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![Carker, in Dombey and Son, may serve as an example of the way
this is sometimes done. Daudet is quite as energetic in pointing
obvious morals. The way he impales D'Argenton on the point of his
pen and spares no pains in holding him up to ridicule is an instance
of this, while a much clearer one, and one wholly unredeemed by
such permissible satire as at times redeems the portrait of
D'Argenton, is the account of the school to which Jack is sent. There
is no air of reality in the account of the little king of Dahomey who is
Jack's sole friend in that wretched place. Then, too, the poor silly
mother can never appear but the author, besides making her talk
and act like the foolish creature she is, must be for ever whispering
in the reader's ear that she is a great fool and a frivolous creature.
This over-violent method defeats its own object, and surprises and
pains the reader instead of gratifying him. Nothing is taken for
granted; we are not left to perceive anything by our own unaided
vision; everything is made as plain for us as if it were written in
words of one syllable. But that way of writing palls at length, and
calls forth a feeling of disappointment with what is in some respects
a very able novel.
X. Doudan, Mélanges et Lettres. Avec une introduction par M. le
comte d'Haussonville, et des notices par MM. de Sacy et Cuvillier-
Fleury. Tome III. Paris: Calmann Lévy.
Only a year ago two volumes of M. Doudan's correspondence were
given to the public—they received notice in these pages,[10] it will be
remembered—with a conditional promise of more in case the first
should be duly appreciated. Fortunately, these letters were widely
read and heartily admired, so that now we have this third volume,
with further selections up to the year 1860, and the promise of the
speedy appearance of a fourth, to contain letters after that date and
Doudan's essay on the Revolutions of Taste. There need be no fear
in any one's mind that all the best letters were taken for the first
publication, and that the editor has been obliged to swell the pages
of this volume with Doudan's hasty, uninteresting notes. Far from it:
everything that Doudan wrote had, as some one has well said, the](https://image.slidesharecdn.com/2149757-250530152922-af809515/75/Asset-Securitization-Theory-And-Practice-Joseph-C-Huauth-59-2048.jpg)
![appreciating even slight matters without placing them above things
of real importance.
[10] See number for October, 1876.
Here is a bit of his criticism: You were quite right to be irritated with
this Fanny. I had to see what success Madame Bovary had with all
the clever people of society to believe in the success of Fanny. His
emphatic and declamatory style has helped the author in putting into
his book more shocking and absurd things than there were in the
vile anecdotes about Madame Bovary. If a young buffalo in the
Pontine Marshes were to write his memoirs, with a detailed account
of his loves, his jealousy, his excesses and his despair, he would
doubtless give expression to the same sentiment of moral good and
evil among buffaloes, but he would not exaggerate the fashion of
description in such a ridiculous way. The genuineness of his feelings
would prevent his seeing a number of things which do not concern
his passions. He would not describe, while sharpening his horns for
the fight, the little field-flowers, which he could not notice, nor the
village curé's wig, which does not concern him at all; but this small
and numerous school of self-styled realists has, in my opinion, so
little keen feeling and true passion that it is like the mathematician
who wrote from his mother's deathbed, 'I lost my mother this day at
twenty-two and one-half minutes after eight [mean time].' The
passions are not so accurate, and do not see so many things.
Here is an extract from a letter written in the perturbed days of
1848: In the country, whence I write, there is no news. The
vervain, the heliotropes, are in flower, as they are every year, and
the squirrels run up and down the trees without asking what is going
on in Paris. Not one has subscribed to the most insignificant
newspaper. By the way, do you suppose there are social
disturbances among the beasts of the air, or of the fields, or of the
waters? That is not impossible, and I should be very sorry if it were
the case: it pleases my imagination more to think that the squirrels
are living to-day just as they lived in the garden of Eden; but I have
already told you that at a not very remote period a race of rats,](https://image.slidesharecdn.com/2149757-250530152922-af809515/75/Asset-Securitization-Theory-And-Practice-Joseph-C-Huauth-61-2048.jpg)
Asset Securitization Theory And Practice Joseph C Huauth
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- 5.
- 6. Theory and Practice JOSEPHC. HU John Wiley & Sons (Asia) Pte. Ltd. Asset Securitization
- 7. Copyright # 2011John Wiley & Sons (Asia) Pte. Ltd. Published in 2011 by John Wiley & Sons (Asia) Pte. Ltd. 2 Clementi Loop, #02–01, Singapore 129809 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte. Ltd., 2 Clementi Loop, #02–01, Singapore 129809, tel: 65–6463–2400, fax: 65–6463–4605, e-mail: enquiry@wiley.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Neither the authors nor the publisher are liable for any actions prompted or caused by the information presented in this book. Any views expressed herein are those of the authors and do not represent the views of the organizations they work for. Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data ISBN 978–0–470–82603–4 (Hard cover) ISBN 978–0–470–82898–4 (e-PDF) ISBN 978–0–470–82897–7 (e-Mobi) ISBN 978–0–470–82899–1 (e-Pub) Typeset in 10/12pt, Sabon by Thomson Digital, India Printed in Singapore by Toppan Security Printing Pte. Ltd. 10 9 8 7 6 5 4 3 2 1
- 8. Contents Preface xiii Introduction xv PARTONE Basics of Asset Securitization 1 CHAPTER 1 Asset Securitization: Concept and Market Development 3 Basic Concept of Asset Securitization 3 Special Purpose Entity 5 Asset Sale versus Debt Financing 5 The Requirement of Servicing 7 Credit of the Underlying Assets 8 Need for Credit Enhancement 9 Development of the Asset Securitization Market in the United States 10 CHAPTER 2 Originators and Investors of the Asset Securitization Market 19 Efficient Financing for Originators with Asset Securitization 19 Satisfying Varying Investor Demands with Asset Securitization 24 Cultivating Investors: Matching Products with Investment Demands 25 The Importance of Understanding the Underlying Assets 25 Three Types of Investors 26 Yield-Oriented Investors 26 Credit-Oriented Investors 27 Maturity-Oriented Investors 27 v
- 9. CHAPTER 3 Intermediary Participantsof the Asset Securitization Market 29 Attorneys 29 Accountants 31 Guarantors and Credit Enhancers 31 Self-Insurance 32 Bond Insurance 32 Corporate Parent Guarantee 32 Letter of Credit 33 GSE Credit Guarantee 33 Credit Rating Agencies 33 Investment Bankers 35 CHAPTER 4 Necessary Ingredients and Benefits of Asset Securitization 39 The Nine Necessary Ingredients 39 Sound Loan Origination Process 40 Complementary Legal Framework 40 High Integrity of Cash-Flow Analysis 40 Clearly Defined Accounting Rules 41 Prudent Risk Evaluation 42 Full-Fledged Investment Banking Services 42 Mature Government Debt Market 42 Active Secondary Market 43 Broad Investor Base 44 Benefits of Asset Securitization 45 Improvement in the Financial Operation for the Originator 45 Provision of Diversified Investment Products 45 Lowering the Borrowing Cost 46 PART TWO Residential Mortgages and Securitization of Residential Mortgages 49 CHAPTER 5 Residential Mortgages 51 Description of a Residential Mortgage 51 Characteristics of a Fixed-Rate Mortgage 52 Amortizing a Mortgage 53 vi CONTENTS
- 10. Comparison of TwoMortgages with Different Mortgage Rates 54 Alternative Mortgages 57 Adjustable-Rate Mortgages (ARMs) 57 Fifteen-Year Fixed-Rate Mortgages 60 Graduated-Payment Mortgages (GPMs) 61 Biweekly Mortgages 62 Balloon Mortgages 63 Second Mortgages 63 Home Equity Loans (Subprime Mortgages) 63 Hybrid Mortgages 64 Reverse Annuity Mortgages 65 CHAPTER 6 The Residential Mortgage Market 67 The Origination of a Residential Mortgage 67 Housing and Debt Ratios 68 Credit History 69 Property Appraisal 69 Down Payment 70 Mortgage Originators 71 Mortgage Servicers 72 Mortgage Insurers 72 FHA Mortgage Insurance 73 VA Loan Guarantee 73 Private Mortgage Insurance 73 The Development of the Residential Mortgage Market 74 CHAPTER 7 Residential Mortgage Pass-Through Securities 79 Mortgage Pass-Throughs 79 Ginnie Mae Mortgage Pass-Throughs 79 Concept and Terminology 82 Freddie Mac Participation Certificates 87 Fannie Mae Mortgage-Backed Securities 89 Private-Label Pass-Throughs 91 Subprime Mortgage-Backed Securities 92 Trading and Relative Value of Pass-Throughs 92 TBA Trade 93 Forward Settlement 93 Contents vii
- 11. Specified Trades 93 Bid–OfferPrice Spreads 94 Benchmark Current-Coupon Yield Spreads 95 CHAPTER 8 Multiclass Mortgage Pass-Throughs 99 Prepayment of Mortgage Pass-Throughs 99 The Need for Multiclass Securities 100 Collateralized Mortgage Obligations 102 The Concept of Average Life 102 Real Estate Mortgage Investment Conduits 103 Issuance of Agency-Guaranteed Multiclass Securities 104 Variety of REMIC Classes 105 Planned Amortization Classes (PACs) 106 Floaters 106 Interest-Only and Principal-Only Securities (IOs and POs) 107 Z-Bonds 107 The Rise, Collapse, and Recovery of REMICs 108 The Rise of REMICs 108 The Collapse of REMICs 108 The Recovery of REMICs 109 Trading and Relative Value 111 CHAPTER 9 Private-Label Mortgage Pass-Throughs 115 The Growth of the Private-Label Pass-Through Market 115 A Typical Transaction 117 Characteristics of the Underlying Mortgages 119 Low Loan-to-Value Ratios 119 High Credit Quality of Borrowers 120 The Cash-Flow Structure—Mechanism of Credit Enhancement 120 Senior/Subordinated Cash-Flow Structure 120 Bond Insurance 121 Pool Insurance and Corporate Guarantee 122 Letter of Credit 122 Credit Rating Criteria 122 Performance of Credit Ratings 124 viii CONTENTS
- 12. Prepayment Pattern 126 Tradingand Relative Value 126 CHAPTER 10 Subprime Mortgage-Backed Securities 131 Evolution of the Subprime Mortgage Market 132 Features of Home Equity Loans 134 Two Types of HELs 134 Underwriting Criteria—Three Ratios 135 Credit Quality of Borrowers 136 Delinquencies and Defaults 136 Varying Characteristics of Pools of Subprime Mortgages 137 Examples of Transactions 142 An Early-Year Transaction: RASC 2003-KS4 143 Mixed Pools of Fixed- and Adjustable-Rate Mortgages 143 Mechanism of Credit Enhancement 143 Bond Insurance to Enhance Credit 145 Maturity Tranching to Capture Pricing Efficiency 145 A Later-Year Transaction: ABFC 2007-WMC1 146 Unique Prepayment Pattern 149 Performance of Credit Ratings 149 Trading and Relative Value 152 PART THREE Securitization of Commercial Mortgages and Consumer Loans 155 CHAPTER 11 Commercial Mortgage-Backed Securities 157 The Growth of the CMBS Market 157 The Origination of a Commercial Mortgage 159 The Loan-to-Value Ratio 161 The Debt Service Coverage Ratio 161 Defaults and Losses of Commercial Mortgages 161 A Typical Transaction 164 Characteristics of Underlying Mortgages 165 Re-Underwriting Mortgages for Credit Ratings 167 Credit and Maturity Tranching 169 Contents ix
- 13. Performance of CreditRatings 170 Trading and Relative Value 171 CHAPTER 12 Asset-Backed Securities 175 The Growth of the ABS Market 175 Credit Card ABS 176 Pattern of Cash Flow of the Underlying Collateral 176 Three Types of Issuers 177 Transaction Parameters 177 Investor Interest and Seller Interest 177 Revolving Period and Accumulation or Amortization Period 179 Portfolio Yield, Delinquency Rate, and Loss Rate 179 Payment Rate and Purchase Rate 180 Certificate Rate and Servicing Fee 180 Excess Spread 180 A Typical Transaction 181 Underlying Collateral 181 Credit Enhancement 182 Stress Test for Credit Ratings 183 Auto Loan ABS 184 Pattern of Cash Flow of the Underlying Collateral 184 Major Types of Issuers and Underlying Assets 184 A Typical Transaction 185 Cash Flow and Credit Enhancement 186 Prepayment 187 Performance of Credit Ratings 188 Trading and Relative Value 189 CHAPTER 13 Collateralized Debt Obligations 193 Basic Concept and Market Development of CDOs 194 CDOs Are Not Mutual Funds 195 Different Structural Types of CDOs 196 Cash Flow CDOs 196 Synthetic CDOs 197 Market Value CDOs and Hybrid CDOs 198 Motivations for Issuing CDOs 199 Arbitrage 199 x CONTENTS
