Crash Explainer 3: Asset Securitization

In yesterday's SEC Currents there was a story about the role played by the Resolution Trust Corporation in developing the asset securitization methods that investment banks have recently used to blow themselves up.

I thought this as good an opening as any to talk about asset securitization and about the Resolution Trust Corporation.

WHAT IS ASSET SECURITIZATION?

Asset securitization allows a business (called the "originator") to turn a steady trickle of cash into a great, huge whack of cash. The steady trickle is generally some kind of loan receivable like credit card or mortgage payments.

Let's imagine our originator is a bank with a portfolio of residential mortgages.

1. The bank organizes a new company called a special purpose vehicle (SPV).
2. The SPV buys all the bank's residential mortgages.
3. Then, the SPV sells securities (called asset-backed securities - ABS) on the public market.

The bank gets cash and relieves itself of the burden of policing mortgages or getting clobbered if borrowers default. The risk associated with the mortgages shifts to the SPV's shareholders.

Stop, I hear you cry - who in their right mind would buy these ABS? Good question! Not so many people it turns out, so originators developed ways to enhance the appeal of ABS. Some of the methods included:

* A guaranty by the originator
* Third party letters of credit
* Several tranches

The tranches enhancement segregates risk from gain - some tranches bear all potential losses and some get all the gain. Thus, the risk is shifted from the bank to the holders of only one tranche. And what poor unfortunates buy these all-risk securities? The originators, of course.

For a very nice treatment of the origin of ABS see: Culver, The Dawning of Securitization, Probate & Property, March/April 1994 (8-APR PROBPROP 34).

WHAT WAS THE RTC's ROLE?

Mortgage-back securities were invented by Ginny Mae and Fannie Mae in the 1970's. Ginny and Fannie pooled and sold only residential mortgages (in the example above, imagine the bank selling its mortgages to Fannie and Fannie organzing the SPV).

The Resolution Trust Corporation (RTC) came on the scene in 1989 to clean up after the collapse of many savings and loan banks in the late 1980's. RTC, created by the Financial Institutions Reform and Recovery Enforcement Act of 1989 (FIRREA, PL 101-54), was supposed to buy the assets of the failed S&Ls and resell them in hopes of making a little money for taxpayers.

RTC ended up owning a large portfolio of commerical mortgages. Because of the complexity involved, no one had attempted to package commerical mortgages as ABS. Realzing that the alternative of disposing of the mortgages individually would be even more difficult, RTC developed methods for packaging commercial mortgages as ABS.

To see an example of an RTC ABS deal see the S-11 filed by Lehman Structured Securities on 8/12/1996. The securties being sold are called Commerical Mortgage Pass-Through Certificates Series 1996-1. For something more recent, try Bear Stearns Alt-A Trust, 424B5, 2/01/06.

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