Strengthening Taiwan's Capital Markets Through Asset Securitization

2000/01/02

Joseph Hu, Ph. D.*
Director of Structured Finance Research
Standard & Poor's
55 Water, New York, NY 10041-0003
212-438-2491 (office) ; 212-438-2660 (fax); e-mail: joseph_hu@standardandpoors.com
*The views expressed here are the author's and do not reflect those of Standard & Poor's.

Executive Summary
Asset securitization was one of the most important capital market innovations in the U.S. in the 1980s. In 1980, asset securitization amounted to only $24 billion annually, and the underlying assets were exclusively residential mortgages. By 1990, however, the annual volume of asset securitization had expanded to slightly over $300 billion. It soared to just under $1.1 trillion in 1998. Asset securitization has allowed depository lenders (commercial banks and thrifts) and non-depository lenders (mortgage bankers and finance companies) to use their capital more efficiently. It has also broadened the variety of investment choices of for investors and reduced borrowing costs for borrowers. Taiwan can greatly strengthen the efficiency of its capital markets by learning from the U.S. experience and securitizing an assortment of assets held by various financial institutions, particularly commercial banks.

Introduction
Asset securitization (hereafter, simply securitization) began in the U.S. in 1970 when mortgage bankers pooled newly originated residential mortgages and issued mortgage pass-through certificates (PTs). Nowadays, the PTs are generically termed mortgage-backed securities (MBS). The interest and principal payments of PTs were generated exclusively from the cash flows of their underlying mortgages. The credit of these mortgages was guaranteed by either the Federal Housing Administration (FHA) or the Veteran's Administration (VA), both are agencies of the federal government of the U.S. Further, the credit of the PTs was guaranteed by Government National Mortgage Association (now conventionally called Ginnie Mae) with the full faith and credit of the U.S. government.

During the entire 1970s, the pace of mortgage securitization was slow. Annual issuance volume of Ginnie Maes during the decade rarely exceeded $15 billion. However, annual issuance of MBS accelerated in 1981, when Fannie Mae and Freddie Mac (government sponsored enterprises, GSEs) initiated mortgage swap programs with thrifts. (Freddie Mac had been a guarantor of MBS since 1970, but Fannie Mae only became a MBS guarantor in December 1991.) Under the programs, thrifts would sell their holdings of mortgage loans to these GSEs and in return receive MBS backed by the very pools of mortgages that they sold. As a result of the swaps, issuance of MBS guaranteed by Fannie Mae and Freddie Mac in 1992 surged to over $40 billion. Issuance of MBS quickly surpassed the $100 billion mark in 1985 and toppled $800 billion in 1998 (see Chart 1).

Equally as significant, a few years later, originators of credit cards, automobile loans, student loans, and manufacturing housing loans began to pattern securitization after MBS and pooled their portfolios of newly originated loans for the issuance of asset-backed securities (ABS). Annual issuance of ABS was just under $1 billion in 1985, but exceeded $220 billion in 1998 (see Chart 2). In recent years, other new financial assets (from creditors' point of view) such as property-tax liens or any instruments with an expected cash flow have been securitized. Moreover, during the 1990s, securitization of commercial mortgages has grown tremendously. Annual commercial MBS issuance grew from less than $5 billion in 1990 to nearly $80 billion in 1998 (see Chart 3). All told, securitization of all residential MBS, commercial MBS, and ABS in 1998 amounted to just under $1.1 trillion.

Benefits Of Securitization
As mentioned earlier, the concept of securitization was originally implemented by mortgage bankers. In essence, they obtained a short-term funding (warehousing line of credit) from commercial banks and drew down the credit line to originate FHA/VA mortgages. As these mortgages were originated, they would pool the mortgages and issue an MBS guaranteed by Ginnie Mae. With the proceeds from issuing the MBS, the mortgage bankers would replenish the warehousing credit line and originate more mortgages. The warehousing line of credit thus was never really retired; it revolved. While originations drew down the credit line, issuance of MBS replenished it. But it would be drawn down again as mortgage bankers originated still more mortgages. And it would be refilled by the proceeds of MBS issuance. This process is repeated several times a year, allowing mortgage bankers to originate a far larger volume of loans than they could if they had to rely on any permanent funding. The costs of the revolving credit is far lower than what otherwise would have been had the funding been voluminously longer term debt.

As mortgage securitization became popular, other lenders, such as commercial banks and thrifts, patterned new products after mortgage bankers to originate residential mortgages. And as mentioned before, these financial institutions began to securitize other consumer loans on their portfolios such as credit cards, automobile loans, manufactured housing loans, and student loans.

There are several advantages for depository institutions in the process of securitization. From the viewpoint of balance-sheet management, securitization is an asset sale. It allows lenders to originate loans and earn origination fees without ballooning their balance sheets. Not having to include the new loans in their portfolios, lenders do not have to expand liabilities to fund the loans. Carrying the concept a step further, securitization enables depository institutions to efficiently manage balance sheets by selling new and seasoned loans. As the asset side of the balance sheet is reduced through securitization, lenders can correspondingly reduce their liabilities. This enhances the efficiency of lenders' use of capital.

