Structured Finance and the Financial Turmoil of 2007 2008

Banco de españa 15 documento ocasional nº 0808 3

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BANCO DE ESPAÑA 15 DOCUMENTO OCASIONAL N.º 0808 3 Securitization and the creation of asset-backed securities This section explains the basic principles of securitization and the creation of asset-backed securities and presents examples of securitizations which have played the most prominent roles in the financial turmoil of 2007-2008. These are mortgage-backed securities (MBS; section 3.1), asset-backed commercial paper (ABCP; section 3.2) and (cash-flow) collateralized debt obligations (CDOs; section 3.3). 3.1 Asset-backed securities: The example of mortgage-backed securities Generally, asset-backed securities (ABS) are securities that are collateralized by loans or other assets. These securities are generated through a securitization process by Special Purpose Entities (SPEs) or Special Purpose Vehicles (SPVs) in order to transform illiquid assets of a certain entity (the “originator”) into transferable securities. When these securities are collateralized by mortgages, they are called mortgage-backed securities (MBS), including commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS) (see also Figure 1 in section 2). An example of the securitization of residential mortgages, which involves the creation of RMBS and is based on the “true” sale of the mortgage pool to the SPV, is shown in Figure 2. A bank provides mortgage loans to various homeowners A, B, etc., and puts these mortgages together in a pool of many mortgages. Subsequently, this bank that has “originated” these loans, sells the pool of mortgages to a SPV, in return for cash. In this “true sale” securitization, the mortgage loans disappear from the balance sheet of the bank. In order to finance its purchase of the mortgage pool, the SPV issues RMBS and sells these securities to various investors. The RMBS sold are “tranched” in specific classes according to their credit risk, such as rated by the rating agencies [Elul (2005); Citigroup (2007)]. Thus, a tranche can be defined as a specific portion of a securitized portfolio of assets [Morgan Stanley (2008)], based on a group of assets with similar credit risk characteristics. The process of tranching is shown in Figure 3. On the basis of a pool of mortgages of 100 million, RMBS are created which consist of 96 million of investment grade securities, subdivided in tranches rated “super-senior” AAA, “senior” AA and “mezzanine” BBB, and of 4 million of below investment grade securities, with tranches rated “subordinated” B and unrated (the so-called “equity” tranche). According to their specific risk preferences, various types of investors buy specific tranches. For example, pension funds often may have a preference for the less-risky, higher-rated but lower yielding AAA or AA tranches, whereas more risk-prone investors such as hedge funds may invest in the more risky and higher yielding B or equity tranches. Thus, in the process of the creation of the RMBS, rating agencies are of enormous importance, as they rate the
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