- 14. Capital Relief 199 RiskManagement 200 Facilitating the Growth of the Asset Securitization Market 200 Incentives for Investing in CDOs 200 Structuring and Credit Rating CDOs 201 A Simulation Model to Structure CDOs 203 Trading and Relative Value 205 PART FOUR The Current Asset Securitization Market in the United States and Asia-Pacific 209 CHAPTER 14 The Collapse and Recovery Prospects of the Asset Securitization Market 211 How the Market Collapsed 212 Sloppy Origination of the Underlying Assets 212 Overly Zealous Investment Banking 213 Complacent Credit Ratings 214 Irresponsible Investing Behavior 215 Prospects for Recovery 215 Underlying Asset Originators: Back to Basics 216 Investment Bankers: Reduce Leverage and Look Out for Investors 217 Credit Rating Agencies: Strengthening Rating Criteria through Research 217 Investors: Know What You Are Buying 218 CHAPTER 15 Asset Securitization in Asia-Pacific 221 Asset Securitization in Japan 221 Market Growth with Variety of Underlying Assets 221 Complementary Factors in Strong Growth 223 Asset Securitization in Australia 224 Rapid Growth with Focused Underlying Assets 224 Tapping the World Financial Markets for Funds 225 The Strong Base for the Australian RMBS 226 Different Patterns of Asset Securitization in Japan and Australia 226 Asset Securitization in Taiwan 226 Asset Securitization in China 229 Contents xi
- 15. APPENDIX A Analysis ofPrepayment and Prepayment Rate 233 Measurement of Prepayment Rate 233 Single Month Mortality (SMM) 233 Constant Prepayment Rate (CPR) 234 Public Securities Association Standard (PSA) 235 Two Fundamental Reasons for Prepayment 236 Refinancing 236 Housing Turnover 237 Home Sale 237 Default 238 Disaster 238 Death 238 APPENDIX B Housing Price Appreciation and Mortgage Credit Performance 239 The Importance of Housing Price Appreciation 239 The National Experience 239 The California Experience 241 Credit Performance of Mortgages 241 Delinquencies and Defaults 241 The Standard Default Assumption 242 APPENDIX C Fundamental Elements in Credit Ratings 245 Evaluating Credit Quality of the Underlying Assets 245 Reviewing Payment Structure and Cash-Flow Mechanics 247 Analyzing Legal and Regulatory Risks 247 Assessing Operational and Administrative Risks 248 Examining Third-Party Dependencies 248 APPENDIX D The Collapse of the Asset Securitization Market 251 Index 255 xii CONTENTS
- 16. Preface This book, AssetSecuritization: Theory and Practice, is based on my 30 years of observations and work experience in the U.S. asset securitiza- tion market. It is a celebration of this efficient financing method that has, over the last four decades, benefited lenders, borrowers, and investors alike. As a capstone for a career spent in some of the major investment banking firms and a leading credit rating agency, this book is also written with an unavoidable tinge of sadness. Powerhouses such as Salomon Brothers, Bear Stearns, and Lehman Brothers, and venerable investment firms like E. F. Hutton—places I admired or worked and honed my analytical skills at as a young man—have been swept away by the change of times or mis- management. And the asset securitization market was almost destroyed by greed, abuse, and complacency. As a market practitioner who believes in the power of asset securitization, and contributed in a small way to its suc- cess, the events of the last three years have been painful to witness. How- ever, ever the optimist, I am hopeful that the market will storm back bigger, better, and stronger, to once again provide financing to consumers and busi- nesses, creating wealth for our society. This book could not have been published without the help of many of my colleagues and friends. I would like to thank Rocco Sta. Maria, Head of Sales and Client Services for Standard & Poor’s in Asia-Pacific, for putting me in touch with John Wiley & Sons. I am grateful for the assistance extended to me by my colleagues at Standard & Poor’s offices in Tokyo (Yu-Tsung Chang), Melbourne (Vera Chaplin), Beijing (Li Jian), Hong Kong (Frank Lu), and Taipei (Aaron Lai), who provided insights into the development of the Japanese, Australian, Chinese, and Taiwanese asset securitization markets. I would also like to express my gratitude to K. C. Yu, Deputy CEO of SinoPac Holdings and Nick Ding of Standard & Poor’s Beijing office, for providing me access to up-to-date market information. Over the years, the excellent market commentaries of Citigroup Global Markets, J. P. Morgan Securities, Merrill Lynch, Morgan Stanley, and UBS Securities kept me abreast of the asset securitization market. I would also like to thank many of my friends who helped me clarify and improve the content of this book. Additionally, I greatly appreciate the assistance of xiii
- 17. Nick Melchior, SeniorPublishing Editor, John Wiley & Sons, without whose encouragement and enthusiasm this book would not have been com- pleted so expeditiously. Though I am solely responsible for the content of this book, the skills and professionalism of my copy editor, Michael Hanrahan, made the text eminently more readable. Finally, I wish to thank my wife, Linda, and my children, Justin and Brian. Their love and support made the writing of this book and, in fact, my whole professional journey all the more rewarding and enjoyable. Joseph Hu November 2010 xiv PREFACE
- 18. Introduction In A Taleof Two Cities, Charles Dickens described the chaotic and brutal period of the French Revolution as the best of times and the worst of times. For the asset securitization market, one might similarly regard the period after the subprime mortgage debacle that caused panic and tremen- dous financial loss worldwide as the worst of times—the winter of hindsight and reflection. Yet this period can also be viewed as the spring of hope and rebirth, and as the best time to study the concept and practice of asset secu- ritization, to once again make it a powerful financial engine that creates wealth and prosperity. Over the last 40 years, the asset securitization market has grown and flourished to become the largest sector of the U.S. fixed-income securities market. In the initial development of the asset securitization market in 1970, residential mortgages were the only type of securitized assets. Re- markably, however, since the mid-1980s, many other types of financial assets with a predictable future receivable cash flow began to be utilized as the underlying asset for the issuance of asset-backed securities. These assets include, but are not limited to, commercial mortgages, credit card receiv- ables, auto loans, student loans, equipment leases, and small business loans. By facilitating the funding of consumption and business activities, asset securitization has contributed substantially to the steady growth of the U.S. economy and the increase in the American standard of living. Asset securiti- zation has been the living proof of the adage, ‘‘finance creates value.’’ Alas, asset securitization became the victim of its own success. With the abundance of funds available to be invested, market participants became overly creative with the underlying assets of their originations and created a variety of new asset-backed securities. Throwing caution to the wind, originations of residential mortgages—the securitization market’s most prominent and best performing underlying assets—began to grossly deviate from prudent underwriting guidelines. Driven by greed, more and more of the low-credit-quality (subprime) mortgages were originated and their inherent credit risks were consistently underestimated. When incidences of delinquencies and defaults of these mortgages became abnor- mally frequent, investors were alarmed and began to shy away from xv
- 19. subprime mortgage-backed securities.Like dominos, fear and panic quickly spread to the mortgage-backed securities market and eventually put a stran- gle hold on other sectors of the capital market as well. A credit risk problem created a liquidity problem so severe that funding became unavailable to consumption and business activities. Since late 2007, the U.S. economy has experienced the worst contraction both in depth and duration since the Great Depression. The rest of the world has been sim- ilarly impacted with their economies languishing in a severe downturn. In the initial panic, ‘‘asset securitization’’ became one of the most vilified and demonized financial terms in the world. Critics questioned the justification of such a market and there were doubts aplenty about whether the asset securitization market would ever recover. It would seem that this is indeed the worst time for asset securitization. Yet, the bottom of the market is the perfect place and time to examine asset securitization anew—its successes and failures—and plan for a future asset securitization market that is trans- parent, self-disciplined, and rigorous in its regulation and supervision. This book is intended for students and entry-level market professionals alike who are interested in learning about asset securitization—its con- cepts and practices. It is designed so that the readers will come away with a fundamental but comprehensive understanding of the asset securitization market. As such, the book aims to provide a review of the market’s develop- ment, necessary framework, potential benefits, and detailed descriptions of major asset securitization products. Part 1 of the book, which consists of four chapters, will discuss the fun- damental concepts, the funding efficiency, the market participants, and the potential benefits of asset securitization. An analysis of mortgage finance will be provided in Part 2, which consists of six chapters. They cover a vari- ety of topics from the description of many different types of residential mort- gages to the securitization of these mortgages, including the now infamous subprime mortgages. Also included are important topics, such as prepay- ments, cash-flow structure, maturity and credit tranching, and the trading and relative value of the various mortgage-backed securities. The three chap- ters in Part 3 will explain the other major asset securitization products, such as commercial mortgage-backed securities, credit card receivable-backed securities, auto loan-backed securities, and collateralized bond obligations. Part 4 has two chapters: one reviews the collapse and the potential recovery of the asset securitization market, and the other describes the asset securitiza- tion efforts in Japan, Australia, Taiwan, and China. Extensive tables and charts are presented to help illustrate a concept or describe a product. Neither analytical discussions nor investment strategies of the various asset-backed securities are included as they are not the focus of this book. xvi INTRODUCTION
- 20. It is hopedthat, after reading this book, students of asset securitization will gain new insight into and appreciation for the creative financial instru- ments that make up this market. And be mindful of the critical lesson learned that not all good things need come to an end, if prudence is always the guiding principle of our behavior in the financial market. Introduction xvii
- 21. PART One Basics of Asset Securitization AssetSecuritization: Theory and Practice by Joseph C. Hu Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.
- 22. CHAPTER 1 Asset Securitization:Concept and Market Development The concept and market practice of asset securitization started in 1970, when mortgage bankers pooled their newly originated residential mort- gages and issued residential mortgage-backed securities. By issuing residen- tial mortgage-backed securities, mortgage bankers were able to raise funds more efficiently in the capital market to finance their originations of resi- dential mortgages.1 It took only 20 years for the asset securitization market to become the largest sector in the U.S. capital market, with the outstand- ing balance exceeding one trillion dollars. In the early development of the asset securitization market, residential mortgages were the only type of underlying assets that were being securitized. Since the mid-1980s, a great variety of financial assets that had predictable and steady future receivable cash flows have been utilized as the underlying assets for securitization. This chapter will first discuss the basic concept of asset securitization. It will then present the development history of the asset securitization market in the United States over the past 40 years. BASIC CONCEPT OF ASSET SECURITIZATION Asset securitization is an innovative way for lenders to raise funds in the capital market by selling the future receivable cash flows of their assets.2 The cash flows are sold in the form of securities that are backed by the cash flows of the very assets sold. The securities are therefore called asset-backed securities. This method of financing differs from the traditional means of raising funds by attracting deposits or borrowing in the form of loans. It is also different from issuing debt or equity securities (bonds or stocks) to ob- tain funds in the capital market. 3 Asset Securitization: Theory and Practice by Joseph C. Hu Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.