Through most of the past twenty years, securitization has greatly benefited not only lenders but also borrowers and investors. These benefits actually reinforce one another. From the viewpoint of depository lenders, securitization allows them to originate loans without having to fund them through expanded long-term liabilities. They can behave just like mortgage bankers. The bottom line of securitization for lenders is that long-term, or even short-term, loans can be originated with even shorter term funding. This avoids any potential balance-sheet maturity mismatching by selling the new loans through securitization. It also significantly reduces the funding costs of originating loans, and the benefit of these lowered funding costs is often passed on to borrowers. The best example of securitization benefiting lenders is mortgage securitization to thrift lenders. Prior to the mortgage securitization, thrifts had to fund their mortgage originations with deposits. This is a clear case of maturity mismatching with liabilities of short-term deposits to fund the assets of long-term mortgages. This mismatching actually was the major reason for the nearly financial collapse of the thrifts in the early 1980s. With securitization, thrifts no longer have to fund originations with deposits. It has not only enabled thrifts to continue their traditional business of residential mortgage lending but doing so with profits without maturity mismatching.

From the standpoint of investors, securitization broadens the variety of the asset mix that investors can purchase. Again, the best example is MBS. Originating mortgages is limited to a highly specialized profession and, prior to securitization, only banks and thrifts were major lenders or investors in residential mortgages. After securitization, however, even individuals can be investors in mortgages by purchasing MBS. They do not need any expertise in originating mortgages and can find comfort about the credit risk of mortgages through guarantees from a federal government agency such as Ginnie Mae, or GSEs such as Fannie Mae and Freddie Mac, or even mortgage insurance companies. To the extent that MBS are not guaranteed, individuals can rely on the credit ratings provided by rating agencies.

More significant, the guarantee and rating mechanism has allowed insurance companies and pension funds to be major investors of residential mortgages. The broadening of the investor base has markedly reduced the funding costs of mortgages. That is, residential mortgage rates have been lowered substantially. In 1998, conventional mortgage rates averaged about 120 basis points above the yield of 10-year Treasury notes. In the early 1980s, the average mortgage-to-Treasury rate spreads were as wide as 250 basis points. The narrowing of the rate spread has greatly enhanced the homeownership in the U.S. Similarly, the proliferation of securitization has also lowered the borrowing costs of credit cards, automobiles loans, student loans, manufactured housing loans, and many other consumer loans that have become the collateral of ABS.

Necessary Ingredients

It is through the decade-long cooperation of various professions of capital markets that lenders, borrowers, and investors can reap the benefits of securitization in the U.S. There are seven necessary ingredients to a successful securitization effort.

1. The legal framework. For each securitization transaction, an air-tight legal arrangement has to set up to guard the interest of the investor. Most important, the law has to protect the investor against any claim on the cash flow of the security's underlying asset. Thus, for each securitization transaction, a bankruptcy-remote special-purpose entity (SPE) is established. The economic purpose of the SPE is, on the one hand, to receive all the loans that are sold by the lender, and on the other, to pay to the security investor the interest and principal generated from the underlying loans. Being a bankruptcy-remote entity, a SPE has no other assets other than the loans acquired from the lender, and has no other liabilities other than those associated with the issued security. Additionally, there has to be a legal arrangement to define the duties and responsibilities of the issuer, the trustee, the custodian of the pool of loans and the servicer of the security.

2. Cash flow analysis. From a financing point of view, securitization essentially enables the lender to obtain the cash that is equivalent to the present value of the future cash flow of the loans. At the outset of securitization, it is critical for the issuer to conduct the cash flow analysis to ensure that the obligation of the SPE can be paid in a full and timely manner. In analyzing and pricing the future cash flow, many assumptions are made. In addition to the assumed discount rate, the analysis requires the assumptions on the behavior of the cash flow, such as economic scenarios during the life of the underlying loans, borrowers' propensity to repay the loans (if loans are amortizing instruments with a prepayment option), and incidence of default. Only on the basis of in-depth analysis of the historical cash flows of a vast amount of underlying loans can these assumptions be made realistically.

3. Accounting treatment. Two accounting issues are critical. First, the tax treatment of the security. Since the security is issued by the SPE and it has interest income from the underlying loans, it supposedly will be taxed. But taxation at the SPE level would render the securitization uneconomical because the interest income to the investor of the security will also be taxed. To avoid the "double taxation," the SPE (if it satisfies all the requirements) is granted a "grantor trust" status, exempting it from federal taxation. (For tax purposes, the SPE can also adopt the "owners trust" status.) Second, the protection for the investor in terms of a clear accounting of interest and principal of the periodic cash flow from the underlying loans. On a monthly basis, the servicer of the security needs to inform the investor about the components of the cash flow and the part of the cash flow that is taxable versus non-taxable. There also has to be clear accounting of the various expenses of securitization and payments to the trustee, the custodian, and the servicer.

