How Is Structured Finance Doing?
Structured finance has been vilified as the culprit behind the worst recession since the Great Depression. Every aspect of its design has been disparaged: faulty underlying loans, bad incentives for originators, dubious AAA ratings and mispriced risks. Did the Great Recession spell the end of structured finance or is it making a comeback?
Structured finance securities are debt instruments collateralized by a securitization pool of loans. The pool’s cash inflow supports the cash outflow to pay the securities off. The securities are divided into multiple tranches characterized by their seniority. The most senior tranche is paid first; the second senior gets paid only after the first senior is paid and so on. Investors buy the tranche that best fits their risk appetites.
We look at three products that fall under the general heading of structured finance: mortgage-backed securities (MBS), asset-backed securities (ABS), and collateralized debt obligations (CDO). MBS are backed by mortgages, ABS are backed by assets such as credit card loans, auto loans, student loans, and the like, while CDO are backed by investment-grade loans, high-yield loans, other structured finance products, and the like.
U.S. mortgage loan originations and MBS issuance began to increase rather sharply in 2000 and peaked in 2003. They dropped off pretty sharply in 2004, rose slightly in 2005, and then gradually dropped off until they reached their bottom in 2008. They are still hovering around that bottom now, with no meaningful recovery relative to the 2003 peak. The strong correlation between the two series is expected, since mortgage origination determines the amount of loans that can be securitized.
The series’ levels gives us an idea about the health of the mortgage market in general. To examine the health of the securitizing market, it is more useful to look at the mortgage securitization rate, the proportion of loans securitized relative to total loans originated.
The securitization rate has increased pretty drastically over the past 10 years. It had two periods of increase, with one period of slight drop, slight rise, and stagnation.
The first increase was from about 50 percent in 2000 to about 67 percent in 2003, an increase of about 34 percent. The second increase started around 2006 from about 68 percent to almost 85 percent in 2010, a 25 percent increase. Exactly how much of a role private demand, GSE policies, and Federal Reserve MBS purchases played in each episode is a matter of conjecture. No matter what the reasons are, the solid increase in the securitization rate and the current elevated level (around 85 percent) shows that the mortgage securitization rate remains strong despite the decline in mortgage loan originations and MBS issuance.
Next on our list are ABS. The total volume of ABS issued in the United States increased gradually from 2000 to 2003, rising around 13 percent in total. It then fell slightly before climbing to a peak of $293 billion in 2005. A slight drop followed with another peak in 2007 of $292 billion. In 2008 volume fell sharply by almost 54 percent. Since then, the market has continued to zigzag, experiencing a slight rise in 2011.
The two largest asset classes of ABS are credit card receivables and auto loans. Because we lack the necessary detailed data, we plot instead ratios to total outstanding debt. The ratio of outstanding auto loan ABS to total outstanding auto loan debt has been gradually declining. This trend started before the latest recession. It gradually decreased throughout our timeframe. The ratio of outstanding credit card receivables ABS to outstanding credit card debt peaked in 2003 and has gradually slid since then. The ABS securitization rate seems to have been undergoing a gradual decline throughout the last decade.
The most notorious of structured finance products is the CDO. Total global CDO issuances increased gradually from about $68 billion in 2000 to about $87 billion in 2003. A spectacular growth ensued afterwards from $87 billion in 2003 to about $520 billion in 2006. A slight decline followed in 2007 to $481 billion. Afterwards the market almost completely collapsed, falling to $61 billion in 2008 and only about $4 billion in 2009. In 2011 there was a slight uptick.
New CDO issuances in 2011 were about $14 billion, nearly doubling the amount from the year before but still very far from the 2006 pre-recession peak. The recent uptick has been driven mostly by CDOs that are long-term and collateralized mostly by high-yield loans.