- 23. Issuers of asset-backedsecurities are mostly originators of the assets backing the securities. These assets can be a wide variety of residential or commercial mortgages, consumer loans, commercial leases, or any financial instruments that have predictable and stable receivable cash flows. In recent years, there have been new and popular asset-backed securities that are sup- ported by assets that are corporate bonds, commercial and industrial loans, or even asset-backed securities themselves. Since asset-backed securities are issued by lenders through the mechanism of structuring future receivable cash flows of the underlying assets to finance their funding needs, the securities are also called structured finance securities. From an accounting point of view, the issuance of asset-backed securities is considered an asset sale. This differs from the issuance of bonds, which is debt financing by corporations, the various levels of government, or authorities. Specifically, by issuing an asset-backed security to raise funds to finance the origination of loans, the financing has the following five salient features: & The asset-backed security is issued through a special purpose entity. & The accounting treatment of issuing an asset-backed security is asset sale rather than debt financing. & An asset-backed security requires the servicing of the underlying assets for the investor. & The credit of the asset-backed security is derived primarily from the credit of the underlying assets (the collateral). & There is invariably a need of credit enhancement for the asset-backed security. At the outset, it is critical that several basic terms of asset securitization are clarified to avoid possible confusion in future discussions. Throughout this book, the presentation and the analysis, unless specifically noted, are from the viewpoint of the lender, who is a loan originator. The originator is the one who originates the loans that are pooled as the underlying assets for the issuance of asset-backed securities in the asset securitization transac- tion. Therefore, the term originator is synonymous with the term lender. The two terms are used in the book interchangeably. Further, since asset securitization is primarily enabling those originators to use their newly orig- inated or existing loans to obtain funds, the loans are really their assets (although from the point of view of the borrowers, they are debts). Thus, the terms loans and assets in the context of structured finance are also syn- onymous. They are interchangeable terms. The issuer of asset-backed secu- rities is mostly an entity that is set up by the originator of the underlying assets. So, while the originator and the issuer are legally two different enti- ties, they are economically the same or very closely related business entities. 4 ASSET SECURITIZATION
- 24. Special Purpose Entity Aspecial purpose entity (SPE) is a unique feature of asset securitization.3 Alternatively, an SPE is also referred to as a special purpose vehicle (SPV) or a special purpose trust (SPT). Basically, an SPE is a trust that is set up by the originator for the purpose of purchasing the loans it originates and issuing in the capital market a certificate of beneficial interest, for which the cash flows are backed solely by the cash flow of loans purchased from the originator (see Figure 1.1). Actually, the purchase of loans and the issu- ance of the certificate of beneficial interest take place simultaneously. They are two parts of a transaction. The SPE, on the one hand, raises the funds in the capital market by issuing the asset-backed security; and on the other hand, it uses the very issuance proceeds to pay for the purchase of the underlying assets. The holder of the certificate of beneficial interest is gener- ically called the investor of the asset-backed security. From a balance-sheet point of view, the SPE has no assets other than those purchased from the originator, and no liabilities other than those of the asset-backed security it issues. With this special and strict asset–liability structure, the cash flows of the assets are matched by those of the liabilities. From the accounting and legal points of view, the SPE is considered bankruptcy-remote. Asset securitization is also called structured finance, because it is done through a special legal structure of the SPE and the inter- est and principal payment of the security it issues is through the structuring of the projected future receivable cash flows from the underlying assets. Structured finance is a formal and generic term for asset securitization. The term structured finance is often used to differentiate from corporate finance. Colloquially, however, the term asset securitization is more often used to describe precisely the process of pooling assets for the issuance of an asset- backed security. To further simplify the description of asset securitization, it sometimes is just called securitization. Asset Sale versus Debt Financing One great advantage of asset securitization is that it is an effective way of managing the balance sheet by the originator through the selling of its newly originated or existing loans to raise funds. This way of financing ena- bles the originator to collect the present value, at the prevailing market price, of the stream of the future receivable cash flows of their assets. Asset securitization, therefore, is not a debt financing and the funding has no con- sequence of expanding the issuer’s balance sheet. Further, by selling assets, the originator does not rely on attracting deposits or borrowing from other financial institutions to fund the origination of the assets, both of which will Asset Securitization: Concept and Market Development 5
- 25.
- 26. expand the liabilityside of the balance sheet. Actually, it can be said that when a lender raises funds through asset securitization, the financing could even have the effect of shrinking the lender’s balance sheet if it elects to use the issuance proceeds to pay down liabilities (this being the case when the lender sells existing loans on its portfolio). By contrast, a lender raising funds through deposits, borrowing, issuing debt or equity securities to fund the origination of loans would have the consequence of expanding its bal- ance sheet. The Requirement of Servicing The function of servicing is unique for asset-backed securities because the sole source of the interest and principal payments of the securities is sup- ported entirely by the future cash flows of the underlying assets. The servic- ing function is performed by a servicer, who often is the originator and also the seller who sells the very assets to the SPE. Primarily, the servicer per- forms the servicing function by collecting the interest and principal cash flows generated from the underlying assets and then passing them, through the SPE, to the investor (holder of certificate of beneficial interest). Other important elements of the servicing function include working with delin- quent borrowers, disposing of defaulted assets, and providing timely and accurate cash-flow reports to investors. In the early days of the legal structure of the SPE, which was a grantor trust, the servicing function was passive in that the servicer was required not to touch the cash flow generated from the underlying assets other than just passing them on to the investor. This requirement was made necessary so that the Internal Revenue Service would see through the SPE, not levying an income tax at the SPE level on the interest cash flow generated from the underlying assets. The income tax liability will fall on the investor, who is the ultimate owner of the assets underlying the asset-backed securities. It stands to reason that if the tax on interest income to the SPE were to be levied while the interest income to the investor is also taxed, there would be income taxes on two levels of the transaction. This double taxation would completely nullify the economic benefits intended for securitization. Under this passive management requirement, all the servicer was re- quired to do was simply pass the cash flows onto the investor. The servicer could not manage the cash flows to earn incremental yield for the trust by reinvesting the interim cash flow (the cash flow the SPE owns temporarily between the time it was collected by the servicer and the time it was distrib- uted to the certificate holder). Nor was the servicer permitted to allocate the principal cash flow of the underlying assets to satisfy the varying maturity preferences of the different types of investors. Later on, new legislation Asset Securitization: Concept and Market Development 7
- 27. permitted active managementof the cash flow of the underlying assets. It allowed the servicer to allocate the cash flow, without encountering tax consequences, by prioritizing the principal payment of the underlying assets to investors according to maturity and credit-risk preferences. Also, the servicer was allowed to manage the interim cash flow to enhance the income of the trust by purchasing short-term money market instruments with the interim cash flow. As will be explained in later chapters, the ability of the servicer to allo- cate cash flows is critically important in the development of new types of asset-backed securities. It allowed the innovative creation of maturity tranching and credit tranching of the cash flows of the underlying assets. Issuers were allowed to issue asset securitization securities in various matu- rity classes and credit-risk classes. In comparison with asset-backed securities, corporate or government bonds do not need servicers. This is because the interest and principal pay- ment of these obligations are paid out of the issuers’ earnings or tax reve- nues. The cash flows of the liabilities are not matched by the cash flows of any of their assets. Credit of the Underlying Assets Since the interest and principal cash flow of an asset-backed security come solely from its underlying assets, the credit risk of the security is derived primarily from the credit risk of the underlying assets. (As will be explained in later chapters, the credit risk, or simply the credit, of a borrowing entity or a debt instrument refers to the likelihood of the borrower defaulting on its debt. The likelihood of default is assessed publicly by credit rating agen- cies. According to credit rating agencies, the incidence of default is defined as the borrower failing to make timely payment of interest and/or the repay- ment of principal of the debt. A high credit rating, or a strong credit, would mean a low probability of default. Conversely, a low credit rating, or a weak credit, suggests a high probability of default.) More important, the credit of the assets is highly dependent on economic conditions. In a pros- perous economy, the underlying assets would perform strongly with less fre- quent incidences of default. In a depressed economy, however, the underlying asset would have a weak credit performance and the incidences of default would become more frequent. This feature contrasts sharply with the credit determinant of a debt ob- ligation of a corporation or a government entity. The credit strength of a corporate debt is first and foremost dependent on the management of the corporation. A well-managed corporation is likely to have a stronger credit because it is more likely to be financially healthy with a greater earning 8 ASSET SECURITIZATION
- 28. potential. This wouldenable the corporation to service its debt in various economic environments. Conversely, the credit of a poorly managed corpo- ration is likely to be weaker. With the exception of the U.S. government, whose debts are risk free, the credit of a state or local government is also dependent on its ability to manage various expenditures in relation to tax revenues under all economic conditions. Need for Credit Enhancement Credit risk of a security is an important investment consideration for inves- tors. In order for an asset-backed security to attract certain investors, it has to have a desirable credit rating. If the underlying assets cannot provide the security with a desirable credit rating, then the security would require credit enhancement as defined by the credit rating agencies. In this case, four ma- jor sources of credit enhancement are available to strengthen the credit of an asset-backed security. They are: (1) self-insurance, (2) corporate-parent credit guarantee, (3) surety bond, and (4) letter of credit (detailed analysis of credit enhancement will be provided in various later chapters when the cash-flow structure of products is explained). Credit enhancement through self-insurance can be in the form of senior/ subordination, over-collateralization, or interest spread. In senior/subordi- nation, the cash flow of an asset-backed security is subdivided into two classes: senior and subordinated classes. The principal cash flow of the sub- ordinated class is structured to support (enhance) the credit of the principal of the senior class. Under the senior/subordination structure, the investor of the senior class of the security will be repaid before the investor of the sub- ordinated class. One simple example may be appropriate to explain the senior/subordi- nate cash-flow credit enhancement. Consider a pool of assets that is expected to experience a lifetime cumulative default rate (default frequency) of 30 percent. After the default, the underlying assets may be liquidated to recover 60 percent of the original loan amount. That is, the loss on the defaulted assets is 40 percent (loss severity). For the life of the pool, the cumulative loss therefore would be the product of default frequency and loss severity; that is, 12 percent (30% 40% ¼ 12%). Based on these cash- flow assumptions, it is possible to structure a senior/subordinate credit enhancement with the senior class security being supported by the 88 per- cent (1 – 12%) of the pool’s cash flow and the subordinate (junior) class being supported by the first loss of 12 percent of the pool’s cash flow. In an over-collateralization structure, the principal amount of the underlying assets is greater than the principal amount of the asset-backed security so that more principal protection can be provided by the excess Asset Securitization: Concept and Market Development 9
- 29. principal. For example,the underlying principal cash flow can be 110 percent of that of the security. Thus, the additional 10 percent of over-collateralization is behaving like a subordinate class that supports the principal of the senior class. In addition to the principal, the interest can also be used in credit enhancement. This is under the structure where the interest on the asset- backed securities is set to be significantly less than that of the underlying assets and the excess spread is used to support the credit of the asset- backed securities. All these are viewed as self-insurance because the princi- pal and/or the interest of the underlying assets are the sources of credit enhancement. Sometimes, it may be more economical to issue an asset-backed security with the corporate-parent of the issuer providing the credit enhancement. In this case, the credit strength of the security is equivalent to that of the corporate parent. An alternative to a corporate-parent guarantee can be a credit guarantee provided by a bond insurance company in the form of surety bond. The bond insurance companies often have a very strong credit so that the bond-insured structured security would also be highly rated. The fourth alternative is credit enhancement via letter of credit from a commer- cial bank with a strong credit. In this case, the credit of the asset-backed security is the same as the credit of the commercial bank. DEVELOPMENT OF THE ASSET SECURITIZATION MARKET IN THE UNITED STATES Asset securitization began in the United States in 1970, when residential mort- gages were securitized by mortgage bankers with the issuance of mortgage- backed securities. Over the last 40 years (1970 to 2009), more than $23 trillion worth of principal amount of asset-backed securities has been issued with a wide variety of underlying assets, ranging from residential mortgages to air- plane leases to corporate bonds. As of year-end 2009, outstanding principal of asset-backed securities approached $11 trillion. Three major factors contributed to the rapid growth of the asset securi- tization market. First, during the thrift crisis of the 1980s asset securitiza- tion enabled thrifts to convert their holdings of residential and commercial mortgages to mortgage-backed securities. It greatly increased the market- ability of mortgages and expedited the resolution of failed thrifts. Second, the coming of home-buying age in the late 1970s of the post–World War II baby boomers created a strong demand for housing for nearly 20 years. Securitization of residential mortgages facilitated the funding for the surge of demographic demand for housing. Third, after the economic slowdown in the early 1980s, consumption turned robust and persisted almost until 10 ASSET SECURITIZATION
