Table Of Content

ASSET-BACKEDSECURITIES: THEDETERMINANTSOFYIELDSPREADS BY RICHARDH.BORGMAN ADISSERTATIONPRESENTEDTOTHEGRADUATESCHOOL OFTHEUNIVERSITYOFFLORIDAINPARTIALFULFILLMENT OFTHEREQUIREMENTSFORTHEDEGREEOF DOCTOROFPHILOSOPHY UNIVERSITYOFFLORIDA 1994 TABLEOFCONTENTS ABSTRACT iv CHAPTERS 1 INTRODUCTION 1 2 INSTITUTIONALFEATURESOFSECURITIZATION 8 TheMarketforAsset-BackedSecurities 8 TheFrameworkofanAsset-BackedSecurity 11 ImplicationsforPricing 26 3 PREVIOUSLITERATURE 32 BondPricingStudies 32 Mortgage-BackedSecurityPricingStudies 35 Asset-BackedSecurityLiterature 45 4 ASSET-BACKEDSECURITYRISKFACTORSAND HYPOTHESESFORPRICING 52 DOepftaiuolntCRhiasrkact(ePrairtsti1)c:soCfreadnitARBaSting 5537 DefaultRisk(Part2):TheSufficiencyofCreditRating 67 Marketability 72 Collateral 76 Summary:HypothesesConcerningtheDeterminantsofABSYield Spreads 77 5 METHODOLOGYANDDATA 80 Data 81 SampleDescription: EntireABSSample 85 RegressionSample 88 TheModel 89 6 REGRESSIONRESULTS 101 TheBasicAbsoluteSpreadModel 101 InteractiveVariablesforBTranchesandMultipleATranches... 117 ReputationandOriginatorRating 119 "AreBanksDifferent?" 122 CreditEnhancement 126 7 CONCLUSION 146 ImplicationsoftheAnalysis 147 ExtensionsofthePricingAnalysis 149 APPENDICES A ABSGLOSSARY 151 B REGRESSIONTERMSANDABBREVIATIONS 155 C RELATIVESPREADREGRESSIONS 162 REFERENCES 168 BIOGRAPHICALSKETCH 175 AbstractofDissertationPresentedtotheGraduateSchool oftheUniversityofFloridainPartialFulfillmentofthe RequirementsfortheDegreeofDoctorofPhilosophy ASSET-BACKEDSECURITIES: THEDETERMINANTSOFYIELDSPREADS By RichardH.Borgman December1994 Chairman: MarkJ.Flannery MajorDepartment: Finance,Insurance,andRealEstate Asset-backedsecuritizationhasenjoyedrapidgrowthinitsrathershortexistence asapublicmarketThesenonmortgage,nongovernment-guaranteedasset-backedissues havecreatedanewsourceoffixedincomesecuritiesforinvestorsandanewsourceof liquidityforbanksandotherlendingfirms. Thisstudyexaminesthedeterminantsof asset-backedsecurities'(ABS)equilibriumyieldspreadoverTreasury,usingacross- sectionofprimarymarketissueprices. Theprocessofconvertingilliquidassetstotradedsecuritiesinvolvesacomplex setofinstitutionalarrangementsandstructuresthatcreateanintricatesetofrisksforthe investor. Theseinstitutionalarrangements,structures,andrisksareanalyzedasa precursorforspecifyingamodelofthedeterminantsofpricing. Thismodelextends modelspreviouslyusedinpricingstudiesofcorporatebondsandmortgage-backed securities. Thereisnostandarddatasourceforthesesecurities,sotherehavebeenno previousstudiesofhowthesesecuritiesarepriced.Amajorcontributionofthestudyis theassemblyandanalysisofasubstantialdatasetthatdescribesthepricingand characteristicsofover700ABSatissue. Ordinaryleastsquareregressionsareutilized inthepricinganalysis,whichincludesissuesfrom1985through1992. Thisanalysis findsthatABSpricing(absoluteandrelativeyieldspreads)isrationalandpricesreflect premiumsfordefaultrisk,interestrateandreinvestmentrisk,andmarketability.Asone wouldexpectinarapidlyevolvingmarket,institutionalformshavechangedfrequently, andnewoneshavebeenadded,overthesampleperiod.Tosomedegree,themarkethas requiredpremiumsfortheunfamiliarornewanddiscountedforexperience. ABSin generaldonotexhibitnegativeconvexityandarenotsubjecttoexcessiveprepayment