Aurora Borealis
1 February 2015 CFA Institute Journal Review

Alternative Structures for Investment in Credit and Operations in MBS Securitization (Digest Summary)

  1. Marc L. Ross, CFA

The author reviews existing structures for investments in credit and operations of securitized mortgage products and proposes alternatives.

What’s Inside?

Home loan securitization has been, for the most part, a closed shop, with such entities as Fannie Mae and Freddie Mac managing most aspects of the process that links borrowers to investors before, during, and after securitization. The author surveys the current state of affairs and suggests wider private sector involvement.

How Is This Research Useful to Practitioners?

Mortgage securitization is a multifaceted process that involves numerous processes and participants. Its two distinct sets of functions are (1) the creation of an investment product to fund home loans and (2) operations management to facilitate infrastructure that supports the securitization machine that connects investors with borrowers. Traditionally and primarily these functions have been the responsibility of government-sponsored enterprises (GSEs), but the author proposes an enhanced private sector role alongside them.

Mortgage investment offers exist along a risk continuum that ranges from pure interest rate to credit products. Private label securities in the capital markets, GSEs, and mortgage insurance companies have historically separated interest rate risk from credit risk, although the GSEs have borne a disproportionate amount of the latter. This risk includes securitization after assuming all credit risk on a pool of mortgages and shedding some of the risk over time through structured product issuance. The 2008 financial crisis called these arrangements into question and made them increasingly unsustainable.

The author proposes an enhanced credit risk–sharing arrangement that would involve greater private sector participation in the creation of a product tradable in a forward market coexisting with traditional GSE securitization. These participants would include insurers and reinsurers as well as capital market products.

He also proposes fixes to the various operational functions of GSE securitization. These functions include product and participant standardization; loan sourcing, acquisition, and aggregation prior to securitization; securitization mechanics (e.g., issuance, servicing); and credit risk management after securitization.

Policymakers and regulators will find the author’s prescriptions for alternatives in the securitization process useful in light of the 2008 financial crisis, which laid bare the GSEs’ vulnerability to credit risk.

How Did the Author Conduct This Research?

The author’s review of existing risk management and operational functions of the GSEs informs the proposed changes to these roles. The process is an evolving one. In the analysis, he considers the current roles of the capital markets and insurance in the risk-transfer process after GSE securitization. He then provides a fairly robust quantitative analysis of recent instances of GSE risk sharing through a comparison of an insurance and structured credit model: the FNMA National Mortgage Insurance Corporation transaction in October 2013 and the Freddie Mac Structured Agency Credit Risk transaction in August 2013.

From there, the author evaluates two possible alternative approaches to risk sharing. The first involves insurers and reinsurers along with private equity firms as long-term investors in mortgage credit taking the first-loss portion of risk over a long time period for a set price. This approach would occur prior to securitization with the aim of guaranteeing a pre-established volume of loans going to the GSEs to be securitized. In so doing, the investors would create liquidity throughout the economic cycle and then implement reinsurance or capital market products to hedge risk. This approach includes varied financial institutions and invites private sector competition.

The second approach is what the author terms a “front-end collateralized recourse transaction.” In it, mortgage lenders establish a trust formed as a special purpose vehicle that aggregates loans and sells credit-linked notes (a structured credit product) in the capital markets against loan collateral. The trust would keep a piece of the loan pool’s coupon. Proceeds would collateralize credit losses when the loans are transferred to the GSEs to be securitized.

A final consideration is the management of credit risk after securitization and its viability as a self-sufficient business open to private sector competition. Current arrangements have the GSEs bearing the credit risk and acting as the post-securitization credit manager. The author proposes opening the post-securitization duties of trustee and master servicer to competition to mitigate the risks primarily borne by the GSEs.

Abstractor’s Viewpoint

An effective means of linking borrowers with investors, securitization faces the ongoing challenges of risk and operations management. The author considers the existing framework and suggests a greater role for private sector competition in these two areas. Post-securitization operations is only one example. The GSEs’ vertical integration of all aspects of the securitization process has burdened them with outsized risk that has, in turn, increased the risk of investment in them. The larger private sector role that the author proposes could lead to a more efficient and competitive securitization industry.

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