- 30. the severe recessionof 2008. Securitization of consumer loans, such as credit cards and auto loans, provided needed financing for consumers. This section will present a brief history of the development of the asset securitization market in the United States. Detailed description of the evolution of the major securitized products will be provided later in the relevant chapters. The earliest type of asset-backed security was Ginnie Maes. Actually, during the 1970s, Ginnie Maes were not even thought of, in today’s sense, as asset-backed securities. They were designed by the federal government simply as a vehicle for mortgage bankers to raise funds in the capital market to finance their originations of residential mortgages. It was natural that mortgage bankers were the first originators to practice asset securitization because they, unlike thrifts and banks, were non-depository lenders in that they could not attract deposits as a source of funds. They could make loans only with borrowed money and repay the borrowing after selling the newly originated loans. The issuance of Ginnie Maes efficiently facilitated the operation of mortgage bankers by enabling them to borrow directly from the capital market. The underlying mortgages backing Ginnie Maes were either in- sured by the Federal Housing Administration (thus called FHA-insured mortgages) or guaranteed by the Veterans Administration (now the Depart- ment of Veterans Affairs, VA-guaranteed mortgages). Ginnie Maes were ac- tually called mortgage pass-through securities (certificates of beneficial interest) and the investors of Ginnie Maes owned the pro rata share of inter- est in the pool of the mortgages backing Ginnie Maes. Because of the gov- ernment insurance or guarantee, the credit of the underlying mortgages for Ginnie Maes was enhanced to that of the U.S. government. (Here, the term credit refers to the probability of the borrowers paying lenders the monthly mortgage payment of interest and principal on time.) To further ensure the acceptability of the pass-through securities among investors, the credit of the securities was further enhanced by the guarantee of the Government National Mortgage Association (GNMA, nowadays called Ginnie Mae). The credit of GNMA in turn was backed by the full faith and credit of the U.S. government. (Here, the credit refers to the probability of the issuer of the pass-through security paying investors the monthly payment of interest and principal on time.) In a sense, it can be said the Ginnie Maes are the safest security because they carry a double credit guarantee from the U.S. government. In the early 1970s, there was another type of mortgage pass-through security being issued in the marketplace. It was a participation certificate called FHLMC PC (also a type of certificate of beneficial interest). This cer- tificate was issued and guaranteed by the Federal Home Loan Mortgage Asset Securitization: Concept and Market Development 11
- 31. Corporation (FHLMC), nowa government-sponsored enterprise (GSE) with a new official name of Freddie Mac.4 The reason this type of mortgage pass-through was called a participation certificate was that the originator who sold the mortgages to FHLMC was required to retain a 5 percent par- ticipating interest in the pool of mortgages sold. One reason for the partici- pating interest was to ensure that the originator, by retaining an interest and therefore having a stake in the mortgage pool, would have a strong incen- tive to maintain high underwriting standards of the mortgages. To differen- tiate from Ginnie Maes, the underlying mortgages for FHLMC PCs were conventional mortgages, meaning that they were not insured by FHA nor guaranteed by VA. Generically, all mortgage pass-throughs are now termed residential mortgage-backed securities (RMBS). During the decade of the 1970s, the combined issuance volume of Gin- nie Maes and FHLMC PCs was small; it never exceeded $30 billion annu- ally. The pace of securitizing mortgages, however, accelerated dramatically from 1981, when Freddie Mac and the Federal National Mortgage Associa- tion (FNMA), another GSE now called Fannie Mae, became the guarantor of RMBS. The sudden issuance surge of RMBS in the early 1980s was to assist the thrifts that were in dire financial conditions to manage their bal- ance sheets and improve earnings. The most critical financial problem of the thrifts was their greatly mismatched assets and liabilities. They were hold- ing long-term assets of mortgages (which were of mostly 30-year maturity) with short-term liabilities of time deposits (which were of short maturities, ranging from just a few months to mostly less than five years). In the early 1980s when interest rates were at a historical high with short-term interest rates hovering significantly above long-term rates, thrifts were having great difficulties rolling over their short-term debts. Worse, with the yields of long-term asset substantially below those of market short-term rates, thrifts were running huge negative cash flows, greatly depleting their capital position. The two GSEs initiated mortgage swap programs to facilitate the thrifts to securitize their holdings of long-term residential mortgages. Through the swap programs, the thrifts would sell their residential mortgages to the GSEs and in return receive certificates of beneficial interest backed by the very mortgages they sold. By doing the swap, thrifts would now own more marketable and liquid RMBS rather than the illiquid residential mort- gages. This would enable thrifts to more easily and quickly sell their RMBS and pare down liabilities. The mortgage swap programs were also timely to facilitate the financing for the demand for housing that was greatly strength- ened in the late 1970s due to the coming of home-buying age of the post– World War II baby boomers. This demand was temporarily suppressed by the financial difficulties at thrifts and the historically high interest rates. 12 ASSET SECURITIZATION
- 32. As the thriftsgradually returned to health and interest rates began to decline, mortgage originations advanced sharply. Securitization facilitated an increasingly larger portion of the originations. As shown in Figure 1.2, issuance of GSE RMBS and Ginnie Maes (together called agency-guaranteed RMBS, or simply agency RMBS) for the first time exceeded $50 billion in 1982. In three years, the annual issuance volume was over $100 billion. It soared pass $450 billion in 1992 and exceeded $560 billion in 1993. Escalating mortgage rates in 1994, which slowed housing activity and curtailed the mortgage financing needs, dimin- ished the annual issuance from 1994 to 1996 to a range between $250 bil- lion and $350 billion. However, as mortgage rates resumed their declines toward the end of 1996, issuance of agency RMBS in 1998–99 jumped back to around $700 billion annually. In 2000, as the economy suffered a slowdown, the agency RMBS issu- ance again dropped sharply to $480 billion. But in 2003, agency RMBS is- suance soared dramatically to $2,130 billion. (As will be discussed in detail in chapters on RMBS, the huge fluctuation in the annual issuance volume was triggered primarily by the oscillation in mortgage rates that affected home purchases and refinancings.) Between 2004 and 2008, agency RMBS issuance fluctuated within a narrow range between $900 billion and $1,150 billion. In 2009, as the economy suffered the most severe recession since 1929, issuance of agency RMBS increased sharply to $1,670 billion. This increase reflected the strong commitment of the federal housing 2,500 2,000 1,500 1,000 Billion Dollars 500 0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Non-Agency-Guaranteed Agency-Guaranteed FIGURE 1.2 Agency- and Non-Agency-Guaranteed Mortgage-Backed Securities, 1970 to 2009 Sources: Agency-guaranteed securities: Ginnie Mae, Freddie Mac, and Fannie Mae; non-agency guaranteed securities: Standard Poor’s. Asset Securitization: Concept and Market Development 13
- 33. agencies in supportingthe seriously weakened housing and mortgage fi- nance markets. As the agency RMBS grew rapidly over the past 20 years, RMBS issued without the agency guarantee, called non-agency-guaranteed pass-throughs, also developed with remarkable speed. In 1977, the first type of non-agency pass-throughs, called private-label pass-throughs, were issued.5 The market development in the next 13 years was rather slow, with the new issuance of private-label pass-throughs between 1977 and 1989 totaling only $50 bil- lion. Beginning in the 1990s, private-label pass-throughs started to grow rapidly. By 1993, they registered a new issuance of over $100 billion. Be- tween 1994 and 1996, due to escalating mortgage rates, private-label issu- ance nearly halved to between $50 billion and $60 billion. However, it resumed in 1997 with just under $120 billion offerings. Beginning in the late 1980s, a new and more aggressive breed of mort- gage finance began to catch fire in the mortgage securitization market. Bor- rowers with a less pristine credit history had been granted loans to refinance or purchase homes. The securitization of these new loans, generically called subprime mortgages, became an increasingly important part of the non- agency-guaranteed RMBS, sowing the seeds for the 2008 financial crisis. In 2003, out of the $535 billion new issuance of non-agency-guaranteed pass- throughs, $215 billion were subprime mortgages. More significant, in 2005 and 2006, when non-agency RMBS issuance totaled around $1,150 billion annually, over $500 billion belonged to subprime mortgages. As will be dis- cussed later in more detail, the collapse of the mortgage-backed securities market in 2008 was triggered by the rampant defaults of subprime mort- gages, where the non-agency issuance plummeted to just $15 billion. The non-agency market remained nonexistent in 2009 with the minuscule issu- ance of under $30 billion. The success of mortgage-backed securities was copied early on in many other areas of consumer lending. In that respect, it was the mortgage swap programs that revolutionized the thinking of asset securitization. No longer was asset securitization practiced simply as an alternative method of raising funds for mortgage bankers. It now had an additional, and more important, benefit of balance-sheet management. Depository lenders, especially banks, can now perform their intermediary function not just with deposits from primarily consumers but also with funds from a great variety of institutional investors in the capital market. More important, by securitizing their origi- nations of consumer loans, banks can also strategically manage their assets and liabilities with earnings and capital requirements. Since the mid-1980s, commercial mortgages have also been pooled for the issuance of commercial mortgage-backed securities (CMBS). Issuance of CMBS in 1990 was merely $5 billion (see Figure 1.3). It exceeded 14 ASSET SECURITIZATION
- 34. $25 billion in1996 and approached $95 billion in 2004. It grew further in 2005–07 with the 2007 issuance topping $230 billion. Amid the subprime mortgage debacle, the 2008 CMBS issuance plunged 95 percent to $12 bil- lion. It dropped further in 2009 to a mere $3 billion. During roughly the same period, patterning after the issuance of mortgage-backed securities, banks began to securitize in earnest their originations of consumer loans. They pooled credit card receivables, auto- mobile loans, student loans, and manufactured housing loans for the issu- ance of Asset-Backed Securities (ABS).6 In recent years, other new financial assets such as property-tax liens and equipment leases have been securi- tized. Figure 1.3 also shows that the annual issuance of ABS expanded from just over $15 billion in 1988 to $125 billion in 1996. It grew further to exceed $190 billion in 2001. Between 2002 and 2007, annual issuance was consistently high, in the range of $230 billion and $275 billion. How- ever, amid the severe recession in 2008 and 2009, the issuance was halved to around $125 billion in each year. The latest creation of asset-backed securities was generically called col- lateralized debt obligations (CDOs). These included collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs). The CLOs FIGURE 1.3 Annual Issuance of RMBS, CMBS, ABS, and CDOs, 1980 to 2009 Sources: RMBS: Ginnie Mae, Freddie Mac, Fannie Mae, and Standard Poor’s; CMBS: Commercial Mortgage Alert; ABS and CDO: Standard Poor’s, Merrill Lynch, and Citigroup Global Markets. Asset Securitization: Concept and Market Development 15
- 35. were primarily issuedby banks by selling their holdings of commercial and industrial (CI) loans. CBOs were mainly issued by bond or stock fund managers, who issue these securities to raise funds to purchase more bonds or stocks for their management. As mentioned earlier, CDOs are the new and popular asset securitization securities, as their underlying assets are ac- tually themselves securities which include asset securitization securities. In 1996, CDO issuance was around $20 billion. It quickly grew to $75 billion in 1998. Between 1998 and 2004, issuance of CDOs hovered between $50 billion and $70 billion. CDOs flourished in the banner years of 2005 and 2006 when they posted two consecutive years of record-breaking issu- ance of around $150 billion and $340 billion respectively. In 2007, as the situation of subprime mortgages got progressively worse, CDO issuance dropped markedly by one-third to $250 billion. In 2008 and 2009, there was virtually no issuance of CDOs. In summary, the extensive effort to securitize a great variety of assets over the past two decades has formed four major sectors of the asset securi- tization market: RMBS, CMBS, ABS, and CDOs. Figure 1.4 shows that, as of year-end 2009, outstanding balances of RMBS (agency, private label, subprime), CMBS, ABS, and CDOs amounted to an estimated $7,600 bil- lion, $700 billion, $2,100 billion, and $600 billion, respectively. Combined, the asset securitization sector’s outstanding balance at year-end 2009 totaled $11 trillion. It represented the largest sector of the U.S. fixed-income market (Figure 1.5). It surpassed U.S. Treasuries, corporate bonds, GSE obligations, and tax-exempted debt (state and local government, or municipals). FIGURE 1.4 Outstanding Balances of Asset-Backed Securities by Type, Year-end 2009 Source: The Securities Industry and Financial Markets Association. 16 ASSET SECURITIZATION
- 36. NOTES 1. Actually, thephrase asset securitization was unheard of back in 1970 and the verb securitize to describe the action of ‘‘an issuer pools mortgages and issues a security backed by the mortgages’ cash flows’’ was not even recognized as an English word. Possibly, it was not until 1983, when this author, then a housing economist at Salomon Brothers, published a research report, entitled The Multi- faceted Revolution in Securitizing Residential Mortgages, that the word securi- tizing was first used formally in a published report. The usage of the phrase asset securitization in the press and financial reports became popular only in the mid-1980s. 2. Asset securitization was originally a straightforward financing by primarily mortgage bankers (who were non-depository lenders) and a limited number of thrifts (savings and loan associations and savings banks, who were depository lenders) to raise funds in the capital market to originate residential mortgages. Toward the end of the 1980s, commercial banks had been increasingly involved in the asset securitization market to originate consumer and business loans more than just residential mortgages. In the 1990s, even money managers began to rely on asset securitization as a way of raising funds and arbitraging in the capital market. 3. There has been a claim that securitization actually started as early as the 1920s, when the U.S. real estate market experienced a building boom and the construc- tion financing was done by collateralizing profits of commercial buildings. This type of securitization was different from the present one in that it did not have the critical element of an SPE that purchases the underlying assets and FIGURE 1.5 Outstanding Balances of Fixed-Income Securities by Type, Year-end 2009 Source: The Securities Industry and Financial Markets Association. Asset Securitization: Concept and Market Development 17
- 37. simultaneously issues theasset-backed securities. See ‘‘In the Packaging of Loans, A Bust with Precedent,’’ Floyd Norris, New York Times, January 28, 2010. 4. In the midst of the global financial crisis of 2008, both Freddie Mac and Fannie Mae experienced tremendous financial difficulties with huge negative earnings and severe shortages of capital. In September 2008, the U.S. government placed the two GSEs into conservatorship run by the Federal Housing Finance Agency. 5. As will be elaborated on in later chapters, for this book non-agency pass- throughs include private-label pass-throughs and subprime mortgage–backed securities. Private-label pass-throughs were first issued in 1977 and subprime mortgage-backed securities made their debut in the RMBS market in the late 1980s. 6. It should be noted here that as a general practice of market participants the generic term of asset-backed securities refers to all structured finance securities that are backed by any type of assets. A specific term, Asset-Backed Securities, however, refers to only those securities backed by non-residential and non- commercial mortgages, such as receivable cash flows of credit cards, auto loans, student loans, manufactured housing loans, and small and medium enterprise (SME) loans. Structured securities backed by residential mortgages are specifi- cally called Residential Mortgage-Backed Securities (RMBS), and those backed by commercial mortgages are termed Commercial Mortgage-Backed Securities (CMBS). 18 ASSET SECURITIZATION
- 38. CHAPTER 2 Originators andInvestors of the Asset Securitization Market The story of the nearly four-decade long and successful development of the asset securitization market was written mainly by a great many originators of underlying assets and a still far larger number of investors.1 They cooperated to provide financing for consumers and businesses that created value and raised living standards. Their cooperation was guided by the invisible hand in that the originators and the investors were driven by self-interest to participate in the asset securitization market. This chapter discusses the raison d’^ etre of asset securitization: the origi- nators’ need to raise funds efficiently in the capital market to finance their loan originations and the investors’ varying demands for diversified invest- ment products to earn attractive returns for their funds. EFFICIENT FINANCING FOR ORIGINATORS WITH ASSET SECURITIZATION As mentioned at the outset of this book, one critical participant in the pro- cess of asset securitization is the loan originator. This is obvious because the initial reason for securitization is to enable the originator to secure funding efficiently in the capital market to finance the origination of loans. To secure the funding, the originator first sets up an SPE. The originator then sells to the SPE its newly originated loans (this could also be existing loans in its portfolio). To finance the purchase of the loans from the origina- tor, the SPE issues in the capital market a security that is backed by the very loans it purchases from the originator. Because the originator sells the loans it originates, the originator is also called the seller. Therefore, in asset secu- ritization, the originator, the lender, and the seller are the same entity and the three terms are used interchangeably. 19 Asset Securitization: Theory and Practice by Joseph C. Hu Copyright © 2011 John Wiley Sons (Asia) Pte. Ltd.
