Securitization of Loans and Mortgage Backed Securitization

The main reason for the Sub Prime Crisis was not bad loans but securitization of these mortgage loans, this process is known as Mortgage Backed Securitization (MBS). This raises the main issue like
· What is Securitization?
· What is Mortgage backed securitization?

Securitization
Thirty years ago, if you got a mortgage from a bank, it was very likely that the bank would keep the loan on its balance sheet until the loan was repaid. That is no longer true. Today, the party that you deal with in order to get the loan amount is highly likely to sell the loan to a third party. The third party often then packages your mortgage with others and sells the payment rights to investors who are willing to invest in such securities. This may not be the final stop for your mortgage. This can continue for additional steps. The process by which most mortgage loans are sold to investors is referred to as Securitization.
In the mortgage market, securitization converts mortgages to Mortgage Backed Securities. Securitization is a process, which involves pooling and repackaging of cash flow producing financial assets into securities that are then sold to investors. It is the process of conversion of existing assets or future cash flows into marketable securities. In other words it deals with conversion of less liquid assets into more liquid ones.
Conversion of existing assets into marketable securities is called Asset Backed Securitization, whereas the conversion of future cash flows into marketable securities is called Future Flows Securitization. Similarly, when the mortgage payments are securitized it is called as Mortgage Backed Securitization. Example of assets that can be securitized is housing loans, car loans, credit card payments etc. Example of future cash flows that can be securitized are car rentals, lease rentals etc.

Mortgage Backed Securitization (MBS)

In layman’s term, Mortgage Backed Securities (MBS) is a mortgage backed/secured by one’s asset wherein one looses the ownership of the asset on default of payment. In the traditional lending process, bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower’s creditworthiness. This requires banks to hold assets up to the maturity. The funds of the bank are blocked in these loans and to meet its growing fund requirement a bank has to raise additional fund from the market. Securitization is process of freeing up these funds blocked in loans.
To free these blocked funds, the assets are transferred by the originator (the lending bank) to a special purpose vehicles (SPV). The SPV is a separate entity formed exclusively for facilitation of the securitization process and providing funds to the originator. In order to fund the purchase, SPV issues tradable securities to banks, mutual funds, other financial institutions and government. The performance of the securities is then linked to the performance of the assets.
The assets transferred to the SPV need to homogeneous in nature, i.e. only one type of loans (say housing loans) and of similar maturity period (say 20-24 months). These assets are bundled together for creating the securitized instrument. The SPV will act as an intermediary which divides the pooled assets of the originator into marketable securities.
The securities issued by the SPV to the investors are known as pass-through-certificates (PTC). The cash flow received (principal, interests etc) by the originator from the borrowers are passed on to the investors on the pro rata basis. The difference between the rate of interest being charged from the borrowers and the rate of return promised to the investors in PTC is the servicing fees for the SPV.
The originators are generally responsible for collecting the repayments from the borrowers and passing it on to the SPVs.

There are three major risks to MBS investors.

· The first is interest rate risk and it is common to all bondholders. The investors invest in these securities because they carry higher return as compared to other bank deposits. Also, the valuation of these securities is important for the investors as their decision for purchase lies on them. These valuations have an inverse relationship with the interest rate in the market. Higher the interest rate, lower is the value for MBS and vice-versa.
· The second risk is prepayment risk. Many mortgages in the United States can be prepaid without penalty. If they prepay the loan when the interest rate is low, the banks will have to issue fresh loans at the current market rate which would eventually lead to lower return for the IB and thus lower returns to the investors of the securities
· The third risk faced by MBS investors is default risk—that is, the risk that homeowners will default on the mortgages that back the MBS. Private sector MBS issuers may obtain direct insurance against default, but often they structure their MBSs to allocate default brisk toward parties willing to bear it. This risk was overtaken and misjudged in the US’s MBS Market which led to Sub-Prime Crisis.


Re-securitization

Mortgage-backed securities are not the end of the line. Pools of MBSs are sometimes collected and securitized. Bonds that are themselves backed by pools of bonds are referred to as Collateralized Debt Obligations (CDO). The CDOs can look like MBSs, except that the underlying assets are bonds in case of a CDO as against some physical assets in case of MBS. Structured Investment Vehicle (SIV) is similar to CDOs. The difference between SIVs and CDOs is essentially in the type of debt they issue. The SIVs are structures backed by pools of assets, such as MBSs and CDO bonds. The SIVs issue short- and medium-term debt rather than the longer-term debt of most CDOs. The short-term debt is referred to as asset-backed commercial paper.

