Securitization: the Adventure of the Top-Sliced Lender, Part 1, the slice
London that April was endlessly blanketed in fog thick as treacle, dampening my mood. My old Afghan war wound ached, the more so because my friend Sherlock Holmes, whose housing-finance deductive expositions I have periodically chronicled, was off in hot pursuit of what he mutteringly called the Adventure of the Nine Guaranteed Keys, leaving our Baker Street lodging musty and dank. I was, therefore, all the more delighted to receive a card informing me that Managing Director Holmes would be pleased should I join him for luncheon at the Diogenes Club. I made haste to accept.
Upon my arrival in the paneled Gentlemen’s Lounge, I asked Mycroft what moved him to invite me.
Mycroft Holmes surrounded himself with the most comfortable of masculine surroundings
“Idleness, sir. I am virtually idle. The market is awash in capital, awash, and I have little to securitize.” When I questioned that surely ready liquidity was essential to any primary or secondary market, he waved that aside. “Yes, from the perspective of aggregate monetary policy, it is essential that capital be able to flow. That is a bedrock of a monetary society. But here, we in the bank have an entirely different problem; there are no income streams.”
“No income streams?”
Mycroft smiled broadly. “I knew Sherlock was on to something sharing lodgings with you. Your questions stimulate me to expound, which may prompt an insight from which I can profit. Let us consider the bank.” The cigar in his waving hand traced smoke whorls toward the City. “As we have seen, it is merely a money store, and every time we bring in money, via deposits or otherwise, we must find ways to put that money to work, by putting it out — debt, equity, hybrids — to people who need cash now and have promising streams of future income with which they can pay our huge and hideous yield requirements.”
I pondered this inversion of all that seemed logical: a bank desperate for people to come needing its money. “What then is securitization?”
“A product ahead of its time, one I have sought my colleagues to embrace but I fear will not flower until late in the twentieth century. The distillation of risk and the extraction of risk premium. Allow me.” Two white-gloved servants wheeled in the largest, and most exquisitely clean blackboard I had ever seen, together with a broad array of perfect sticks of colored chalk. Mycroft squared his waistcoat, tapping the board. “Let us presume that a particular mortgage originator has been writing a series of individual home loans, each with interest rates of eight percent, and he has aggregated £850 million. A total, in other words, of £68 million in annual payments.”
“You are overlooking principal repayments.”
Watson was not prepared to let Mycroft have all the insights
“For this purpose, yes, as they add complications without changing the essential points. We will represent that book as a series of individual loans, each a slim volume in the aggregate book. Thus:”
“The horizontal axis represents each loan. The vertical axis is its loan-to-value. Thus the lowest part is the first dollar of payment, the highest is that final full payment. Each individual loan is a vertical stripe, and we show them as being of slightly different heights to indicate that, while they all were financially identical at inception — similar loan-to-value, similar debt service coverage — as time has passed some of them look safer (lower height) and some modestly more risky (higher). In finance, risk is known as beta, the term adapted from mathematical theory.”
Basic risk, modest beta
“Consider this e-textbook definition:”
Beta is a measure of how a particular stock’s price moves relative to the market as a whole. It is usually described as a measure of volatility. There are individual stock betas and industry betas.
A beta of one indicates that the stock’s price moves exactly with the overall market. For example, if the market goes up 20%, the stock price goes up 20%. Market down 10%, stock down 10%. This is, of course, calculated over a period of months and does not necessarily hold true on a daily basis.
A stock with a beta of more than one is more volatile than the market. If the market goes up, it tends to go up at a greater magnitude (i.e. market goes up 10%, stock goes up 15%). The higher the beta, the more volatile the stock. A beta of less than one indicates that the stock’s price is more stable than the market (in general and over a long time period).
Now, suppose I wished to sell this portfolio of loans. One way would be to package them all into a bond issue. In that case, I transfer all the risk to the buyer, and I exit. Yet such a move, by itself, is unappealing to buyers, for they know that the originator should take first loss, and they want only to lend on a portion that they are certain will be repaid. In other words, they wish to buy a security, from me, whose payment reliability is higher than that of this loan pool. How can they do that?”
“They lend you an amount less than the £850 million total. Graphically, they lend up to some level lower than the average peaks of the individual loans.”
“Precisely so,” Mycroft said, and drew a horizontal line.
“The resulting rectangle represents a security that our bank might issue, backed by that pool of mortgages. If the entire pool represents £850 million, we might capture £600 million, a little over 70%. This new mortgage-backed security — a new security backed by a pool of mortgages — can be rated by the rating agencies [in the US, Standard & Poors, Moody’s, or Fitch — Ed.]. That makes it not only safer, but also appear safer as measured by a disinterested analyst, and the resulting rating lowers the cost of capital, viz:”
“The senior security, often called the ‘A piece,’ might sell for, say, 6.5% interest rate. We place it to customers on the lower floors of the money store”
I found myself fascinated. So instead of selling the bundle — indeed, instead of selling the loans at all — your bank uses them as collateral for a new issue of your own, and makes an interest rate spread since you have brought in the capital at 8.0% and have now laid off a portion of it at the lower rate of 6.5% — interest payments of only £39 million.”
“Sir, you have the instincts of an investment banker. Yet in creating this security, we are still at risk for the balance:”
The remaining unsecuritized portion totals £250 million. And it is paid only after the A holders are fully paid. Thus we have all the risk.” Again he smiled but this one was less accommodating. “The A holder likes that, for it means they have less to fear. In fact, we sought to persuade them to go higher, but they declined. Thus, after placing the A security, we consider ourselves as holding a £250 million ‘B piece.’ It has a higher beta.”
The same risk laid over a smaller capital base means higher beta
“But the residue is not a security; it is what you continue to hold.”
“It is better thought of as a security, but as you rightly observe, its risk profile is quite irregular.”
“Yet if it is considered a security, it must have a yield, indeed a higher expected yield than either the A piece or the original portfolio.”
“That is a principle of securitization; each time the banker slices offer a lower tranche — as a concession to the Bourse, we have adopted their term — the remaining junior security is on the one hand higher yield, and on the other, a distilled or more concentrated residue of risk.”
Concentrating the risk
“Even so, it is a significant capital sum to have invested in one’s own securities.”
“Too significant by far,” rumbled Mycroft.
Watson knew that he would need another day to bone up on securitization
[Concluded tomorrow in Part 2.]