- 39. The remainder ofthis section uses simple numerical examples to describe how an originator finances its loan originations through securi- tization. By way of securitization, the originator is able to raise funds effi- ciently. This efficiency is achieved by producing higher returns in the use of capital with an effectively managed balance sheet. An effectively managed balance sheet puts no undue pressure on capital adequacy and limits the exposure of various risks on assets. Consider, for example, an originator, Bank XYZ, that was not in the business of originating residential mortgages in 2008, but plans to do so in 2009. (Residential mortgages are used in the hypothetical example because they were the first to be securitized. Also, the example selects a bank, not a mortgage banker, to show the economics of securitization because the latter cannot attract deposits and has no choice but to sell to finance its loan origi- nation.)2 As of December 31, 2008, Bank XYZ had a balance sheet as shown in Table 2.1. For the purpose of illustration, the balance sheet is sim- plified to have only a few assets and liabilities. Among the few assets, the bank held consumer loans totaling $500,000 and a cash position of $25,000. To finance its $525,000 worth of total assets, the bank relies on the traditional funding source of deposits and debentures totaling $483,000. There is, of course, an additional source of funds: the sharehold- ers’ equity of $42,000. This equity amounts to 8 percent of the total assets. For the 2009 operation, assume this bank decides to originate $4,000,000 worth of residential mortgages and to fund the origination entirely by attracting deposits. This is the traditional way of banks funding loan originations. It is generally referred to as portfolio lending, in that the originator books the newly originated loans as an addition to its portfolio. In this case, assume further that the bank does not engage in any other lend- ing activities during the year; the asset side of its balance sheet at the end of 2009 will have an additional item of $4,000,000 mortgages (Table 2.2). This portfolio lending has the consequence of substantially expanding the size of the bank’s total assets to $4,525,000. Similarly, the lending also in- creases its liabilities to $4,163,000. To maintain the same assets-to-capital ratio, the bank also manages to raise its capital by $320,000 to $362,000. TABLE 2.1 Balance Sheet of Bank XYZ, as of December 31, 2008 Cash $ 25,000 Deposits $433,000 Consumer loans $500,000 Debentures $ 50,000 Capital $ 42,000 Total Assets $525,000 Total Liabilities and Capital $525,000 20 ASSET SECURITIZATION
- 40. With no securitization,Bank XYZ has three sources of income for 2009. First, it has an interest earning on the newly originated mortgages. Second, for the origination of mortgages it also earns the origination fees. The third income is the interest on the existing portfolio of consumer loans. All these are indicated in its 2009 income statement, as shown in Table 2.3. The interest on the $4,000,000 new mortgages is $120,000. (This amount is arrived at by first assuming a 6 percent annual mortgage interest rate. Then, it further assumes that the origination process is smooth throughout the year so that the principal amount of the mortgages grows steadily from zero in the beginning of the year to $4,000,000 at the end of the year. Thus, the total interest earned for the first year on all the newly originated mortgages amounts to 6 percent on only one-half of the $4,000,000 principal.) There is also an $80,000 fee for originating the mortgages, assuming that the fee is 2 percent (or called 2 points) on the principal balance of the mortgages. For the interest income on the consumer loans, this example assumes an 8 percent annual interest rate. All told, the 2009 gross income amounts to $240,000. TABLE 2.2 Balance Sheet of Bank XYZ, as of December 31, 2009 (No Securitization) Cash $ 25,000 Deposits $4,113,000 Mortgages $4,000,000 Debentures $ 50,000 Consumer loans $ 500,000 Capital $ 362,000 Total Assets $4,525,000 Total Liabilities and Capital $4,525,000 TABLE 2.3 Income Statement of Bank XYZ, December 31, 2009 (No Securitization) Interest on mortgages $120,000 (half of 6% interest on $4,000,000) Interest on consumer loans $ 40,000 (8% interest on $500,000) Origination fees $ 80,000 (2-point origination fee on $4,000,000) Gross Income $240,000 Less: Interest costs on deposits $ 22,730 (1% interest on $433,000 and half of 1% on $3,680,000) Less: Interest costs on debentures $ 4,500 (9% interest on $50,000) Net Income Before Tax $212,770 Originators and Investors of the Asset Securitization Market 21
- 41. Bank XYZ hastwo expenses (for simplicity, ignore operation expenses) in 2009. The first expense is the $22,730 interest paid on deposits, assuming an annual 1 percent interest on both the existing and the new deposits. There is the interest expense of $4,330 on the existing deposits of $433,000. For the funding of the $4,000,000 mortgage originations, the in- terest cost on the corresponding new deposits $3,680,000 steadily acquired throughout the year is $18,400 (for the same reasoning as calculating the interest earned on the new mortgages). The second expense is the $4,500 interest paid on the debenture (assuming an annual interest rate of 9 per- cent). To sum up, after netting out the two expenses, the bank has a before- tax income of $212,770. This income represents a 4.7 percent return on assets and 58.8 percent return on equity. Now, alternatively, suppose Bank XYZ decides to finance its mortgage originations through securitization. Suppose further that the pace of the origination is smooth; that it originates $1,000,000 worth of new mort- gages every three months. That is, the bank originates and securitizes the newly originated mortgages (the turnover rate of the origination–securitization process) four times a year. To facilitate the mortgage originations, the bank secures a warehousing line of credit from another financial institution. This line of credit is revolving. As the bank originates the mortgages, it draws down the credit line. However, once the loans have been originated, the bank sells the loans (through securitization) and uses the selling proceeds to replenish the credit line. But the bank will draw down the credit line again to originate still more loans, only to replenish it again with the proceeds of selling the newly originated loans. As shown in Table 2.4, since the bank secures the funding of mortgage originations through securitization, it will not alter the composition of its balance sheet at the end of 2009. Thus, its total assets remain $525,000 with an unchanged equity capital of $42,000. This unchanged size of bal- ance sheet is substantially smaller than the no-securitization balance sheet of $4,525,000 at the year-end 2009. With securitization, the bank has four sources of income on its in- come statement during 2009 (Table 2.5). As the bank warehouses the TABLE 2.4 Balance Sheet of Bank XYZ, as of December 31, 2009 (Securitization) Cash $ 25,000 Deposits $433,000 Consumer loans $500,000 Debentures $ 50,000 Capital $ 42,000 Total Assets $525,000 Total Liabilities and Capital $525,000 22 ASSET SECURITIZATION
- 42. newly originated loansbefore they are sold, it still earns interest on the loans. On average, by holding the new loans for a three-month period, it would earn one-and-a-half months of interest. To do it four times a year, the total interest income would be equivalent to six months of interest, or $30,000 on a principal of $1,000,000. The bank also has the same interest income on the consumer loan and the same origination fee for the new mortgages. However, by resorting to securitization the bank also services the mortgages that it sells and earns the servicing fee. Assuming an annual servicing fee of 50 basis points on the principal amount of the mortgages, the servicing income for the first year is $7,500. (The servicing income for the mortgages sold at the end of the first quarters is three quarters of 0.5 percent on $1,000,000; at the end of the second quarter, one-half on $1,000,000; at the end of the third quarter, one-quarter on $1,000,000. The servicing income for the mort- gages sold at the end of the fourth quarter can only be booked for the next year.) The total income for the year amounts to $128,670. On the cost side, while the bank no longer relies on deposits for funding loan originations, it has to pay $20,000 interest on the warehousing line of credit. (Assume that the interest cost on the credit line is 1 percent annually, the same as the interest cost on the short-term deposit. Also, since the bank only pays interest on the portion of the credit line that is actually used in each quarter, the total interest cost of the revolving credit line is four times one-half of the $1,000,000 credit line.) The bank still has two interest expenses on the original deposits of $433,000 and the same debenture of $50,000. The bottom line is that, for 2009, the bank would have a before- tax net income of $128,670. This earning represents a 24 percent return on assets and a whopping 306.4 percent return on equity. TABLE 2.5 Income Statement for Bank XYZ, December 31, 2009 (Securitization) Interest on mortgages $ 30,000 (6% on $1,000,000 for 6 months) Interest on consumer loans $ 40,000 (8% on $500,000) Origination fees $ 80,000 (2-point origination fee on $4,000,000) Servicing income $ 7,500 (one-and-a-half of 0.5% on $1,000,000) Gross Income $157,500 Less: Cost of bank credit lines $ 20,000 (4 times half of 1% on $1,000,000) Less: Interest costs on deposits $ 4,330 (1% interest on $433,000) Less: Interest costs on debentures $ 4,500 (9% interest on $50,000) Net Income Before Tax $128,670 Originators and Investors of the Asset Securitization Market 23
- 43. While Bank XYZproduces much smaller earnings through securitiza- tion than no securitization, it earns more dollar-for-dollar in terms of return on assets (24.5 percent versus 4.7 percent) and return on equity (306.4 per- cent versus 58.8 percent). There are also additional advantages that are not evident in financial figures. First, since the balance sheet has not expanded, the bank is under no pressure to raise new capital. Second, with securitiza- tion, there is no maturity mismatch between assets and liabilities. With no securitization, the bank runs a huge interest rate risk with the maturity of its assets being much longer than that of liabilities. Third, in addition to the interest rate risk, the no-securitization approach also adds substantial credit risk to the bank’s balance sheet. The simplified example demonstrates this: through securitization, the bank is able to not only satisfy its financing needs, but also generate better earnings with an efficiently managed balance sheet. By generating better earnings, the bank can maintain a stronger capital position. By efficiently managing the balance sheet, the bank can free up precious capital for other lending and investment activities. SATISFYING VARYING INVESTOR DEMANDS WITH ASSET SECURITIZATION One important reason why the U.S. asset securitization market could achieve a remarkably long run of success was its ability to create investment products that satisfy the varying investor demands. It can also be said that the steady expansion of the investor base through the years has facilitated the rapid growth of the asset securitization market. This expanded base comprises a great variety of investors, ranging from short-term money mar- ket investors, commercial bank portfolio managers, to long-term pension fund managers. (It is important to note that investors in asset-backed securi- ties are primarily institutional investors with very few individual investors. To the extent that individual investors do get involved, they basically invest through mutual fund managers.) Nowadays, virtually all types of fixed- income investors own, to a varying degree, asset-backed securities with underlying assets in the form of various consumer loans, commercial loans, residential mortgages, and commercial mortgages. The rapid expansion of asset-backed securities investors is not inciden- tal. It took a great deal of research and marketing efforts on the part of issu- ers, investment bankers, and rating agencies to cultivate and educate investors on the investment features and credit performances of the asset- backed securities. Investors, through the prices they are willing to pay, also constantly provided feedback on the asset securitization products, which 24 ASSET SECURITIZATION
