Lending options:Generallythere are two options available to financial institutions for creating andrecording the loan transactions. The simplest way is to give loan to any partyby charging some interest and recording that loan as an asset in the balancesheet. Other option is to sell the loan to third party by charging some fees ofbrokerage. This provides several advantages to financial institutions, byselling the loans they can transfer the credit risk to other party, reduce theliquidity risk by removing those loans from balance sheet and can meet thereserve requirement, generate more loans and charge more fees or earn interest.Another reason for selling the loan is to get rid of lower yielding assets inorder to make room for higher yielding assets when interest rates rise. Butthis also put some disadvantages, selling the loans may affect customerrelationship, customers may take negative view of having their loan sold toanother party, there can be fraudulent activities and results in legal concernsand in greed of incentives the quality of loan may be affected.Theloans can be sold in different ways: Ø Byparticipations lenders can sell part of loan to other party and have sharedrisk and monitoring cost.
Ø Sellloans to other parties but keep the servicing rights to themselvesØ Sellboth the debt and the servicing rights to other partyØ Sellingthe loans by means of securitization”Securitizationis a financial arrangement that consists of issuing securities that are backedby a pool of assets, in most cases debt. The underlying assets are”transformed” into securities. The holder of the security receives income fromthe products of the underlying assets.” Theentity that originally holds the assets (the originator) initiatesthe process by selling the assets to a legal entity, an SPV (Special PurposeVehicle), specially created to limit the risk of the final investor via theissuer of the assets. Then, depending on the situation, the SPV either issuesthe securities directly or resells the pool of assets to a “trust” that, inturn, issues the securities. The typical structure of securitization isgiven in Exhibit 1.Themajor assets that can be securitized are mortgages, auto loans, leases, creditcard debt, a company’s receivables, royalties and other future cash flowsecurities.
The securities that are backed by pool of mortgages are calledmortgage backed securities (MBS) and the securities that are backed by otherassets except mortgages are called asset backed securities (ABS).History of MBS and ABSTraditionallymortgage loans have originated in transactions between individual borrowers andlenders, typically depository institutions. Insurers and other institutionalinvestors had historically been inactive in the residential mortgage market,holding only 13% of residential mortgage debt outstanding in 1970. Investorshad been reluctant to purchase “whole loans” because of the cumbersomedocumentation required to transfer title to individual loans and the relativeilliquidity of the whole loan market. Instead, residential market capital hadbeen provided by thrift institutions and commercial banks who originated,serviced and funded fixed rate mortgages by keeping them on their balancesheets. The range of loan types was also limited. The key vulnerabilities ofdepository institutions were exposure to high default rates in local marketsand an interest-rate mismatch between short-term deposits and long-termfixed-rate mortgages.
So in order to boost the economy government took manyinitiatives to increase the home ownership. Two government sponsoredenterprises (GSE) were created Fannie Mae in 1968 and Freddie Mac (Federal HomeLoan Mortgage Corp) in 1970, while retaining Ginnie Mae (Government NationalMortgage Association) as a government agency, these agencies were charged toprovide broader and more stable sources of capital to the residential mortgagemarket and together, these institutions created a secondary market formortgages during 1970s, a broad range of investors, including insurancecompanies have expanded their involvement in this market.Followingthe growth and benefits of MBS, Asset backed securities (ABS) were evolved in1980s.
ABS enable depository institutions, finance companies, and othercorporations to raise cash by borrowing against assets and remove those loansfrom their balance sheet, transfer the risk and develop new sources of capital.Types of MBSPass-through securitiesi introduced in 1970s, were adramatic innovation in the secondary mortgage market. By combining similarloans into pools, the government agencies are able to pass the mortgagepayments through to the certificate holders or investors. This change made thesecondary mortgage market more attractive to investors and lenders alike.Investors now had a liquid instrument and lenders had the option to move anyinterest rate risk associated with mortgages off of their balance sheet. Andthey just charge their service fee. This provided them with new sources of fundand bridge the gap between demand and supply for loans.
Growthin the pass-through market inevitably led to innovations especially asoriginators sought a broader MBS investor base. In response, Fannie Mae issuedthe first collateralized mortgageobligations (CMO)iiin 1983. , CMOs redirect the cash flows of trusts to create securities withseveral different payment features. The central goal with CMOs was to addressprepayment risk—the main obstacle to expanding demand for pass-throughs.Prepayment risk for MBS investors is the unexpected return of principalstemming from consumers who refinance the mortgages that back the securities.Homeowners are more likely to refinance mortgages when interest rates arefalling. As this translates into prepayment of MBS principal, investors areoften forced to reinvest the returned principal at a lower return. CMOsaccommodate the preference of investors to lower prepayment risk with classesof securities that offer principal repayment in order of maturity.
Most CMO series included a discountzero bond or Z-bond as the longest maturity class. Interest on Z-bond wasaccrued but not paid, until all previous maturity classes had been fullyretired. Interest accrued in this manner was applied to principal payments onthe shortest maturity class outstanding. Although number of MBS have beencreated but these both types have dominated the market.
Types of ABSThere are different typesiiiof asset backed securities such as homeequity loans which are like mortgages but the difference is that itsborrowers usually does not have good credit rating and are not able to getmortgages, auto loan ABS a type ofamortizing asset usually backed by car, Creditcard receivable ABS are a type of non-amortizing asset ABS, because they donot have scheduled payment amounts and the composition of the pool can bechanged and new loans can be added. Collateralized debtobligations (CDOs) is a well-known type of structured asset backedsecurities. It is an organizedfinancial product that pools together cash flow-generatingassets and repackages this asset pool into three types of tranches thatcan be sold to investorsiv.
The senior tranche is more secure with having higher credit ratings thus payinglower coupon rate, they have first priority on the collateral in the event ofdefault, and the mezzanine tranches have moderate ratings, risk as well ascoupon, while junior tranches have low credit ratings thus paying higherreturns to compensate high default risk as in the event of default firstly theloss will be borne by this tranche holders.Securitizationin PakistanPakistanwas little late in catching up the securitization mode of financing. InNovember 2002 after so many requests from financial institutions State Bank ofPakistan issues guidelines of securitization through SPV for banks, developmentfinancial institutions (DFIs) and other parties. Thesecuritization processv inPakistan arises when any SPV raises funds by the issue of Term FinanceCertificates (TFCs) or any other instrument with the approval of SECP, for suchpurpose and uses such funds by making payment to the originator or through suchprocess acquires a property, or right in the receivables or other assets in theform of actionable claims. MBS in PakistanPakistan is lagging behind Asian countries inhousehold loans due to delayed enactment of non-judicial foreclosure laws. Creditto households accounted for less than 20 percent of gross domestic product inPakistan in 2015 which is very less compared to other Asian countries.
In Pakistan, banks are confronted by various hurdlesrelating to recoveries –ranging from specific legal constraints to broaderissues that have societal and cultural origins; thus, lending to households hasnot lived up to its potential in the country, compared to other Asian nations.”Historically, in addition to a weak valuation mechanism for real estate, legalglitches faced by commercial banks in exercising their right to collateral havebeen one of the major restrictive factors in Pakistan,” according to a researchconducted by two-member research team of the State Bank of Pakistan on ‘BankCredit to private Sector, A critical Review in the Context of Financial SectorReforms. In the absence of a strong non-judicialforeclosure framework in the country, it took a huge amount of time and moneyfor the banks to take possession of, and sell the collateralized propertiesupon borrowers’ default.