In a typical deal a sponsoring bank moves loans off its balance sheet and sells them to a special-purpose entity. For legal and tax reasons this is a non-profit vehicle; if it is established under US law it is usually known as a ‘trust’. The special-purpose entity then sells bonds to investors, known as ‘tranches’ (from the French word ‘tranche’ – ‘slice’) of different seniority. The most senior tranches have the first claims on the interest and principal payments from the loans. The proceeds from the bond sales are then used to purchase the loans from the bank.
The senior tranches of these securitizations are extremely safe. They are protected in several ways: first, by ‘over-collateralization’ – that is, the practice of putting a larger value of loans into the special-purpose entity than the value of bonds sold – second, by the interest margin earned because the interest rate paid on the loans is always higher than the interest rate paid on the tranches; and, third, because of the seniority of the senior bonds. In a typical structure the most senior AAA tranches are only about 75 per cent of the total issue. This means that they are virtually free of any default risk; the losses on the loans would have to eat up all the interest surplus, all the over-collateralization and the 25 per cent of more junior tranches before the most senior tranches lose money. Loan losses of this magnitude would be quite extraordinary.
Sponsoring banks often keep the riskier tranches of securitizations themselves. This is a reasonable thing for them to do if the main motive for creating the structure is, as it usually is, obtaining cheap funding rather than transferring risk. They may also buy and sell loans in and out of the mortgage or other loan pool, in order to maintain the asset quality. There is often no legal obligation for them to buy bad loans and replace with good loans, but doing this helps to maintain a reputation for quality and thus helps when selling loan-backed securities in the future.
Even if the sponsoring bank retains the riskier tranches it still benefits from the securitization, because it can replace relatively expensive wholesale borrowing on its balance sheet with the relatively cheap funding from selling senior structured securities. The difference in cost can be very large; a bank might pay a spread of, say, 25 basis points above the standard London Interbank Offer Rate (Libor) on the senior tranches of a loan securitization but a spread of 150 basis points or more on floating-rate bonds issued on its own balance sheet.
Commercial banks and the structuring departments of the investment banks created a lot of paper during the boom years of structured and mortgage-backed credit, from 2002 until 2007. While there are no comprehensive statistics, industry bodies have recently released estimates of the outstanding stock of most categories of these securities. With some further estimation of remaining stock, based on the issue flows, it is possible to get approximate figures for the overall size of the market.
There are many acronyms in the world of structured credit.
The largest market is for so-called ‘agency RMBS’ in the United States – the residential mortgage-backed securities issued by the government sponsored enterprises Fannie Mae and Freddie Mac. $5.9 trillion is a huge number. It is about half of all US mortgage lending and not far shy of half of US national income (which was close to $14 trillion in 2007). But these agency RMBS are a special case; the mortgages that back them are guaranteed by Fannie and Freddie, so they are backed at least implicitly by the US government.
The next biggest market, especially in the United States, is the $2 trillion market for asset-backed securities (ABS). These are securitizations of retail lending of all kinds including vehicle loans, credit card receivables, student loans, equipment leases, small business loans and also home equity loans.
There are some other surprises from looking at these numbers. The sub-prime residential mortgage-backed securities, where all the credit market problems first appeared, are only around one-tenth of the entire market for mortgage-backed and structured securities, less than half of the ABS market (sub-prime RMBS are issued only in the United States, not in Europe) and less than the market for commercial mortgage-backed securities.
The broadest category here comprises ‘collateralized debt obligations’ or CDOs. They include a range of structures where the securitized assets are neither retail loans nor mortgages, for example restructured securities (such as the ABS-CDOs), corporate bonds, corporate loans and so-called ‘synthetic CDOs’, where the assets are the tradable insurance contracts known as credit default swaps.
Even if we exclude the agency-backed RMBS, there was close to $7 trillion outstanding, which is about twice the size of the market for tradable US government debt, normally regarded as the biggest and most liquid securities market in the world.