- 44. drove improvement andinnovation of asset-backed securities. (As will be presented in later chapters on various asset-backed securities, the prices are actually expressed in yield spreads through secondary market trading.) The remainder of this section explains how investors facilitated the growth of asset-backed securities and how the facilitation in turn benefited inves- tors by providing attractive returns for their investments. Cultivating Investors: Matching Products with Investment Demands One of the most important goals of investing is to achieve the highest possi- ble return given the risks of the investment. Since the cash flows of asset- backed securities are derived solely from the underlying collateral, it is critical that investors understand the investment characteristics of the underlying assets. One example of this is RMBS. As will be discussed later in detail in the RMBS chapters, residential mortgages are prepayable at par. Thus, RMBS have a unique prepayment risk. When mortgage rates decline, mortgagors (homeowners who borrow money from lenders to purchase homes) tend to refinance their existing mortgages with new mortgages that carry lower interest rates. As mortgagors refinance, the proceeds of pre- payment would be returned at par to the RMBS investors. This prepayment hurts the potential return on the investment because the proceeds now would have to be reinvested in a low-interest-rate envi- ronment that would mean a lower rate of return for the RMBS. Because of this prepayment risk, RMBS have been yielding significantly higher than other securities with comparable maturities and credit risk. Investors who do not appreciate the inherent prepayment risk of RMBS would mistakenly view the higher yield as an excellent investment opportunity, not an incre- mental return that is necessary to compensate for the extra risk. During the 1980s, when RMBS were in the early stage of development, investment bankers spent a great deal of resources educating investors on the pre- payment risk. Investors with different risk appetites also helped create inno- vative products to satisfy their specific demands. The Importance of Understanding the Underlying Assets The ability to appreciate the unique features of the underlying assets is a prerequisite for understanding the potential investment performance of the asset-backed securities. Once investors acquire the knowledge on the under- lying assets, they will then be able to analyze the cash-flow behavior of Originators and Investors of the Asset Securitization Market 25
- 45. asset-backed securities undervarious economic conditions. Only then can the investment demand be solid for the continued expansion of asset-backed securities. Again, from the RMBS example, investors need to be able to analyze the potential cash flow of the securities under various interest rate scenarios. This ability is vitally important because they need to be sure that the securities are the right investment for them. Certain basic and unique measurements of the cash-flow characteristics of asset-backed securities are critical for investors to fully comprehend. They include the annual prepayment rate (calculated under various assump- tions on the economy and interest rates), the average life (calculated on the basis of the assumed prepayment rate), the option-adjusted yield and yield spread, duration, and convexity (incorporating expectations of pre- payment) of RMBS. Further, investors need to understand that the under- lying cash flows of the securities have often been credit tranched and maturity tranched. This means that the issuers of asset-backed securities have often segmented the cash flow of the underlying assets into many maturities and credit classes. These maturities and credit classes perform very differently in various interest rate and economic environments. Invest- ment bankers and rating agencies have spent an enormous amount of time and effort to research and provide information on the historical perform- ance of these maturities and credit classes as a service to the investors. Three Types of Investors Yield-Oriented Investors As the asset securitization market expanded and became more sophisticated, so did the types of investors. In the early stage of market development, the most important investors in asset-backed securities were yield-oriented investors, such as savings and loan associations and com- mercial banks. These investors are also known as the spread bankers who focus on the spreads between the costs of their funds and the returns from their investments. (Note that yield investors are not the junk bond investors who are sometimes notorious, known as yield-oriented investors.) They were naturally attracted to the securitization market because they had been first to securitize their assets. They understood very well that asset-backed securities offered significantly higher yields than corporate bonds with comparable maturities and credit ratings. Another way of saying this is that asset-backed securities offer substantially greater yield spreads to investors. In the fixed-income market, the yields of all securities are measured against the comparable maturity Treasury securities (Treasuries) which are considered to be free of credit risk, or technically referred to as credit-risk free. The yield differential between a fixed-income security and its compara- ble-maturity Treasury is called the yield spread. In the early stage of market 26 ASSET SECURITIZATION
- 46. development when theirinvestment characteristics were new and not well understood, asset securitization securities offered generous yield spreads as enticement for investors. Even to this day, yield spreads of asset-backed securities are still markedly greater than corporate bonds with comparable maturity and credit ratings. The rapid growth and increased popularity of the asset securitization market is attributable significantly to the attractive yield spreads to yield-oriented investors. Credit-Oriented Investors It is well established in investment theory that risk and return go hand in hand with an inverse relationship: the higher the risk is, the higher the return will be, and vice versa. Since asset-backed securities are backed by mainly consumer loans they are perceived by inves- tors as of higher credit risk. Thus, credit ratings are a very important consid- eration in the minds of investors. This is particularly so for institutional investors, who have a fiduciary responsibility to the funds they manage and therefore are limited to investments with only investment-grade credit ratings. (These are credit ratings above BBB–/Baa3.) In other words, these investors were prohibited from investing in any securities with non- investment-grade credit ratings (any rating at BBþ/Ba1 or below). There- fore, credit-oriented investors are just the opposite of yield-oriented inves- tors. The primary concern of credit-oriented investors is to comply with the fiduciary requirements. Only within the confines of investment grades do credit-oriented investors start looking for greater yields. Maturity-Oriented Investors Just as there are investors who are restricted to investments of certain credit ratings, there are investors who are confined to certain maturity ranges. As mentioned earlier, through maturity tranching, asset-backed securities have the advantage of offering investors multiple maturity choices within a given transaction. For example, one residential mortgage-backed transaction may offer maturities ranging from 1, 3, 5, 7, 10 to 30 years. Money market mutual fund managers or commercial banks may therefore purchase an RMBS with a 1- or 3-year maturity. An insur- ance company portfolio manager may purchase a 5- to 10-year maturity RMBS. A pension fund manager may purchase an RMBS with long matu- rity of 10 or 30 years. NOTES 1. Of the 40-year development of the asset securitization market that started in 1970, the first 37 years were basically without significant glitches. The sharp increases in delinquencies and defaults of subprime mortgages in 2007 Originators and Investors of the Asset Securitization Market 27
- 47. eventually brought downthe entire asset securitization market over the next two years. To keep the matter simple, the book will discuss the success of the market in all chapters except Chapter 14, where it will examine the causes of the collapse of the asset securitization market. It will also discuss the potential recovery of the market. 2. The author first used the balance sheet of a hypothetical bank as an example to illustrate the benefits of asset securitization at a seminar in Taiwan in 2002. The seminar represented the first comprehensive effort of a U.S. company to share the country’s successful experience in asset securitization with capital market participants in Taiwan. A portion of the seminar presentation was pub- lished in a research report. See Joseph Hu, Real Estate Securitization and the Capital Markets: A Study of U.S. Experience and Policy Implications for Taiwan, Taiwan Ratings Corporation (a Standard Poor’s Rating Partner), July 2002. 28 ASSET SECURITIZATION
- 48. CHAPTER 3 Intermediary Participantsof the Asset Securitization Market In the asset securitization market, many intermediary participants are working either upfront or behind the scenes with originators and investors to ensure the to-be-issued transactions are appropriately structured with respect to the tightness of legal documents, the rigor of accounting, the integrity of the cash flow, and the evaluation of the credit risk. (Note that throughout the balance of this book, the terms of transaction and securities are used in such a way that a transaction refers to the issuance of asset- backed securities that are backed by a specific pool of assets. In a transac- tion, several securities are often issued. These securities have different maturities and different credit ratings. Each security, which is supported by a specific portion of the total cash flow of the underlying assets, has a specific expected maturity and a specific credit rating.) The purpose of the many different parties participating in a transaction is to clearly identify and protect the interests of the originator/seller, the issuer, the servicer, and the many investors in the transaction. Further, after the securities of a transaction are issued, the participants will continue to monitor all the factors that affect the market value and credit performance of the securities for the benefit of the issuer and the investors. This chapter discusses the functions of attorneys, accountants, guarantors and credit enhancers, credit rating agencies, and investment bankers. ATTORNEYS It is fair to say that asset securitization transactions are far more legal- intensive than corporate or public (government) finances. This is primarily because the credit of the asset-backed securities is supported solely by that of the underlying assets. Many parties with different expertise have to be 29 Asset Securitization: Theory and Practice by Joseph C. Hu Copyright © 2011 John Wiley Sons (Asia) Pte. Ltd.
