Wednesday, March 21, 2012

How Has Structured Finance Evolved?

As Mahmoud Elamin and William Bednar of the Cleveland Fed point out: "Structured finance has been vilifi ed as the culprit behind the worst recession since the Great Depression. Every aspect of its design has been disparaged: faulty underlying loans, bad incentives for originators, dubious AAA ratings and mispriced risks." In the March 2012 issue of Economic Trends, Cleveland Federal Reserve, they update the story by asking: "How Is Structured Finance Doing?"

Start with defining terms: "Structured finance securities are debt instruments collateralized by a securitization pool of loans. The pool’s cash inflow supports the cash outflow to pay the securities off. The securities are divided into multiple tranches characterized by their seniority. The most senior tranche is paid first; the second senior gets paid only after the first senior is paid and so on. Investors buy the tranche that best fits their risk appetites. We look at three products that fall under the general
heading of structured finance: mortgage-backed securities (MBS), asset-backed securities (ABS),
and collateralized debt obligations (CDO). MBS are backed by mortgages, ABS are backed by assets
such as credit card loans, auto loans, student loans, and the like, while CDO are backed by investment grade loans, high-yield loans, other structured finance products, and the like."

What happened in each of these three categories? In the first category, the mortgage market, the total value of mortgage originations dropped off after about 2003. However, the share mortgage originations that were packaged as securities has continued to rise. Here are a couple of illustrative figures.

Why has the share of mortgages packaged as securities continued to rise? Elamin and Bednar name three possible reasons, but don't try to quantify them: a rise in private demand for such instruments, polices of government-sponsored enterprises like Fannie Mae and Freddie Mac, and the Federal Reserve "quantitative easing" policies, which have involved direct purchase of about a $1 trillion in mortgage-backed securities.

The second broad category of securitized finance is asset-backed securities. The biggest categories here are securities backed by auto loans and by credit card loans, with securities backed by student loans as another large category. Issuance of asset-backed securities dropped off by about half after 2006. In addition, the share of total auto-loan debt that is securities fell from above 40% to 30%, while the share of credit card debt repackaged as asset-backed securities fell from more than 30% to around 15%.

The third category is collateralized debt obligations. This is the category of structured finance most thoroughly implicated in the housing price bubble. Issuance of these securities rose from less than $100 billion in 2003 to about $500 billion in both 2006 and 2007, at the peak of the housing bubble, and since has fallen to near-zero. In addition, these collateralized debt obligations at the peak were largely based on mortgages, especially subprime mortgages. These were the financial instruments that started off with subprime mortgages, and then were divided into tranches. The junior tranches agreed to take the first of any losses that arose. Thus, the senior tranches--seemingly protected by the junior tranches--managed to get AAA credit ratings, and thus regulators let banks hold these "safe assets." When the housing bubble burst, and many of these subprime mortgages went sour, the popping of the housing market bubble had leaked into the banking system. Today, CDOs aren't based on housing; instead, what remains of the market is main involve securitizing investment-grade bonds and high-yield loans.