Rupee Depreciation

Currency depreciation is defined as a decrease in the value of one currency relative to another currency, i.e. because of change in exchange rates, unit of one currency buys less units of another currency.

 

The value of a currency can be maintained by the Central Bank of the Country in the following three manners:

 

• Free Floating: The value of one currency to another is determined by the supply and demand for that currency
• Partly Fixed: The rates are determined by the Supply and demand of the currency but the Central Bank of that country interferes through open market operations and thus controls the currency value. India’s Currency Management system is partly fixed.
• Fixed: The value of the Currency is kept fixed as compared to the other currencies. China’s currency is fixed.

 

Rupee Depreciating is Indian Rupee depreciating against dollar; it means that a unit of rupee will buy less units of dollar or that more units of rupee will be required to buy one unit of dollar.

 

Let us understand the dynamics of the currency movement. Just like any other commodity, the upward/downward movement of the value of a currency is based on the dynamics of demand and supply. As the demand for rupee increases, its value rises and vice versa. Thus if the rupee has depreciated against dollar, it means that the demand for dollar and supply of rupee is rising.

 

But there is a significant role of the RBI in this process. Since India’s currency is partly fixed so the Central Bank through its open market selling and purchasing of Rupee tries to fill the supply demand gap and thus control the value of the currency.

 

Now when we say that rupee is depreciating against dollar, it would mean that the demand for dollar is rising and there is a selling pressure on rupee. Now from where do the above arise?

 

Imports – If a person in India imports goods/services from a foreign country, he/she will have to make payment in the currency of that country. Now to acquire that currency, he/she will have to sell Indian Rupee to the banks. Thus in the process creating a demand for foreign currency against the Indian rupee

 

Investments abroad – If a person in India plans to invest abroad, he will have to acquire foreign currency by selling the home currency.

 

Repayment of loan – If a corporate had taken an overseas loan, the repayment is done in the lender’s currency. Thus at the time of repayment, corporate will have to acquire foreign currency.

 

Disinvestment by FIIs – When foreign investors liquidate their investments in Indian market, they sell rupee and buy foreign currency in order to repatriate the funds to their home currency. Earlier when Indian economy and Indian stock market was on a roll, strong capital inflows from FIIs had led to the rupee appreciation. Now, when the market is at its all time low, there is continuous withdrawal of capital by the FIIs from the market which has primarily led to this rupee depreciation.

 

Similarly, any activity that requires outflow of funds from the home country will create a demand for the foreign currency and hence would lead to rupee depreciation. Similarly, any activity that would require inflow of funds to the country, it will create a demand for the home currency and lead to rupee appreciation.

 

Having understood the reason for rupee depreciation we must understand its implications. Ask any patriotic enthusiast whether rupee depreciation is good for economy or bad for economy and probably his reply would be “Obviously bad for our economy….we are losing the battle to the green buck….”

 

Well let us understand its implication from a broader perspective.

 

Positive Implications of Rupee Depreciation:

 

1)      Higher revenue for exporters – Exporters earn their income in dollars which is spent in rupees back home for further investment or consumption. If the rupee depreciates, their earnings in rupee terms will rise.

To explain it better, say that exchange rate is USD 1 = 50 INR. If an exporter earns USD 1000, his earning in rupee terms is 50000 INR. If the rupee depreciates to USD 1 = 60 INR, then in rupee terms the earnings of exporter will be 60000 INR. A rise in earnings, despite the revenue in dollar remaining constant.

2)      IT Industry – IT industry has been a major contributor to exports. IT companies have more than 60% of their revenues from US. It is said that for 1% depreciation in INR, their earnings rise by 30 basis points. Other export oriented industries in India will benefit from the depreciating rupee.

3)      Repatriated profits – Remittances to India by NRIs - Rapid currency depreciation increases the value of repatriated profits.

4)      Tourism – India is now a cheaper place to visit.