- 49. involved to properlystructure an asset securitization transaction. Mainly, the parties include the loan originator/seller, the issuer, the servicer, the custodian (for the assets in the underlying pool backing the securities), the trustee (for the trust that issues the securities), the insurer (against the default on the individual underlying assets and/or the securities themselves), the credit rating agencies (for the evaluation of credit risk of the underlying assets and the securities), and finally the investors (who ultimately provide financing for the origination of the underlying assets). To clearly specify the responsibility and interest of each party in the transaction, attorneys are needed to draft various documents and agree- ments to govern the duties and compensations for the duties of the various parties. Attorneys of different expertise represent the originator/seller, the issuer, the credit insurer, the credit rating agency, the investment banker, and the investors. The documents for the transaction must be drafted to meet the satisfaction of the attorneys representing all parties. Notably, there are four important legal documents in an asset securitiza- tion transaction: The loan purchase agreement. This agreement specifies the transaction between the loan originator/seller and the trust (special purpose entity). Elements of the agreement cover such items as the description of eligible loans, commitment to purchase the loans, underwriting and property appraisal, delivery of the loan documentations, payment for the pur- chase, and seller’s obligations, representations and warranties, seller’s repurchase obligations and repurchase price. The trust agreement. The trust agreement creates the SPE, identifies the trustees and describes the assets placed under the trust. The agreement also specifies the responsibilities, the power, and the limitations of the trustee in administrating the trust, and the reporting requirements. The servicing agreement. This agreement enumerates the responsibili- ties of the servicer. Major responsibilities include collecting and passing onto the investors the periodical payments of the asset cash flows, keep- ing accounting records of the assets, advancing the payment to inves- tors when the underlying assets are in delinquency or default, and making periodical reports to the investors on the performance of the assets. For some transactions, there is a pooling and servicing agree- ment, which essentially is the combination of the trust agreement and the servicing agreement. The indenture. This document contains the most nuts and bolts on the financing aspect of the transaction. It is prepared for the issuer and the investors, specifying the maturity terms of the asset-backed securities, the coupon interest, the principal, and the repayment of the principal. 30 ASSET SECURITIZATION
- 50. There are additionallegal documents, such as the custodian agreement that specifies the duties of the custodian on behalf of the trust, the insurance agreement that covers the elements of bond insurance of the transaction, and the indemnification agreement that protects the bond insurer of the transaction. In all, the attorneys for a transaction have to spell out in the offering memorandum or the prospectus all the detailed agreements, duties and responsibilities of all parties involved, expenses and payments, and ulti- mately the interest and principal to be returned to the investors. ACCOUNTANTS The role of the accountants in an asset-backed transaction is to ensure the cash-flow integrity of the underlying assets for the transaction. In structur- ing a transaction backed by newly originated assets, it is difficult to predict precisely the future cash-flow behavior of the underlying assets. For exam- ple, for residential mortgage-backed securities, the question of how the borrowers would fail to keep up the monthly payments due to delinquencies or defaults will affect the cash flow generated from the underlying assets. Also, an important factor that impacts the cash flow is the question of whether the borrowers will repay their mortgages before maturity. These situations need to be considered and assumptions need to be made in order to cast out the cash flows of the underlying assets. Accountants will examine the assumptions and tie out their projected cash flows based on the assumptions provided by the issuer. Their major function is to provide the necessary comfort to both the issuer and the inves- tors that all parts of the transaction’s cash flows are accounted for. Also, that all parties involved in the transaction are legally and reasonably com- pensated for their responsibilities and contributions to the transaction. The tying out of the cash flow becomes critically important when the transaction involves segmenting the cash flows to create securities with different matur- ities and credit ratings. The comfort is documented in two letters for the transaction. One is the comfort letter of accountants relating to the prospectus and its supplement. The other letter is relating to all cash-flow computation materials. GUARANTORS AND CREDIT ENHANCERS As mentioned at the outset, one of the unique features of asset-backed secu- rities is the requirement of credit enhancement. This is so because the credit of the transaction’s underlying pool of assets by themselves may not Intermediary Participants of the Asset Securitization Market 31
- 51. necessarily be strongenough to warrant high credit ratings from rating agencies for the various securities. To achieve high credit ratings that are not obviously supported by the underlying assets, the credit of the securities within a transaction needs to be enhanced from a variety of sources. In general, there are four ways to enhance the credit of the securities: self- insurance, bond insurance, corporate parent guarantee, and letter of credit. Additionally, for RMBS, there is the unique federal government or GSE credit guarantee. Self-Insurance In the case of self-insurance, the credit enhancer is the principal and/or in- terest of the cash flow from the underlying assets. As explained briefly in Chapter 1, the mechanism of self-insurance can be in the form of senior/ subordination, over-collateralization, or interest spread. Bond Insurance A bond insurance company may also be the credit enhancer for an asset securitization transaction. A security for which the credit is enhanced by a bond insurance company would therefore have the same credit rating as the insurer, which is mostly rated triple-A. For example, an asset- backed security may initially, at structuring, have only enough amount of principal for self-insurance to obtain an A credit rating. In this case, a triple-A–rated bond insurance company can use its own capital to pro- vide the necessary additional principal credit support for the security so that it can achieve a triple-A rating. There are several bond insurance companies with the top credit rating of triple-A in the asset securitization market whose function is solely to enhance the credit of asset-backed securities.1 Corporate Parent Guarantee The issuer of an asset-backed security may obtain a desired credit rating by relying on the credit of its corporate parent. For example, a mortgage bank may issue a private-label RMBS and opt to rely on its corporate company to guarantee the credit of the RMBS. In this case, assuming that the credit rating of the corporate parent is AA by Fitch and Standard Poor’s and AA2 by Moody’s, the RMBS would be rated by the three rating agencies with the same ratings. (Symbols of credit ratings by different rating agencies are discussed in the following section.) 32 ASSET SECURITIZATION
- 52. Letter of Credit Sometimesthe issuer may ask for a commercial bank to provide credit enhancement to a transaction through a letter of credit (LOC). This credit enhancement, however, is usually for short-term transactions. Similar to cases of bond insurance and corporate-parent guarantee, the credit of the LOC-enhanced security will be that of the LOC issuing bank. GSE Credit Guarantee In the mortgage-backed security arena, there is an additional and unique credit enhancement from three federal government agencies. As mentioned in Chapter 1, the three agencies are Ginnie Mae, Fannie Mae, and Freddie Mac. Through the credit guarantee of Ginnie Mae, the mortgage-backed security will have a credit that is equivalent to the full faith and credit of the U.S. government. The credit of Fannie Mae and Freddie Mac, on the other hand, is not exactly that of the U.S. government. But, because they are fed- eral GSEs, their credit has been perceived to be at least very close to that of the U.S. government.2 CREDIT RATING AGENCIES The role of a credit agency in an asset securitization transaction is critical on two levels of the credit risk assessment. The first level is on the underlying assets; the second, the transaction. At the issuance of a transaction, a credit rating agency expresses its opinion on the credit risks of the many securities of the transaction. (It is critical for all market participants to clearly under- stand that a credit rating is an opinion of the credit rating agency on the credit risk of a security. A credit rating is not an investment advice and should not be treated as such. As time goes by, a credit rating agency can change its opinion on the credit risk of a security. See Chapter 9 for more on the fundamental elements of credit ratings.) After the issuance of a transaction, the function of the credit rating agency remains important because it continues to track the credit per- formance of the underlying assets and the securities of the transaction. This surveillance is an important responsibility of the credit rating agencies. It is performed for as long as the principal of the underlying assets is still outstanding. Before issuing an asset-backed transaction, the originator will present to a rating agency (in many cases, more than one agency) the underlying assets for the transaction for the credit analysis of default frequency and Intermediary Participants of the Asset Securitization Market 33
- 53. loss severity ofthe assets. Based on the historical credit behavior of similar types of assets, the rating agency will devise a base case loss curve for the assets. This curve basically relates the expected cumulative loss and the age of the assets. Assuming that the current economic conditions prevail, the expected loss curve quantifies the amount of expected loss of the pool of assets as they age during the term of a transaction. Once the loss curve is devised, the rating agency can express its opinion on the credit quality of the to-be-issued transaction. Given the expected loss of the underlying assets, there will be varying amounts of credit enhance- ment for the securities to achieve different credit ratings. The different credit ratings entail different multiples of the expected loss as credit support (credit enhancement) for the various securities. In the current asset securitization market, there are four credit rating agencies: Dominion Bond Rating Services (DBRS), Fitch Ratings, Moody’s Investors Service, and Standard Poor’s Financial Services. DBRS is a rela- tively young agency, having been formed only in the mid-1970s. Also, prior to early 2000, there was another agency, Duff Phelps, which was ac- quired and merged with Fitch. For Standard Poor’s, Fitch, and DBRS, there are four major investment-grade rating grades (categories): AAA, AA, A, and BBB. There are also two non-investment (speculative) rating catego- ries: BB and B. With the exception of AAA, all other rating grades have þ and notches to indicate slightly better or worse than the major grades. For Moody’s, the symbols for the investment grades are Aaa, Aa2, A2, and Baa2. For slightly better credits, the 2s will become 1s; for worse, 3s. Thus, Standard Poor’s, Fitch’s, and DBRS’s AAþ would be comparable to Moody’s Aa1, and BBB would be comparable to Baa3. Once the credit enhancement requirements are agreed upon between the issuer and the rating agency, the security will be issued. After the issu- ance, the rating agency continues to track and to ensure that the credit of the structured security constantly performs (in terms of its expected default probability) as it was originally rated. If the performance becomes worse than the original rating had allowed for, the security will be downgraded. Conversely, if the performance turns out to be better than originally expected, the security will be upgraded. The downgrade and upgrade con- stitute the rating transition of asset-backed securities. (It is important to mention the fundamental difference in the interpretation of ratings among rating agencies. For Fitch and Standard Poor’s, a specific credit rating reflects their opinions on the probability of default of the security. For Moody’s, a rating reflects its view on the expected loss of a security after default.) Credit ratings, both the original and the subsequent transitions, are important for the function of the asset securitization market. Given the 34 ASSET SECURITIZATION
- 54. coupon rate, asecurity with a top credit rating will command a much higher price (with a lower yield) than a lowly rated security. Given the cash flow from the underlying assets, the issuer of a highly rated security will there- fore obtain a greater amount of the issuing proceeds than the lowly rated security. Further, in the secondary market trading, a highly rated security will trade at a tighter yield spread than a lowly rated security. (The yield spread is the difference in the yield between an asset-backed security and a risk-free comparable-maturity Treasury security. In the trading of all fixed- income securities, Treasury securities, or just Treasuries, are the bench- marks for which yields are the lowest for a given maturity. Thus, for exam- ple, given the maturity, an AAA security will trade at a tighter yield spread than that of an AA security, and a much tighter yield spread than a BBB security.) Further, for an asset-backed security for which the credit rating is expected or perceived to be lower than its current rating (i.e., it is expected to be downgraded), its trading yield spread will be wider than other simi- larly rated securities for which the ratings are expected to remain stable. It is interesting to note that while there is competition among the four credit rating agencies in the credit rating market, one rating agency’s expansion of market share may not necessarily be at the expense of the other agencies. That is, the market shares of the four agencies always add up to more than 100 percent. This is because normally two or more rating agencies are asked to provide credit ratings for the same asset-backed transaction. INVESTMENT BANKERS During the entire process of asset securitization, the role of an investment banker is multifaceted.3 Generally, the role evolves from initially helping the issuer structure the transaction, to assembling investors, to eventually pricing (determining the market value) the transaction by taking down posi- tion of the newly issued security. In the very beginning of a transaction, an investment banker would work with the issuer to conceptualize the pooling of underlying assets and the legal structure of a transaction. The investment banker would involve specialized attorneys and accountants to ensure the transaction is sound from the economic, legal, and accounting perspectives. The purpose of the transaction is to help the issuer secure funding efficiently for the origination of the underlying assets. As the structuring of a transaction is getting completed and ready for the issuance of the asset-backed security, the investment banker’s role switches to becoming a financial intermediary, to secure funding for the Intermediary Participants of the Asset Securitization Market 35
- 55. Another Random Documenton Scribd Without Any Related Topics
- 56. equality, which makesalmsgiving in every form appear more as a duty than a benefit, and the afore-mentioned tendency to hypocrisy. Whatever Frau Migerka finds good in America which is not hypocrisy or a relic of the past she ascribes to German influence. We are undoubtedly indebted to Germans for many excellent and pleasant usages, as well as for the rapid decay of that superstitious deference to women of which she complains. Our increasing love of music she rightly claims is due to her countrymen, but its primitive manifestations are all our own, and her sufferings from them form one of the few lively passages in the narrative. The piano in the steamboat saloon; the boarding-school girl—dear Carry, who has got on so splendidly with her music in such a short time; the Canadian rustic dandy, who only knows his notes; the long-haired travelling virtuoso with his violin (in all probability her own countryman, however); the head-waiter and his harp; the young bride in her smart clothes, with her thin voice and endless ballads; the exulting bridegroom, who accompanies her on a three-stopped tin trumpet,—form a Bedlamite procession through which our sympathies follow her; but in setting down this experience as American, although it occurred on a voyage up the Saguenay, she overlooks the proud fact that German influence must be spreading to Canada. Frau Migerka's letters are not to be treated seriously, nor are they merely to be made fun of. They would not deserve more than a paragraph's notice but for their local interest, which will probably make them more entertaining to Philadelphians than they could have been to the female friend in Vienna. They are not written in an unfriendly spirit; yet nothing the lady met with wins cordial, hearty sympathy or approbation, her commendation of our charities being, as we have seen, qualified by the motives for them which she supposes. The one thing in America which she felt she should regret is Niagara, which is unlucky for her, as there are few things for which she could not more easily find a substitute. Of her reflections and aspirations—
- 57. Á la modeGermanorum, With her sentimentalibus lachrymæ roar 'em, And bathos and pathos delightful to see— the following specimen will suffice: Here flows the Wissahickon, silent, dark and motionless, as if dreaming of a bygone world and unable to awaken to the bustling present. Many an Indian maiden has beheld her brown visage and sparkling eyes mirrored in its crystals. Yet let no one trust the quiet of that river: a short space farther and the tranquil stream becomes a rushing mountain-torrent, the friendly vale grows wildly romantic, full of gloomy, mysterious beauty. How like is this water to many a human soul, which lives as serene and shut within itself as if it scarce knew what it is to feel, until passion sweeps over it and the whole being is changed and uplifts its voice loud and tumultuous! Jack. From the French of Alphonse Daudet, author of Sidonie, Robert Helmont, etc., by Mary Neal Sherwood, translator of Sidonie. Boston: Estes Lauriat. Daudet's Sidonie in its English form certainly received in this country all the praise it deserved. It has now been followed by the same author's Jack, which has the additional advantage of its predecessor's success, and shares with it the benefit of careful translation. The story is an exceedingly pathetic one: it describes the career of the son of a frivolous woman, of not even doubtful reputation, from the time of his entering school until his death. This mother is a silly creature with an affectionate heart, who is really fond of her son and tries in her feeble way to do all she can for him. Being rebuffed in her attempt to place him in one school, she thrusts him into another, and leaves him to be first petted and then bullied by a French translation of Squeers and a crowd of his satellites. With one of the teachers, D'Argenton, the mother falls wildly in love, and they are married. Jack runs away from school to their home, and finds himself pursued by the malignity of his step-father, who finally sends him off to work in a machine-shop. The people he sees here
- 58. are kind tohim, but the work is much too hard for his delicate health, and, to make matters worse, he is offered, and accepts in his ignorance, a place as stoker in a large steamship. This is almost his death, but he manages to escape penniless from the wreck of the ship, and returns to Paris. He finds near by, in the suburb where he had formerly lived, the old doctor who had been kind to him, and his granddaughter, with whom he is soon in love. At this point it will be well to stop abridging the story, so that the reader may find out for himself the poor young fellow's subsequent misery. There are occasional slight relapses into the happiness he has at rare intervals already known in his life, and at the last he dies in the arms of the woman he loves; but the general impression is that of great wretchedness. There is this relief to the somewhat monotonous gloom—that Jack's character is refined and strengthened by what he goes through; and there is very touching pathos in his treatment of his mother at all times, and especially when she puts an end to his hopes of saving enough money to marry on by returning to live with him. Yet it is a question whether there is not a wanton and wilful accumulation of wretchedness about the poor fellow's head, which, of course, does its allotted work in depressing the reader, and so makes the book effective, but also, it may be felt, offensive as regards literary art. A cool inventory of Jack's causes for happiness and sorrow might leave the reader undecided about the nature of the book, and its mournfulness might be matched by that of many another novel which is considered to be only allowably pathetic; but this one is written with such virulence, so to speak, or at least with such manifest design to accumulate miseries, that the reader's soul revolts within him at being put on the rack in this violent way. What makes it more noticeable is, that this is a French novel which is thus marked by what are more distinctly the qualities of an English novel. In French novels we expect to find a more temperate method of writing and the absence of such heat as Daudet shows, which is of common occurrence in those English novels where no pains are spared to show the good man's virtues and the bad man's faults. Mr.
