Asset Indivisibility, Security Design and Asset Quality


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Asset Indivisibility, Security Design and Asset Quality


Indivisible assets sold to SPVs are 'lemons. ... Market for Lemons (Akerloff, 1970) ... Are REMIC PCs lemons? ... – PowerPoint PPT presentation

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Title: Asset Indivisibility, Security Design and Asset Quality

Asset Indivisibility, Security Design and
Asset Quality
  • Chris Downing, Dwight Jaffee and Nancy
  • Rice University and University of California,
  • CQA Conference 2006

Purpose of the Paper
  • Model and provide empirical evidence for
  • The quality of assets held by special purpose
    vehicles (SPVs).
  • Model prediction
  • Indivisible assets sold to SPVs are lemons.
  • Empirical findings support prediction for one
    asset class
  • Freddie Mac Participation Certificates (PC) sold
    to REMIC SPVs are significantly lower quality
    than PCs not sold to REMICs.
  • Provide reduced form empirical evidence.
  • Provide structural modelling evidence REMIC PCs
    exhibit systematically more efficient option
  • Provide implied valuation differentials REMIC
    PCs are lower value.

What is a low quality PC?
Prior Theoretical Literature
  • Market for Lemons (Akerloff, 1970)
  • Agents possessing private information about true
    asset quality face problems of market breakdown.
  • Signaling literature (Leland and Pyle,1997
    Nachman and Noe, 1994 Myers and Majluf, 1984
    Demarzo and Duffie, 1999 Demarzo, 2005)
  • Informed agent should design a security
    representing a fractional claim on the asset
    retain residual claim as a credible but costly
    signal of true asset quality.
  • Assume assets are divisible.
  • Focus on equilibria for interior solutions, where
    fractional asset sales are greater than zero or
    less than one.

Problem for Applications to Securitized Asset
  • Asset divisibility is at odds with legal
    restrictions on securitized asset markets asset
    sales to SPVs must be bankruptcy remote from
    asset sellers.
  • Bankruptcy remoteness requires true sales (FAS
  • Future claims back to asset sellers must be
    legally extinguished.
  • Implications
  • Assets sold to SPVs are not divisible.
  • Corner solution equilibria are relevant where
    the fraction of assets sold must be one or zero.

Demarzo (2005) Signaling Model
  • Assumes
  • Assets are infinitely divisible share q is sold,
  • Originator is informed and faces a discount rate,
    d , that exceeds the market rate, 1 gt 1/(1r) gt
  • Payoff on asset i
  • Wi is private information and Zi is idiosyncratic
    risk, EZi Wi 0.
  • Worst case outcome for Wi given by wi0.
  • Expected payoff to the informed intermediary

Demarzo (2005) Signaling Model
  • Suppose originator anticipates a market demand
    curve given by P(q)
  • Rational inference on the part of investors leads
    to an equilibrium demand function that is
    downward sloping a higher quantity is expected
    to be sold when the outcome is poor.
  • Originator chooses a quantity to sell to maximize
  • As long as wi0 gt 0, a unique separating
    equilibrium exists where the market clearing
    price is

But Securitized Assets are Indivisible
  • Bankruptcy remoteness implies asset
  • Asset indivisibility implies that assets are
    either entirely sold to an SPV (q1), or entirely
    held on the originators balance sheet (q0).
  • Thus, the equilibrium price is given by the
    worst-case outcome
  • We are back to the Akerlof prediction assets
    sold to SPVs are lemons.

Why this is an important issue?
  • Issuers of mortgage-backed securities (MBS) and
    other asset-backed securities (ABS) account for a
    rapidly growing share of the credit market assets
    held in the financial sector.
  • At the end of 1980Q1, these special-purpose
    vehicles (SPVs) accounted for just 3 of credit
    market assets held in the financial sector.
  • By the end of 2005Q3, their share had risen to
  • ABS issuers have been growing particularly
    rapidly since about 1995.
  • Are asset sales to SPVs a market response to the
    problem of providing liquidity to originators of
    indivisible assets of low quality?

