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September 29, 1989

The Securitization of Lending Markets
This decade has been a period of unprecedented
financial innovation. In large measure, innovation
has been a response to increased demand for
more sophisticated risk-management products
that counter the high and variable inflation and
interest rates that were observed in the seventies
and eighties.
Much of this innovation has involved "securitization:' In its broadest sense, securitization
is the process whereby borrowers obtain funds
more or less directly from investors through the
sale of publicly-traded, open-market securities.
This process diminishes the roles played by traditional loan instruments and traditional intermediaries, such as commercial banks and savings
and loan associations. As a result, private loans
negotiated between a borrower and a lender (or
a small group of lenders) are being replaced by
or transformed into publicly-traded securities.
Moreover, securitization increasingly has involved the creation of "derivative securities" that
repackage existing publicly-traded securities.
These derivative securities respond to the specific
risk/return profiles of different classes of investors
and thus supplant services traditionally performed by intermediaries. This Letter looks at
alternative forms of securitization to gain insight
into the economics of this process.

and analyze increasingly complex securities,
thereby deepening the market for publicly-issued
The shift toward publicly-issued securities is
evident in a variety of lending markets. In shortterm markets, firms that are considered high
quality credit risks have come to rely increasingly
on commercial paper as an alternative to shortterm loans from commercial banks. (See Chart 1.)
In 1978, commercial paper outstanding totaled
only $65 billion. By 1988, the market had grown
to more than $450 billion, or a seven-fold increase in ten years. Short-term business loans
extended by banks, in contrast, increased less
than three-fold over that period.

Chart 1
Sources of Business Borrowings
(By Instrument)

December, 1978

December, 1988

E3 Commercial Bank Loans
I:;lCommercial Paper
jjij High Yield Bonds

Bypassing traditional markets
A common form of securitization involves
issuance of public securities in cases where
the issuers formerly would have relied on bank
loans. Improvements in the technology used to
gather, process, store, and disseminate information, as well as regulatory changes that have
streamlined the public-securities issuance
process, have made it increasingly economical
for borrowers to bypass traditional lenders by
issuing securities directly in public markets.
The growth of large, financially-sophisticated
institutional investors, such as pension funds and
mutual funds, also has spurred this trend. The
emergence of such investors has enhanced market participants' ability to evaluate credit risks

Banks have been able to retain a role by providing credit enhancement through letters of
credit and more recently, by moving to participate in the underwriting of these securities. Thus,
although the funding aspect of these loans has
moved to the public market, the involvement of
traditional intermediaries (albeit in nontraditional
ways) may have helped to stimulate the growth of
this form of securitization.
Securitization also is evident in the intermediateand long-term lending markets. Of course, high
quality corporations always have issued public
debt. In the 1980s, however, public issues by
lower-quality borrowers became feasible. Referred to as "high yield:' or"junk" bonds, these

instruments rely on the improved ability of market participants to assess a corporation's financial
prospects. The issuers of these bonds are firms
that in the past were forced to rely on commercial banks for their financing needs. This market
has grown dramatically in the last 10 years to
over $190 billion in bonds outstanding in 1988.
These examples suggest that the expansion of
securities markets represents a shift toward the
use of publicly-issued securities as a substitute
for private lending arrangements. As long as
information technology and the market's ability
to underwrite risk continues to improve, competition will remain keen and this trend towards
securitization will continue.

Asset securitization
A second form of securitization involves creating
publicly-traded securities that are in some sense
backed by a pool of private loans. This is often
referred to as "asset securitization:' The loans
that are pooled and securitized in this way generally are all the same type and have similar risk
and maturity characteristics (for example, 30year, fixed-rate residential mortgages). The cash
flow generated by the repayments on such a pool
of loans is used to make the promised payments
to the security holders. These payments generally
are "pass-throughs;' in the sense that the security
holders receive whatever repayments are made
on the loans, including any early repayment of
The majority of securitized assets have been
residential mortgage and consumer debt, with
mortgages by far the most popular. The popularity and success of mortgage loan securitization
largely is due to the credit enhancement provided by government agencies responsible for
creating a secondary market for residential mortgages. The value of mortgage-backed securities
issued by the Government National Mortgage
Association (GNMA), Federal National Mortgage
Association (FNMA), and Federal Home Loan
Mortgage Corporation (FHLMC) exceeded $700
billion in 1988.
Investors receive promised principal and interest
payments on a timely basis as guaranteed by the
issuing agency. As a result, these securities pose
minimal credit risk; however, they still expose
investors to interest-rate and early-repayment

