Mortgaged Backed Securities

MA-Thesis / Master von Harold Keller

Summary:

In order to ensure that the mortgage market remains buoyant, lenders require constant access to sufficient funds. Traditionally, mortgage lenders rely on retail deposits, mortgage covered bonds or dedicated savings to provide this source of funding. However, those providers who do not have the luxury of an established and reliable retail deposit base, or high credit rating necessary for cheap money market credit, are forced to think of alternatives. Securitization of originated mortgage loans can provide the answer.

Financial institutions that originate loans are able to turn their loans into marketable securities through a process known as securitization. The originators of the loans are commonly referred to as the issuers of asset-backed securities (ABS). ABS constitute a relatively new but fast growing segment of the debt markets in Europe. The combination of a number of legal and economic factors has provided a favorable climate for securitization in Europe, especially in the United Kingdom (UK) and in its country of origin, the United States (US). In turn, these countries have experienced considerable growth in securitization volumes over the past years. In contrast, due to a weak economy and an unfavorable legal, tax and regulatory environment the German securitization market was not able to develop in much the same way.

However, the German economy has started to recover in the current year and is forecasted to continue growing in 2007. This economic growth will in turn drive the domestic mortgage demand. In addition, based on the state and structure of the German mortgage market it is becoming increasingly attractive for foreign investors. Thus, both the economic recovery and an increased mortgage demand will drive the funding requirements of German banks. Moreover, the significance of securitization as an alternative refinancing instrument for residential mortgages is likely to grow, not least because the elimination of the legal, tax and regulatory hurdles has enhanced the attractiveness of true-sale securitization in Germany.

The title of the thesis is called, Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks. As raising finance is elementary to the growth and profitability of banks, the hypothesis of the thesis inevitably boils down to the question, whether the application of mortgage backed securities (MBS) increases the ability of German banks to raise finance for residential mortgages and thereby reduce their financing costs, diversify risk and improve their capital ratios. With this problem defined as such, a number of further questions arise with it: how does asset-backed securitization function, what risks are involved when securitizing assets, what are the objectives for a bank to deploy asset securitization as financing instrument, where does the instrument come from and how has it developed, who are the investors, what other refinancing instruments are at a bank’s disposal, what are the drivers for securitization and consequently do German banks need to make use of MBS as refinancing instrument to service the market and keep up with international competition.

The master thesis is written within the framework of an MBA program from the FOM, Essen. The choice of topic is based on the fact that ABS has been the cause of heated debates in the German financial market for the past few years. In turn, while other European financial markets have long adopted and embraced securitization, the German market posed many hurdles for the financial industry. Therefore, the motivation of the topic is to examine what the instrument is all about and what the exact reasons were, why securitization has not developed in the German market as it has developed in the US and other European markets, e.g. the UK.

The thesis provides the answers to the questions raised in the problem definition by explaining the concept of securitization, providing historical background to this method of financing and a brief overview of the US and European markets. Further, the characteristics of the German residential mortgage backed securities (RMBS) market are examined in detail. It builds upon a wealth of pertinent literature as well as secondary information and primary interviews to provide an insightful and balanced view of the German RMBS market.

The executive summary provides the reader with a concise overview of the main contents and findings of the thesis. Chapters 2, 3 and 4 provide the concept, asset types, process and participants, market risks, methods objectives history and development of securitization as well as an overview of alternative refinancing instruments. Chapter 5 in turn provides an overview of the German macroeconomic environment and its impact on the German mortgage market followed by chapter 6 which provides a more in-depth analysis of the German securitization market as a whole. Chapter 7 then summarizes, interprets and concludes on the research findings and finally, chapter 8 provides the reader with the recommendation, outlook and critical comments.

Table of Contents:

Kapitel 2.2.2.4 Special Purpose Vehicle:

As mentioned, the SPV has the sole purpose of raising funds for the purchase of the receivables through issuing securities, e.g. MBS on the capital markets (David 2001, pp. 27ff). Further, the receivables must provide a steady stream of cash flows in order to pay principal and interest on the securities. The most important aspect of the process is the legal separation of the assets from the originator, ensuring that the payments are derived exclusively from the performance of a segregated pool of assets and removing the investor from any insolvency or bankruptcy risk on the part of the originator (Bund 2000, pp. 16-18).

The SPV is thus bankruptcy-remote, which guarantees the investor that in case of insolvency of the originator it still has full claim on the cash flows of the receivables (Baker & McKenzie, 2004). In the essence to achieve a bankruptcy-remote transaction, the transaction needs to qualify as such in theory and practice (Baker & McKenzie, 2004). This important feature gives the debt issue a higher rating than the originator could command in its own right and therefore results in a lower cost source of financing (Bund 2000, pp. 16-18). Thus, the rated securitization allows the issuer to approach investors restricted to rated offerings (Bund 2000, pp. 16-18).

Depending on the number of originators, SPVs are differentiated in „single seller-vehicles” and „multi seller-vehicles” (Schwarcz 1994, pp. 138-141). Single seller-vehicles securitize receivables of only one originator, either on a once-off or revolving basis and multi seller-vehicles securitize receivables of several originators (David 2001, pp. 27 ff). Multi sellervehicles are generally used for high volumes and thereby decreasing the costs through economies of scale (David 2001, pp. 27 ff).

A further aspect of an SPV is that it only has structurally necessary balance sheet positions that in the most minimal case may be limited to the purchased assets on the asset side and the notes issued on the equity and liability side (BayernLB, 2006).

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks - Kapitel 2.2.2.5 Rating Agency:

To achieve the above described benefits, the securities issued by an SPV, need to be rated by a rating agency, e.g. Standard & Poor’s, Moody’s and Fitch, to indicate their credit worthiness and hence their risk. A typical rating system applied by Standard & Poor’s is shown in the figure below.

The rating agency must analyze all specifications of the ABS transaction and then evaluate the risk and quality of the ABS (David 2001, p. 27 ff). In addition the rating agency reduces the information asymmetry between the SPV and the originator on the one hand and between the SPV and the investor on the other hand (Kley and Everling, 2001). The rating process itself starts with a feasibility study which evaluates the prospective issuer’s ability to securitize its assets according to criteria including management, history, strategy and sustainability of its market position (BayernLB, 2006). An agency’s ratings committee will also review the deal’s financial structure in order to determine the levels of credit enhancement required…