4. Credit risk evaluation. Since the security is issued with the backing of a pool of consumer loans, the investor would naturally be concerned with the credit risk of the underlying loans. For most of MBS, the credit is guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac. To the extent that the credit of MBS is guaranteed by neither one of them, the credit of a security needs to be enhanced through various mechanisms. In general, credit enhancement can be structured in terms of a senior/subordinate cash flow structure, letter of credit, surety bonds, and mortgage pool insurance. Depending on how each or a combination of the four mechanisms is structured, the credit of the security often needs to be rated by credit rating agencies before being purchased by most investors. The credit rating agencies will assign credit ratings on the various segments of the cash flow of the security.

5. Investment banking. The underwriting and the distribution of a newly issued security are the responsibilities of the investment banker. The investment banker can be viewed as an intermediary connecting the issuer and the investor. However, during the entire process of securitization, the investment banker performs many critical functions. These include coordinating and helping with the issuer to deal with the legal, the accounting, the taxation, and the analytical cash-flow aspects of the security. After all that work, the investment banker acts as a dealer by setting the initial offering price of the security, purchasing the entire issuance of the security and distributing it to the investor (a typical function of a dealer is to take down the entire issue as inventory and then resale the issue to investors). After performing this task in the primary market, the investment banker also provides liquidity for the security in the secondary market by making a market through buying and selling the security.

6. Government debt market. In order to have a healthy securitization market, it is necessary to have a sound government debt market. Since government securities are generally free of credit risk, the trading of government debt securities establishes the market level of risk-free yields of various maturities. Their yields therefore form the appropriate benchmarks for the pricing of initial offering and the subsequent secondary-market trading of all other fixed-income securities that entail various degrees of credit risk. All non-government fixed-income securities trade at some yield spreads over the government securities.

7. Active secondary market. A successful primary market for the issuance of securities requires the support of an active secondary market. The secondary market provides information on how a similar prospective security should be priced. Once the security is issued, the investor needs an active secondary market to provide liquidity so that the security can be bought and sold without too much price volatility caused by factors not related to interest rates.

Potential Benefits For Taiwan
Taiwan needs to emulate the successful experience of securitization in the U. S. There are four strong reasons that this emulation is imperative for Taiwan.

1. Enhancement in the efficiency of commercial banking system. One of the critical factors contributing to the economic slowdown in Taiwan in recent years has been the lack of commercial and industrial lending from commercial banks. This is primarily the result of banks paying too much attention to the residential real estate lending. While originating residential mortgages is important to promote homeownership in Taiwan, it need not be at the expense of industrial and commercial lending. Commercial banks can emulate the MBS system in the U.S. to originate mortgages without tying down capital. More important, securitization allows banks to free up the scarce capital. By securitizing many assets, banks can substantially reduce the size of their balance sheets. With sharply down-sized assets, the corresponding requirement for capital is significantly reduced. This will create excess capital for banks to make loans in other critical sectors of the economy. The end result is the efficiency in the banking system in Taiwan will be greatly enhanced.

2. Diversification of the investment choices. The capital markets in Taiwan have long been characterized as being lopsidedly equity oriented. Investments have been overwhelmingly in equities with virtually no fixed-income securities. (Government securities are the only visible fixed-income securities in the market, but they have all been hoarded by banks and there is very little secondary market trading of these securities.) By securitizing bank assets, investors will have more fixed-income securities to purchase. Depending on the risk orientation of investors, they can choose between equities and fixed-income securities. This diversification is most critical to institutional investors, such as life insurance companies and pension funds. With a choice of a variety of fixed-income securities to purchase, these investors can more effectively manage their assets in relation to their long-term liabilities.

3. Development of more balanced capital markets. Considering the above two advantages, it is clear that securitization can help develop more balanced capital markets in Taiwan. Corporate equities would not longer be the predominate form of investment. In fact, with more balanced capital markets, corporations can contemplate the floating of bonds as an alternative means of corporate finance rather than solely depending on the offerings of stocks.

4. Reduction in borrowing costs. The ultimate benefit of securitization in Taiwan would be the lowering of borrowing cost for both consumers and manufacturers. Presumably, as in the U.S., the initial stage of securitization in Taiwan would involve residential mortgages. As mortgage securitization gain momentum, mortgage rates relative to government yields would begin to narrow. As MBS frees up capital for commercial banks to make commercial and industrial loans, manufacturers would also enjoy the benefit of securitization by paying lower interest on their loans.

Concluding Remarks
It has been proven in U.S. capital markets that the process of securitization benefits the lender, the borrower, and the investor alike. To modernize its capital markets and to increase the efficiency of the use of capital, Taiwan needs to expedite the effort of securitization. Through securitization, Taiwan can increase the efficiency of the banking system, diversify investment portfolios, develop more balanced capital markets, and reduce the cost of borrowing for both consumers and manufacturers. Ultimately, securitization can significantly increase the country's competitiveness in the international exports arena and further raise the standard of living in Taiwan.