5)      More foreign investments – increase in FDI/FIIs

 

Negative implications of Rupee Depreciation:

 

1) Importers – The importers of goods and technologies are the worst hit. The value payable in the Exporting country’s currency remains the same but the value payable in the Indian Rupee terms increases by a considerable amount.

2)OIL and OMC - Although crude price might have corrected by around 57 per cent in dollar terms, it has contracted by 52.5 per cent in real terms due to the nine per cent rupee depreciation in the last four months. "The crude's cut-off was around $67-68 per barrel when the rupee was trading at Rs 41-42 levels. But, on account of rupee depreciating to levels of Rs 49, recently, the cut-off has been revised to $59/barrel." Thus, the OMCs would make meaningful profits on their direct sales of petroleum products, if the crude prices sustain below break-even rates for a reasonable amount of time.

3) Corporate borrowings – The borrowing rates of Corporate (in case of borrowing from an International Lender) increases as they are supposed to repay more (both as principal and Interest) in Rupee terms in case of the rupee depreciation, since the amount payable is in the lending Country’s currency.

4) Mergers & Acquisition – In the event of an overseas acquisition by an Indian company, the Indian Company has to pay more and thus the returns of the Indian Company go down.

 

 

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SeNSeX DeMyStiFiED

Everyone has heard of the Sensex. Most of us know it is the index of the Bombay Stock Exchange. But there are lots of facts you are probably unaware of. Here are some interesting facts about the Sensex.

1. The Sensex is made up of only 30 stocks: These stocks represent around a dozen sectors. They are leaders in their respective industries.

2. The stocks are picked by the stock selection committee (known as the Index Committee).

There are certain basic parameters fixed when picking these 30 stocks. They are:

·         The stock should have been listed and traded on each and every trading day for the past one year.

·         It should be among the top 150 companies listed by

-       average number of trades (buying or selling of shares) and

-       the average value of the trades per day over the past one year.

The list of companies included in the Sensex is not permanent and the list is revised continuously based on the above criteria. For eg. Tata Power Co. ltd replaced Cipla ltd. on 28^th Aug 2008.

3. The job of the Sensex is to capture the price movement of the equity market.

The Sensex reflects the price movements of shares. If the Sensex rises, it indicates the market is doing well.

The price of every stock price rises or falls for two possible reasons:

News about the company

Great earnings, great annual or quarterly results, product launch, closure of a factory, the government providing tax or duty exemptions to the sector so more profits expected, a feud among the company's top bosses, etc. This is called stock specific news.

News about the country

Testing a nuclear bomb, a terrorist attack, the Budget announcement, new tax regime, declaration of war, change of government, good monsoons and hence a good agricultural crop, etc. This is called index news.

Global Cues

Movement of other stock exchanges world wide, U.S. sub prime crisis, bankruptcy of Lehman Brothers etc.

The job of an index is mainly to capture the news about the country. This will reflect the movement of the stock market as a whole. It could also reflect the sentiment of the market as a whole. If corporate India is largely doing well, then it will get reflected here.

4. How is Sensex Calculated?

Each of the 30 stocks in the Sensex has a weight attached to it. This weight depends on the market capitalisation of the stock.

There are two methods to calculate the market capitalisation:

Full Market Capitalisation Method

Full market capitalisation refers to the total number of shares of a company is multiplied by the market price.

Free-float weightage

In case of free float weightage only the shares that are available for trading (some of the shares issued to the promoters or government are not allowed to be traded) is multiplied by the market price.

Let us take an example:

Assume a company X with following share holding pattern

Shares Held by	No. of Shares	% of holding
Promoters	200000	50.00%
Institutional Investors	100000	25.00%
General Public	100000	25.00%
TOTAL	400000	1

 

Assuming the Market Price per share is Rs. 20

 

Under Full Capitalisation Method

 

Total Market Capitalisation = Rs. 400000 x 20

                                                   = Rs.8000000

 

Under Free Float Weightage Method

 

Total Market Capitalisation = Rs. 200000 x 20

                                                   = Rs.4000000

 

Note: 200000 shares held by promoters is not taken into account

 

This calculation is done every 15 seconds in a trading day

 

 The Sensex uses the free-float weightage method whereas S&P CNX NIFTY uses Full Capitalisation Method

Till 1^st September 2003 the value of Sensex was also computed on the basis of Full Capitalisation method