHLMC). The Government National Mortgage Association (GNMA)
The Government National Mortgage Association (GNMA) is a US Government body promoting securitisations. GNMA pass through securities carry the full backing of the US Govt. GNMA guarantees the timely repayment of principal and interest. The Federal National Mortgage Association (FNMA
The Federal National Mortgage Association (FNMA) is the oldest of the three agencies. The first FNMA pass throughs were issued in 1981. FNMA pools mortgages from its purchase programs and issues Mortgage Backed Securities (MBS) to originators in exchange for pooled mortgages. Like GNMA, FNMA also guarantees repayment terms. Home Loan Mortgage Corporation (FHLMC).
The third agency, FHLMC was created in 1970 to promote active secondary market for conventional home mortgages. The agency runs a participation certificate program under which it pools both fixed rate and adjustable rate mortgages.
¢ RMBS could be either agency-backed or non-agency-backed. Agency-backed refers to the transactions pooled and bought by specialized securitization agencies such as FNMA and GNMA. Outside the USA also, several countries have put up their own models of FNMA as entities that buy mortgages and securitize them. Mortgages securitized by the agencies normally provide the guarantee of the agency to the investors. ¢ Most of the mortgage funding is for very long maturities: say, 15 years to 30 years.
¢ If the securitization is a pass-through, the investors will get paid over such a long period, say 20 years. As that is too long a period for most investors, it is common for mortgage securitizations to adopt the bond method (collateralized mortgage obligations) which are repayable in different maturities. ¢ If the mortgages are secured by the guarantee of the government or the securitization agency (such as GNMA or FNMA in the USA), the only risk that the investors carry is the risk of prepayment. ¢ Depending on the level of development of securitization, mortgage securitization market can be a highly commoditised market where mortgage origination, servicing and administration can all be viewed by the market as independent commodities and be regularly traded.