risk. Althoughthecomplicatedstructuresutilizedtoseparatetheriskofthecollateral fromtheriskoftheoriginatorareeffective,asindicatedbythepreponderanceofAAA ratedissues,investorsnonethelessrequireinformationinadditiontocreditrating concerninganissue'spooland/orservicingwhenpricingtheissue. INCTHRAOPDTUECRTI1ON Thesignificantgrowthofassetsecuritizationbybanksandotherlendersvia nonmortgage,nongovernment-guaranteedasset-backedsecurityissueshascreatedanew sourceoffixedincomesecuritiesforinvestorsandanewsourceofliquidityforbanks andotherlendingfirms. Whileithasbeensuggestedthatasset-backedsecuritiesare technicallysuperiortotraditionalon-balancesheetmeansoffinancingbecauseof potentiallylowercostsandmoreefficientriskallocation,therehasbeennosystematic evaluationofhowinvestorspricethesesecurities.Thisstudyexaminesthedeterminants ofasset-backedsecurities'equilibriumyieldspreadoverTreasury,usingacross-section ofprimarymarketissueprices. Theasset-backedsecurity(ABS)market,inexistencejustsince1985,hasrapidly growntoover$60billionofnewissuesayear.Theprocessofconvertingilliquidassets totradedsecuritiesinvolvesacomplexsetofinstitutionalarrangementsandstructures (describedinChapter2)thatcreatesanintricatesetofrisksfortheinvestor.Thereisno standarddatasourceforthesesecurities,sotherehavebeennostudiesofhowthese securitiesarepriced.Amajorcontributionofthestudyistheassemblyandanalysisof asubstantialdatasetthatdescribesthepricingandcharacteristicsofover700ABSsat issue. Thisstudyofferstheopportunitytoanalyzeanewmarketandcharacterizethe marketmaturationprocess.Itinvestigatesthesensitivityoftheseasset-backedsecurities 1 toprepaymentrisk--dotheyexhibitsensitivitylikemortgage-backedsecuritiesorexhibit positiveconvexitylikenoncallablecorporatebonds. Italsoanalyzesthesufficiencyof creditratingtocharacterizecreditqualityinaheterogeneousmarket. Investorsmay utilizeotherinformationinadditiontocreditrating,suchasoriginatorcharacteristicsand creditenhancementamountandtype. Ifinvestorsdouseoriginatorrating,themarket maynotbelievetheclaimsofa"bankruptcyremote"legalstructure.1Finally,thestudy assesseswhetherstandardproxiesformarketability,defaultrisk,andinterestrateriskare pricedinthisnewmarket. Securitizationreferstothetransformationofprivateloansnegotiatedbetweena borrowerandalenderintopubliclytraded(oratleastsaleable)securities. Itseparates theoriginatorfromtheultimateinvestor. Itisreflectedbytwostreams: loansales (confinedtobanking)andthemorenarrowlydefined(butmorebroadlypracticed) securitization,creditsecuritizationortheissuingofasset-backedsecurities.2 Credit securitizationdiffersfromsingleloansalesbecauseitinvolvesthepoolingofassets-such asmortgages,automobileloans,orcreditcardreceivables-andthecreationandsaleof 'Inthesecuritizationprocess,a"bankruptcyremote"specialpurposevehicleorentity (SSPPVV/isSPaEs)peicsieasltlaybclhiasrhteedrteodsceopraproartaetitohnetrhiastkspuorfcthhaesepsootlheoflocaonlsla(tceorlallatferroalm)tfhreoomritghienaotroirg.inaTthoer andistheactualissuerofthesecurities.Thusthereisnoliabilitycreatedonthebalancesheet oftheoriginator.Forbanks,the"bankruptcyremote"terminologyisnotexactlycorrect,since bankscannotgobankrupt; rather,theycanbedeclaredinsolvent. Ifthisseparationofthe originatorfromtheissuerwerenotcomplete,itwouldimplyanoff-balancesheetliabilityfora bank. 