- 59. Carker, in Dombeyand Son, may serve as an example of the way this is sometimes done. Daudet is quite as energetic in pointing obvious morals. The way he impales D'Argenton on the point of his pen and spares no pains in holding him up to ridicule is an instance of this, while a much clearer one, and one wholly unredeemed by such permissible satire as at times redeems the portrait of D'Argenton, is the account of the school to which Jack is sent. There is no air of reality in the account of the little king of Dahomey who is Jack's sole friend in that wretched place. Then, too, the poor silly mother can never appear but the author, besides making her talk and act like the foolish creature she is, must be for ever whispering in the reader's ear that she is a great fool and a frivolous creature. This over-violent method defeats its own object, and surprises and pains the reader instead of gratifying him. Nothing is taken for granted; we are not left to perceive anything by our own unaided vision; everything is made as plain for us as if it were written in words of one syllable. But that way of writing palls at length, and calls forth a feeling of disappointment with what is in some respects a very able novel. X. Doudan, Mélanges et Lettres. Avec une introduction par M. le comte d'Haussonville, et des notices par MM. de Sacy et Cuvillier- Fleury. Tome III. Paris: Calmann Lévy. Only a year ago two volumes of M. Doudan's correspondence were given to the public—they received notice in these pages,[10] it will be remembered—with a conditional promise of more in case the first should be duly appreciated. Fortunately, these letters were widely read and heartily admired, so that now we have this third volume, with further selections up to the year 1860, and the promise of the speedy appearance of a fourth, to contain letters after that date and Doudan's essay on the Revolutions of Taste. There need be no fear in any one's mind that all the best letters were taken for the first publication, and that the editor has been obliged to swell the pages of this volume with Doudan's hasty, uninteresting notes. Far from it: everything that Doudan wrote had, as some one has well said, the
- 60. flavor of perfection:he never wrote letters as one writes prize essays, cramming into some of them all his wit and wisdom, leaving his less fortunate correspondents to content themselves with the meagre statement of facts. All the qualities that were to be noticed in the volumes that first appeared are to be found here; and they are qualities of the rarest sort. His method of expressing himself is simply delightful, his French is most charming, and his wit and humor must fascinate those who are capable of appreciating anything outside of mathematical exactness of statement. Critics have been by no means unanimous in his praise: some have complained that he wrote his letters with the direct intention of pleasing—not so much those to whom the letters were avowedly sent as deceived posterity. The only reason for this ill-natured supposition would seem to be that the letters were too good for private correspondence; which is a strong argument in favor of reading them. Others—and they are French critics—despise him because he was a friend of the duc de Broglie, but in the course of time this will doubtless be forgiven him. Some, too, object to his humor. M.G. Monod, for instance, who is a very intelligent man, says in the Academy that Doudan makes fun of everything, even when fun is quite out of place. Even in the most tragic occurrences he finds occasion for wit. But, after all, it is a way humorists have: the only remedy for such levity would seem to be decapitation or solitary confinement in prison without pen, ink and paper. Some are so captious that they say Doudan was too delicate and refined a critic for the crude world he lived in. But what is the use of a critic who praises what is worthless, and has no word of encouragement for what is good and deserving of praise? The value of a man like Doudan is that he rises above the common herd by the exactest discrimination: he never follows the multitude in adoring false gods, but is true to his own delicate taste. If common sense is the power of applying the judgment to trifles as well as to important matters, good taste in literature is the habit of applying the judgment to slight as well as to serious questions. Doudan's taste is most refined; that is to say, he is not influenced by general rumor, but he examines everything on its own merits, overlooking nothing, and
- 61. appreciating even slightmatters without placing them above things of real importance. [10] See number for October, 1876. Here is a bit of his criticism: You were quite right to be irritated with this Fanny. I had to see what success Madame Bovary had with all the clever people of society to believe in the success of Fanny. His emphatic and declamatory style has helped the author in putting into his book more shocking and absurd things than there were in the vile anecdotes about Madame Bovary. If a young buffalo in the Pontine Marshes were to write his memoirs, with a detailed account of his loves, his jealousy, his excesses and his despair, he would doubtless give expression to the same sentiment of moral good and evil among buffaloes, but he would not exaggerate the fashion of description in such a ridiculous way. The genuineness of his feelings would prevent his seeing a number of things which do not concern his passions. He would not describe, while sharpening his horns for the fight, the little field-flowers, which he could not notice, nor the village curé's wig, which does not concern him at all; but this small and numerous school of self-styled realists has, in my opinion, so little keen feeling and true passion that it is like the mathematician who wrote from his mother's deathbed, 'I lost my mother this day at twenty-two and one-half minutes after eight [mean time].' The passions are not so accurate, and do not see so many things. Here is an extract from a letter written in the perturbed days of 1848: In the country, whence I write, there is no news. The vervain, the heliotropes, are in flower, as they are every year, and the squirrels run up and down the trees without asking what is going on in Paris. Not one has subscribed to the most insignificant newspaper. By the way, do you suppose there are social disturbances among the beasts of the air, or of the fields, or of the waters? That is not impossible, and I should be very sorry if it were the case: it pleases my imagination more to think that the squirrels are living to-day just as they lived in the garden of Eden; but I have already told you that at a not very remote period a race of rats,
- 62. stronger than thosewho dwelt here, came by chance on a merchant vessel from the East Indies, and drove out all the former population of rats that had lived under our old kings. The ancient race of rats is to be found only in isolated farms. We have no longer the rats that gnawed the cloaks of the knights of the Middle Ages. Ask some professor of the Jardin des Plantes what he thinks of it. When I say that everything is quiet here, I am wrong, for the men at least were very uneasy regarding what might take place on the 14th of July. It was whispered that there was confusion in the capital, and when the diligence passed by a great many small land- owners were on their doorsteps waiting for their newspaper, while their cows were feeding quietly in the meadow, not suspecting that there was a Ledru-Rollin or a Louis Blanc in the world who wanted to begin the world over again on a better model. This eagerness to know what is going on in Paris is a customary sign of disturbance. At present one is naturally anxious to know whether the little field one has planted with handsome trees will by to-morrow's sunrise belong to some obscure soldier of the obscure Sobrier. Formerly they were the veterans of Sylla or of Cæsar, at least, who took the house of Virgil, but now-a-days they are the veterans of Sobrier who threaten the house of Victor Hugo. The times are deteriorating in every direction. Further extracts might be made in abundance to show the humor that played over not the surface of things, but their inmost depths, and threw such a clear light on all sorts of topics; but the reader would do best to add this volume to the other two, and judge for himself how great is the merit of these letters, how rare the intelligence they show, how fine the appreciation of literature and of men which breathes through them all. They are books for all time. Books Received.
- 63. The Wings ofCourage: Stories for American Boys and Girls. From the French, by Mary E. Field. With Illustrations. New York: G.P. Putnam's Sons. Lotus Land, and Other Poems. By G.S. Ladson. Cincinnati: Peter G. Thomson. The Young Magdalen, and Other Poems. By Francis S. Smith. With Portrait of the Author. Philadelphia: T.B. Peterson Brothers. Imaginary Conversations. By Walter Savage Landor. Fifth Series— Miscellaneous Dialogues (concluded). Boston: Roberts Brothers. Biology, with Preludes on Current Events. By Joseph Cook. (Boston Monday Lectures.) Boston: James R. Osgood Co. The Sanitary Condition of City and Country Dwelling-houses. By George E. Waring, Jr. New York: D. Van Nostrand. Meister Karl's Sketch-Book. By Charles G. Leland (Hans Breitmann). Philadelphia: T.B. Peterson Brothers. Beautiful Snow, and Other Poems. By J.W. Watson. Illustrated. Philadelphia: T.B. Peterson Brothers. Dick's Recitations and Readings. No. 5. Edited by William B. Dick. New York: Dick Fitzgerald. Nicholas Minturn: A Study in a Story. By J.G. Holland. New York: Scribner, Armstrong Co. Cooking Receipts from Harper's Bazaar. (Half-Hour Series.) New York: Harper Brothers. Devil-Puzzlers, and Other Studies. By Frederick B. Perkins. New York: G. P. Putnam's Sons. The Outcast, and Other Poems. By J.W. Watson. Philadelphia: T.B. Peterson Brothers.
- 64. The Publishers' Trade-ListAnnual, 1877. New York: Office of Publishers' Weekly. Egypt as it Is. By J.C. McCoan. With Map. New York: Henry Holt Co. The New School-Ma'am; or, A Summer in North Sparta. Boston: Loring. Hetty's Strange History. (No-Name Series.) Boston: Roberts Brothers. East Lynne. By Mrs. Henry Wood. New York: Dick Fitzgerald. Tangled: A Novel. By Rachel Carew. Chicago: S.C. Griggs Co. Selections from Epictetus. Boston: Roberts Brothers. New Music. Sweet and Low: Cradle Song. Words by Tennyson; Music by Mrs. R.H. Alexander. Philadelphia: W.H. Boner Co. Beneath the Stars: Serenade. Words and Music by Charles T. Dazey. Louisville, Ky.: D.P. Faulds. C Co.: Ne Plus Ultra March. By Frank Green. Philadelphia: W.H. Boner Co. Buttercup Polka. By Eastburn. Philadelphia: W.H. Boner Co. Transcriber's Notes: Table of Contents and List of Illustrations added by Transcriber. Page 538 Why should not good and virtuous German Fraüleins, should be Fräuleins. Page 548 she answered dreamily. Changed closing punctuation with period not comma as original text printed. Pages 580-581 end-of-page hyphenation break-fast-tray. Changed to
- 65. breakfast tray. Page 601The Fräulien colored slightly. Changed to Fräulein colored slightly. Page 633 diadem, This ... comma should be period, changed to period. Page 648 Harper's Bazar. Changed to Harper's Bazaar
- 66. *** END OFTHE PROJECT GUTENBERG EBOOK LIPPINCOTT'S MAGAZINE OF POPULAR LITERATURE AND SCIENCE, VOL. 20, NO. 33, NOVEMBER 1877 *** Updated editions will replace the previous one—the old editions will be renamed. Creating the works from print editions not protected by U.S. copyright law means that no one owns a United States copyright in these works, so the Foundation (and you!) can copy and distribute it in the United States without permission and without paying copyright royalties. Special rules, set forth in the General Terms of Use part of this license, apply to copying and distributing Project Gutenberg™ electronic works to protect the PROJECT GUTENBERG™ concept and trademark. Project Gutenberg is a registered trademark, and may not be used if you charge for an eBook, except by following the terms of the trademark license, including paying royalties for use of the Project Gutenberg trademark. If you do not charge anything for copies of this eBook, complying with the trademark license is very easy. You may use this eBook for nearly any purpose such as creation of derivative works, reports, performances and research. Project Gutenberg eBooks may be modified and printed and given away—you may do practically ANYTHING in the United States with eBooks not protected by U.S. copyright law. Redistribution is subject to the trademark license, especially commercial redistribution. START: FULL LICENSE
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