Securitisation is born

In the previous article, we introduced and briefly outlined the concept of securitisation, showing that this is a significant and growing industry in Australia.

In this article, we will expand on the fundamental concepts of securitisation and draw parallels to the concepts of life insurance. The life insurance context will be familiar to most actuaries and help to demonstrate how applicable the actuarial skillset is to securitisation.

A pool of assets

As previously mentioned, securitisation was first conceived to fund mortgages in the US market, which served as inspiration for an Australian adaptation.

The key difference was that the US mortgage market was (and is) dominated by 30-year fixed-rate mortgages. An entertaining summary of the early days of this market is provided in the semi-autobiographical book Liar’s Poker by Michael Lewis.

In contrast, Australia’s primary mortgage structures are generally set for terms varying between 20-to-30 years and use a floating rate that issuers may vary at relatively short notice, often driven by a change in a benchmark such as the official cash rate.

Nevertheless, studying the US market, the Australian originators realised that a pool of mortgages had some key features which were common to both markets:

• generally predictable cashflow
• cashflow that came into the pool in a smooth manner over a period
• any failure in payment by an individual mortgage (arrear) was not as hurtful when averaged over the whole pool’s cash flow e.g. one missed payment in an expected 100 payments (100 mortgages) would have less of an impact on the pool’s ability to pay its funders (investors) than in the financing of a single mortgage
• the above was an important risk control criteria that could be taken advantage of as the pool of mortgages was now less volatile than an individual mortgage.

The mortgage originators also recognised that most of the mortgages were quite homogenous in their structure/characteristics e.g:

• principal and interest structure (annuity)
• similar term e.g. 20 to 30 years at origination
• secured by property (a home in this case)
• borrowers typically expect the interest cost to roughly follow movements in the cash rate
• the risk assessment for a loan was generally based on two key items:
  • The loan to valuation ratio against the property
  • The ability of the borrower to service the loan

Now that the originators had identified a pool of mostly homogenous assets which benefited from risk diversification when pooled, it was time to create the instrument for financing these assets.

A stack of notes

The key structure used for financing the pool of mortgages was to stream the income – i.e. prioritise who got first access to the total pool of income paid from the mortgages.

A simple structure was generally used in the earlier period of securitisation:    

• A-series funders, which provided 80% of the capital to finance the asset pool
• B-series funders, which provided the residual 20%.

The A and B series funders could be constructed legally as debt instruments with defined payment terms. These are referred to as the Class A Notes (“A Notes”) and Class B Notes (“B Notes”) respectively.

The A Notes had priority in payment to the income of the pool, and the B Notes then had access to the residual income. The A Notes were in a better risk position than the B Notes, as they had greater income cover for any of their payments, and any losses came out of the B Notes’ payments first. The B Notes typically received a higher coupon to compensate for this risk.

A special purpose vehicle

One benefit of pooling the assets and streaming the income into the A and B Notes was that these Notes could withstand greater stress than an individual underlying mortgage. This paved the way for the notes to be favourably rated by a rating agency (such as S&P).

The higher the rating achieved, the cheaper the financing would be for the originator. Therefore, originators took additional steps to improve the rating outcome:

• Special Purpose Vehicle (SPV): An SPV is a standalone legal entity, typically a trust, that holds the pool of assets and issues the notes to investors. Crucially for the rating process, this vehicle’s ability to meet its financial obligations is not impacted by bankruptcy of the originator (“bankruptcy remote”), and therefore the credit risk of the originator will not impact the rating process for the purposes of notes issued by the SPV. An SPV generally has the added benefit of being tax-neutral because of its pass-through nature.
• Asset-liability matching: By structuring the A and B notes as floating rate instruments to match the floating rate nature of the underlying mortgage assets, interest rate risk could be largely mitigated, which improves ratings outcomes. Notes earnt a floating rate which reset against the cash rate or similar benchmark, and included a set issue margin, based on the market’s “requirement” for the implied credit risk. Movements in this rate would match movements in the asset benchmark. The notes’ legal definition was such that any early prepayment of principal on the underlying assets (a feature of mortgages) was passed through as principal repayments on the notes (A first, then B after A Notes all paid out) and did not trigger a default to the SPV. Unlike corporate bonds which need to repay principal on maturity, the notes did not, principal only needed to be repaid over time before the final legal maturity date of the SPV.

The A Notes, with proper parameters and structuring, were generally rated AAA, and the B Notes were generally rated AA.

At these ratings, the first Australian originators could quite easily fund a blended margin (A and B Notes) that allowed for:

• excess income in the pool to be generated (being the mortgage rate less A and B Note cost of funding) (“Net Interest Margin”, or “NIM”)
• servicing costs of the mortgages to be paid
• other fees associated with the SPV (such as trustee fees, manager fees, etc) to be paid.

The NIM could further benefit the pools’ ability to defray arrears and defaults.

Most importantly, for the early originators, it represented a source of institutional funding that they otherwise could not access, given their own direct balance sheets were not strong enough to access Investment Grade funding. Securitisation was a more cost-effective funding source than other more traditional capital structures.

A pool of mortgages is like a pool of lives in life insurance

To highlight just how familiar concepts in securitisation may be for actuaries, we draw parallels between life insurance and securitisation by comparing a pool of lives and a pool of residential mortgages, the most commonly securitised asset in Australia. Specifically, a residential mortgage securitisation is like a run-off life insurance portfolio, in that the pool once formed will have no new entrants.

Whilst there are many similarities, there are also some fundamental differences. Managing a pool of lives for life insurance is managing a portfolio of liabilities, whereas a pool of mortgages is a pool of assets. This is particularly noticeable in the direction of cashflows over time (see diagrams below).

Life Insurance Cashflows (simplified)

Mortgage Cashflows (simplified)

Comparison of the two pools

Conclusion

A basic securitisation is:

• a pool of relatively homogenous assets
• with regular defined income payments
• funded by notes (A and B) that have defined priorities to the cashflow and any losses
• sitting within an SPV that issued the A and B Notes

Importantly, the A and B Notes can be rated because the structuring of the cashflows related to the underlying pool of assets meet a set of key rating criteria. Having the A and B Notes rated (highly in this case) allows the Notes to represent an efficient funding source that is not generally possible via more traditional capital structures.

The above describes the basics of securitisation. Whilst there are many variations on this structure, such as variations of assets (mortgages, car loans, equipment loans, interest only loans, etc.), creating more than two classes of notes (A, B, C, D, etc), and unrated securitisations, they all obey the same core principles.

Diagrammatically, and showing some of the additional features required for a properly structured SPV, we can represent the securitisation as follows:

Now that you are familiar with the concepts of securitisation, the next article in this series will explain how the actuarial skillset is highly relevant for this growing industry and explore some of the career opportunities it presents.