Securitization: the Adventure of the Top-Sliced Lender, Part 2, the slicer
[Continued from yesterday’s Part 1.]
Investment bankers love to draw boxes and arrows
By now Mycroft Holmes’s enormous waistcoat was dusty with rainbow hued chalk dabs as this securitization primer roused his enthusiasm.
“Too significant by far,” he repeated, glowering at those unseen readers who had not read yesterday’s post. “We have all of the risk and one-third of the capital. We would rather have all of the risk laid against one eighth of the capital. To do that, we slice off another tranche.”
The City and the Diogenes marked the limits of Mycroft’s travels
“Which you sell to customers who visit a slightly higher floor in the Money Store?”
Go up a floor or two to more sophisticated lenders like mutual funds.
“Having securitized the A piece, we can now create a junior security, what we will call a new B piece.” Using a different color of chalk, he drew another rectangle directly atop the first one.
“We found a more yield-oriented investor —”
“More risk-tolerant.”
“You cannot have one,” Mycroft said gently, “without the other. A more yield-oriented investor, as I say, who was willing to buy a £150 B piece, at 8.25%. Yes, higher than the original pool. But our goal was to reduce our remaining share — the C piece as it will now be called — even further. This we did, so after issuing both the A and B pieces, we still had all the risk but only one-eight of the capital outstanding. We have distilled the risk into a purer form.”
I pointed to the securitization diagram. “Because your yield depends entirely on those top slices of the individual loans, if the underlying loan portfolio goes into default, even a little, your capital could be wiped out.”
The more slices of securitization, the higher the remaining beta
“Sir, it could. Distillation of risk — issuance of securities and holding the residual and most junior piece — requires special handling. That in turn takes special knowledge, special expertise, and constant vigilance.”
There were times when Mycroft so needed expert housing recapitalization assistance he actually called on Holmes.
“Thus the B piece holder, even more than the A, relies on your bank to be capable, not just capitalized.”
“They do more than that. Often in a B security, the buyer will have a post-closing reversionary, the ability to compel us to repurchase some of the individual loans, or otherwise provide collateral protection. Their goal is indeed to give us 100% of the risk, and therefore give themselves none of the risk.”
More investor protections, more issuer beta
“Which is why we must assure the yields are commensurate. As, in this example, they are.”
“The 8.0% yield from the aggregate loan pool, when securitized with 6.5% A piece and an 8.25% B piece, yields our bank 16.6% on the C piece. We have doubled our effective yield on capital by squeezing out the seven-eighths that is risk-free or low risk, and selling those safer slices in the capital markets. That, sir, is one of the several things an investment banker does. There can be further complications. I have drawn this diagram assuming all the loans are the same maturity, and the security coterminous as well. If we add a time dimension, in effect taking this image out into a third spatial dimension — you may wish to recall our discussion of the financing quilt — the potential for arbitrage rises, as does the risk profile.” He slapped chalk from his fat palms.
Watson realized that when evaluating securitizations, one had to study the fine print
“Indeed, now I come to think of it, perhaps we are better served as our bank by lying in wait for those who understand risk less well, and who are about to put themselves into dutch, overusing these brave new financing techniques, for a New Century.”
Too much beta makes banker go blub-blub