risk. (Early-repayment risk is the risk that the security holder will receive a lower-than-expected
return as a result of faster-than-anticipated
repayments of the underlying mortgages. Early
repayment is associated with declines in the level
of interest rates, which induce borrowers to
refinance, and thereby repay, the underlying
mortgages earlier than otherwise would have
been the case.)
Although government guarantees are a motivating factor in the securitization market, private
firms also securitize loans that do not qualify for
government agency programs. Non-qualifying
loans known as "whole loans" increasingly have
been securitized, although the dollar volume
remains small compared to that securitized by
the federal agencies (about $15 billion were
issued in 1988).
To be marketable, these non-agency issues
usually aim for default risk approximating that
offered by the agency issues. This is usually
achieved by obtaining an investment-grade
rating through one of the major securities rating
firms. To provide the requisite credit-risk protection, the issuer usually relies on a senior!
subordinated structure, a corporate guarantee,
or third-party credit enhancement.
Consumer debt also has been securitized, with
the most popular forms being credit-card receivables and auto loans. Leases, marine loans, recreational vehicle loans, and home equity loans
also have been securitized. Typically, the consumer-loan-backed issues are offered with credit

Resecuritizing securities
One of the most important considerations in
issuing publicly-traded securities is the need to
make the issue marketable by matching its characteristics to the risk!return profile of potential
investors. This consideration has given rise to a
third form of securitization: derivative securities.
See Chart 2.
Creating derivative securities is tantamount to
"resecuritizing" existing publicly-traded securities. Here, the cash flows from a pool of public
securities are repackaged. Many of these derivative products enable investors to hedge interestrate and early-repayment risk themselves,

fall, principal-only securities rise in value because accelerated repayments effectively raise
investors' return on their investment.

thereby diminishing investors' need for services
offered by traditional intermediaries.

Chart 2
Mortgage·Backed and Asset·Backed Securities
(Annual Issue Volume)
Preferred Stock &
• Collateralized Bonds
Private Mortgage
IB Pass·Throughs
o Asset Backed Securities

Risk-based capital guidelines
$ Billions



Source: Moody's Investors Service


The two most common examples of resecuritization are collateralized mortgage obligations
(CMOs) and interest-only and principal-only
securities. The vast majority of CMOs are backed
by mortgage-backed securities created through
GNMA, FNMA, and/or FHLMC. Typically, the
CMO repackages the cash flows from these securities to create multiple classes of bonds that
offer different levels of interest-rate and earlyrepayment risk.
Each CMO structure contains a subordinated, or
residual, class of bonds and one or more senior
classes of bonds that carry relatively less interestrate and early-repayment risk. The struCtures are
designed to match the risk-return profiles of
investors, but have the disadvantage that each
CMO is unique and therefore, less liquid.
Interest-only and principal-only securities divide
the cash flows from agency-backed pass-through
securities into interest-only and principal-only
classes. When market interest rates rise, interestonly securities rise in value because early principal repayments decline, thereby extending the
length of time over which interest payments are
received. Conversely, when market interest rates

The passage of the Financial Institutions
Reform, Recovery and Enforcement Act (FIRREA)
in August 1989, requires depository institutions
to hold capital based on the riskiness of their
asset portfolios. Under the currently proposed
version of the risk-based capital regulation, many
securities will require less capital backing than
loans. For example, securities issued by FNMA
and FHLMC would require capital of only 1.6
percent and those issued by GNMA would
require no capital. Non-securitized mortgages
would require capital of four percent, while most
commercial loans and other assets would require
capital of eight percent.
These capital requirements favor investing in
securities. The result of these guidelines, if implemented in their current form, will be to promote
the continued securitization of private loans.

The future of securitization
A variety of forces have spurred securitization.
In some cases, government-provided credit enhancement has played a particularly important
role. Bank entry into securities underwriting
markets, as well as changes in capital adequacy
regulations, are expected to provide an impetus.
Ultimately, however, the trend towards securitization has been and will continue to be motivated by investors' demand for the enhanced
liquidity and interest-rate hedging opportunities
securitization offers investors. With or without
government sponsorship, publicly-tradable
instruments will continue to replace private
transactions, particularly as improvements in
information technology further reduce the costs
of issuing public securities.

James R. Booth
Visiting Scholar, FRBSF
and Associate Professor,
Arizona State University

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San Francisco, or of the Board of Governors of the Federal Reserve System.
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