2Someauthorswouldnotincludeloansalesundertherubricofsecuritization.Greenbaumand Thakor(1987)sharplydistinguishbetweenthetwo:"[Securitizationinvolvesqualitativeasset tcraasnhsffolromwast.ioLn.oa.n.s.aTlehsusm,erseelcuyristeipzaartaitoenfeunnhdainncgesfrloimquiodriitgyi,narteidounc."es(pc.re3d8i0t).riskandrestructures 3 newsecuritiescollateralizedbythepoolofassets. Mortgage-backedsecuritiesusually haveanexplicitorimplicitguaranteefromaU.S.governmentagencyandarenotthe concernofthisstudy.Asset-backedsecuritieswithothertypesofcollateralareaddressed here.ThesesecuritiesareusuallyratedtripleA,aratingattainedbytheadditionofsome sortofcreditenhancement.3 Securitizationtransfersriskfromtheoriginatorandoften restructuresriskbearingtosomedegree. Therapidgrowthofsecuritizationoverarelativelyshorttimeindicatesthatthe processhasbecomeanimportanttoolforbanksandotherfirmsandanimportantsubject ofstudy.4 Thefirstnonmortgagebacked,nongovernment-guaranteed,publiclyissued asset-backedsecuritywasintroducedinMarchof1985bySperryCorporation,a$192.5 'Creditenhancementreferstoanyadditionalprotectionsforinvestorsagainstdefaultriskthat areincludedinthestructureoftheissue. Theseincludeguaranteesofprincipalandinterest paymentsbythirdpartyinsurers,senior/subordinatestructures,andcashcollateralaccountswhich areastatedpercentageofprincipalmaintainedasaseparateaccountasafirstlossprotectionfor investors. 4Assetsecuritizationisusedbymanytypesoffirmstoreduceleverage,todiversifyfunding, uansde,debsypebcaianlklsyifnorfulnodwerrairsaitneg,doirnigaissneatt-olrisa,bitloitryaimsaenlaegsesmeexnpte,nsiinvemefeutnidnsg.cAusssteotmesercudreimtaiznadt,ioannids inavoidingregulatorytaxes(reserverequirementsanddepositinsurancepremiumsonfunding deposits,andregulatorycapitalrequirements).Borrowersbenefitthroughanincreasedsupplyof loans,potentiallylowercosts,andincreasedcreditontermslendersmightnotprovidetosucha degreeotherwise,suchasfixedratemortgages.Investorshaveagreatersupplyandvarietyof investmentopportunitiessuitedtospecificneeds.Thebankingsystemarguablyhasbeenmade morestablethroughanincreaseinliquidityforpreviouslynonmarketableassets,throughincreased Tophpeorotvuenriatlilesecfoornodmiviecrssifyisctaetmionb,enaefnidtsbetcharuosueghofmoarneinocprteiamsaeldraibsiklibteyartiongc.ompIentfeactf,orRoblolrr(o1w9e8r7s). pointstofinancialinnovationssuchascollateralizedmortgageobligationsashelpingto"complete themarket"andthuscreatingvalue(throughlowerrequiredyieldsontheunderlyingmortgages). Jtahmeemsoton,beDeswubasnt,antainadl.Sirmans(1992)attempttomeasurethewelfarebenefitsofCMOsandfind 4 millionissuebackedbycomputerleasereceivables.5Yetinashorttimethemarketfor thesesecuritieshasgrowndramatically.Newissuesfor1993werejustover$60billion. Newissuesfor1994areexpectedtototalbetween$62billionand$70billion,risingfrom $1.23billionin1985.6 Thegrowthinsecuritizationislikelytocontinue,spurredbysomerecent regulatoryandlegislativeevents. First,inNovember,1992,theSECpassedRule3a-7 exemptiontotheInvestmentCompanyActof1940. Underthisexemption,abroad varietyofassetsnotpreviouslyeligiblecannowbesecuritized.7 AccordingtoAsset SalesReport,theadoptionwas"politicallygearedtowardfosteringthesecuritizationof smallbusinessloans"andthustoalleviatethecreditcrunch(ASR,November30,1992, p.1).However,theeffectsaremorefarreachingthanjustsmallbusinessloans,allowing