The securitization of financial assets represents an important new tool in the financial markets of today. The basic premise is a simple one: Net value may be created by redistributing risk, and producing custom, liquid instruments from nooliquid assets.
This technique is now increasingly being applied to the transformation of the nonliquid portions of a corporation's balance sheet into liquid, saleable securities, a potentially effective means of raising capital. Today, the asset securitization market is over $500 billion and growing rapidly.
Since asset securitization involves the redistribution of risk, we must consider the different forms of risk, which may be shifted. A nonexhaustive list of risks might include:
* Prepayment Volatility.
* Interest Rate.
Each of these problems has a corresponding securitization technique as a solution.
This form of risk typically occurs when there is a substantial disparity between the maturity of an organization's financial assets and its liabilities, which might lead to significant value gaps if the shape of the yield curve were to change.'
This is also the most common problem with basic mortgage securities, in which principal payments may occur more or less steadily over a period of up to 30 years, rather than in a single bullet payment as in the case of Treasury or corporate bonds.
An instrument with such a long and ill-defined payment period is far less attractive than an instrument with a sharply concentrated maturity.
These problems are generally solved by tranching the cashflows of the security by maturity class, allowing one tranche to receive the earliest principal payments, others to receive the intermediate principal payments, and the remainder to receive the latest payments. This results in the production of bonds of short, intermediate, and long maturity.
For mortgages, a crucial element of risk is the risk of prepayment, namely the uncertainty regarding when and if individual homeowners will prepay their mortgage loans, effectively resulting in the calling of the bonds out at par.
Under certain circumstances, this might result in a tranche of a mortgage-backed security with a stated maturity of 20 years having an actual coverage life of just six months, with all the entailing disruption of investment strategy and maturity mismatch problems.
The solution to this problem is the assignment of certain tranches to act as "buffers" for other tranches, protecting them from a considerable degree of prepayment uncertainty by absorbing unexpectedly high or low prepayment rates.
Ideally, the increase in market price of the buffered tranches (usually called PACS, TACS, or VADMS) is somewhat greater than the decrease in market price of the buffering tranches, which become especially volatile with regard to prepayments (these are usually called support classes).
Large classes of investors desire to hold floating-rate assets, which are substantially protected against changes in interest rates' Since most assets used in asset securitization have fixed coupons, the use of such assets to produce floating-rate bonds is only possible if inverse-floating rate bonds are also created simultaneously.
This is typically done in CMO/Remic structures, in which certain bond classes are protected against interest rate risk by being assigned floating-rate coupons, while other classes are correspondingly made especially vulnerable to interest rate risk by functioning as inverse floaters.
This is one of the most crucial aspects of asset securitization, since broad classes of assets are - subject to considerable credit risk, whether they are mortgage whole loans, consumer loans, or commercial loans.
Unstructured pools of unrated assets are relatively unattractive investments, since they fall into no clear investment category.
The most elegant solution to this problem is to produce several different classes of bonds from a given pool of assets, some of which absorb any potential losses or defaults, thereby protecting the others from such risk.
This allows the senior classes to receive double-A or triple-A ratings, and be sold at tight spreads to one class of institutional investors, while the junior classes are sold to other investors willing to accept somewhat greater default risk in return for higher yields.
The current era of asset securitization began with the creation of mortgage pass-throughs, mortgage securities representing a passed-through share in the interest and principal generated by large numbers of individual mortgage loans.
Guaranteed by government or government-sponsored agencies such as GNMA, FNMA, or FHLMC, and possessing - because of their large size - much less prepayment volatility than individual mortgage loans, they became an attractive investment vehicle.
Their widespread availability eventually led to the creation of CMO/Remic securities, which tranched the pass-throughs, first by maturity, and later by prepayment volatility and interest rate behavior, resulting in the wide proliferation of complex mortgage derivatives such as PACs, TACs, inverse floaters, Z-bonds, and VADMs.
The securitization of nonguaranteed collateral instruments such as mortgage whole loans, car loans, credit cards, and home equity loans followed, is often accomplished by means of the senior-subordinated structures described above.
Complex Days Ahead
Over the past few years, the securitization of below-investment-grade corporate bonds - junk bond - has resulted in collateralized bond obligations (CBOs), and commercial or real estate loans in collateralized loan obligations.
In all of these cases, the trend of the marketplace has been from the simpler to the more complex, both in underlying collateral (guaranteed, fixedrate home mortgages to highly complex commercial loans) and in bond structure (simple sequential tranching by maturity to complex prepayment, coupon, and loss allocation).
From the beginning, all asset securitizations have been analytically intensive, and the growing complexity of both collateral and bond structure has only increased this intensity. Either producing or valuing asset securitization structures requires he use of extremely sophisticated software systems.
Major investment banks are well aware of this fact, and have spent tens of millions of dollars in analytical software intended to provide them an edge in the market, and perhaps a monopoly on vital information. Good traders, armed with this technology, can generate millions or tens of millions of dollars in excess trading profits their firms and themselves.
However, several recent trends in technology are now beginning to provide a likely end to this investment banking oligopoly.
First, microcomputers such as PCs are becoming a commodity; $10,000 will buy you a machine that used to cost over $1 million.
Second, information distribution systems such as Bloomberg are leveling the trading arena, providing large quantities of analytical data on complex instruments such as mortgage and asset-backed securities.
And finally, analytical systems of true Wall Street quality are now becoming commercially available and PC-based, notably including the products from Wall Street Analytics Inc., which is able to provide some of the best of Wall Street's top capabilities at an affordable price.
The asset securitization software provided by WSA contains modeling and analysis capabilities of accommodating:
* Whole-loan and senior-subordinated securities.
* Home equity loans.
* Collateralized bond obligations.
* Commercial loan and real estate loan securitizations.
* Indexed amortizing swaps, caps, floors, and synthetics.
WSA software has been licensed by 10 major investment banks and used to design and issue over $35 billion of highly complex derivative securities.
RON K. UNZ President Wall Street Analytics Inc.
A theoretical physicist by training, Ron K. Unz has served for the past four years as president and chief software developer at Wall Street Analytics Inc., a small New York-based company specializing in the development of sophisticated financial software systems.
Wall Street Analytics products have been licensed by 10 major investment banks, which have used the software for the design and issuance of over $30 billion of highly complex CMO/Remic mortgage derivatives. Wall Street Analytics products have also been licensed by a number of large financial institutions, for use in the analysis and management of tens of billions of dollars in complex financial assets and liabilities.
Mr. Unz co-founded Wall Street Analytics in 1988. Prior to his creation of WSA, Mr. Unz had been a leading software developer in the mortgage products financial engineering group at the First Boston Corp.
Mr. Unz was a member of the Harvard University Class of 1983, with a bachelor of arts degree in theoretical physics and ancient history, Phi Beta Kappa, magna cum laude. He also has graduate degrees in theoretical physics from Cambridge University and Stanford University.