forthesecuritizationofstudentloansandunsecuredconsumerloans,forexample. Second,theClintonadministrationhasexpressedsupport(withmodifications)forthe FinancialAssetSecuritizationInvestmentTrust(FASIT),proposedtoCongressinMay, 'Thefirstprivateissueoccurredslightlyearlierin1985byComdisco,a$35millionissue backedbycomputerleases. asA6SAsRseatndSarleefserReenpcoerstw,iJlalnubaermya1d,e19p9ar4e,ntph.et1i.caHlelry.eafterAssetSalesReportwillbereferredto 'Priortothisexemption,ABSswereissuedunderexemptionsprovidedbyRule3c-5tothe 1940Act. UnderRule3c-5(a),assetsthatprimarilyrepresentedthepurchasepriceof maeprpclhya(nedxicseep,tfsoerrvsimcaelsl,aomroiunnstusr)antcoecaqsuhalaidfviaendc-easutoonacnrdedictrecdairtdsc.arUdnAdeBrSsRuluese3dc-t5h(ics).,aIstsdetisdtnhoatt pecrlooeiopuglrli"edbslaeaelngsateosensdcaeytpaspnilnsiysnoutfweeorsrecsbsotpaveciecnkrieam"dlofriebtnxyagenammcgpioeatrsltigooaansrgsseertesusa.n,ldeeeTsirhttahReteuerlneqefuiw6xa-elcRdi,uflobieruetdr3e-tavhh-oeo7lsmveeeixnwepgeqa,runietdthsylatatlrhobgeaeylndystehflueiisinmreiidtttieetodhrnimtsso.ofc"Ipaosasnsrsvuteeeitrrastl:s intocashwithinafinitetimeperiod,plusanyrightsorotherassetsdesignedtoassureservicing ortimelydistributionofproceedstothesecurityholders." Bythisdefinition,theonlything clearlyexcludedisstock. 5 1993(H.R.2065)(ASR,June28,1993). FASITwouldextendthetaxbenefitsofthe RealEstateMortgageInvestmentConduit(REMIC)toassetsotherthanrealestate.8 Third,therehasbeenlegislativeefforttoencourageasecondarymarketforbusinessloans viathesecuritizationtechnology.Thesponsor.RepresentativePaulKanjorski,saidthat the"ultimategoalistoallowtheprivatesector,throughthenewsecondarymarket,to takebusiness,commercial,andcommunitydevelopmentdebtandequityinvestments, placetheminsecuritizedpools,andcreateinvestmentproductswhichareattractiveto pensionfundsandinsurancecompanies."'Whateverthepoliticaloreconomicmeritsof theselegislativeproposals,itisclearthatsecuritizationisbeingpushedforwardasifit wereapanaceaforthecreditcrunch. GiventhesignificantgrowthoftheABSmarketanditsfuturepotential,arigorous evaluationofthefactorsthatdetermineABSpricingisimportantThisanalysisfindsthat ABSpricing(absoluteandrelativeyieldspreads)isrationalandpricesreflectpremiums fordefaultrisk,interestrateandreinvestmentrisk,andmarketability.Spreadsarefound tohavewidenedovertimeduetomarketrecomposition.Butspreadsforhomogeneous subst'i"tUutnedearsstehtes.prTophoesalla,ttterheacFtAiSoInTi,seaslseegnatliaelntfiotry,thceousledcuirsistuiezamtuilotniopflereclvaoslsveisngofansedcusrhiotrite-staenrdm a(sAsSeRts,lJiukenecr2e1d,it1c9a9r3d,sap.nd1)t.radereceivables,homeequitylinesofcreditandsmallbusinessloans" amMsal1liopo]mksdoreao"entr'TsrsgkrhAeoaeaeicSrttqgsueRe.uredi,-iirtiTMmeeinJpahnseucltrselieokcyremishepsseeatr6csri,ututasErhereeinad1er.tth9aeib9sadesR3ysnmao,ecatirnFelhstpaelimse.nturnenie,bhn1eidu.asteisntuitcAMnpTnoecdarehtesoiae'rspsgeoortafmlsebhnpioeeel1dalsl9ncot8Fhaoyd4rasmo,ecregeehtdcosniuaedarnrrtilictneswtelooiorutpMteiudpaosniolpcgnrdrw".gtooppubprrnufeoioa(oltscvAmedieeocoxesrctegssatoe'ambhr.itple"dnoletiecanntfrrlgdhierlesiaokotntmowbgiweoceAannteieoSrgpfothriRbaftitiuivsnsa[naiAgtronpne.efre"geiseu)tlwnslhteaei2stHgt6iooSy,oiwvennteecs1o,vro9lenn9comr3drmwue,a,eacrnttphyitoe.t