U.S. Credit Market Asset Holdings
Source Federal Reserve Board, Flow of Funds
Accounts of the United States, Table L.1, Credit
Market Debt Outstanding, Lines 35, 54, 55.
Why focus on Freddie Mac PCs and REMIC?
  • In general, it is difficult to test theories of
    markets for lemons because the causative factor
    is asymmetric information.
  • Thus, cannot observe the key quality variable
    that determines price.
  • Advantages of securitized residential mortgage
  • Private information held by mortgage originator
    is unobservable ex ante
  • Private information related to borrower choices
    on mortgage menu points (horizon) and
    transactions costs.
  • Borrower option exercise behavior is revealed ex
  • Freddie Mac monitoring generates
  • Detailed performance data
  • Means to track whether a given PC pool is sold to

Value of Mortgage Liability and Option Exercise
  • The mortgage liability is the value of the
    underlying bond less the value of the joint
    termination options
  • Prepayment is optimal if
  • Ft remaining principal balance
  • Xp prepayment transaction costs
  • Default is optimal if
  • Ht house prices,
  • Xd default transaction costs

Testable Model Predictions
  • Is option exercise behavior more efficient for
    REMIC PCs than for PCs not sold to REMIC?
  • Are REMIC PCs lemons?
  • Does the fair market value of REMIC PCs reflect
    these relative efficiencies?
  • Are these statistically and economically
    important differences?

PC Sales to REMIC SPVs
  • Step 1
  • Mortgage originator devises a contract menu to
    screen for credit quality and prepayment
  • Step 2
  • Originator securitizes whole mortgages for
    Freddie Mac PCs with same collateral lender
    selects lowest quality subject to the GSE-imposed
  • Step 3
  • Originator selects whole PC pools for sale
    through the TBA market.
  • Are indivisible sales (we verified in data)
  • Prepayment quality known to originators but not
    to forward contract investor
  • TBA is anonymous market repeated game is
  • Step 4
  • PCs sold to REMIC by TBA investors (Investment
    and commercial banks)
  • Key prediction PCs sold to REMIC SPVs will be
    lemons relative to PCs not sold to REMIC (this we

The Freddie Mac PC Time-line
Mortgage Origination
PC Origination
TBA Delivery
REMIC Origination
Median 2 mths IQ Range 2 mths
Median 1 month IQ Range 2 mths
Testing the Prediction
  • Consider whether the REMIC status of a PC pool
    affects terminations.
  • Data
  • Track all Freddie Mac PC pools originated between
    1991-2002 have pool-specific performance and
    origination data (approx. 70,000 pools).
  • Know identity of PCs sold to REMIC SPVs.
  • Interact REMIC PC indicator with measures of
    interest rate movements and other controls.

Approximate path of interest rate changes
  • Summed Treasury Deviations variable cumulates
    monthly deviations in 10-year Treasury rates from
    rate at end of 3rd month after pool origination.

Summed Treasury Deviations variable sums these
two areas in this case.
Interest Rate
Empirical Results
Dependent Variable is the cumulative unscheduled
terminations starting from PC origination date
(Standard errors in parentheses)
Other variables not shown Coupon, quarterly
time dummies, originator dummies, seasoning
dummy, cumulative unscheduled terminations from
mortgage origination to PC origination,
cumulative house price changes.
Does PC REMIC Status matter for Pricing A
Structural Analysis
  • Solve a structural two-factor valuation model
    (Downing, Stanton, and Wallace (2005)) with
    embedded option exercise policies for the
    borrowers prepayment and default options.
  • Controls for term structure, house price
    dynamics, transaction costs, heterogeneity.
  • Condition the borrowers optimal exercise
    policies using an empirical optimization scheme
    to obtain for REMIC and nonREMIC PCs
  • Relative background hazard rates,
  • Relative seasoning component for prepayment and
  • Relative distributions for transaction costs
  • Strike prices for prepayment and default options
    are scaled by a transaction cost distribution.

Relative Prepayment Transaction Costs, Xip
  • Assume
  • Borrowers are heterogeneous different borrowers
    face different transaction costs.
  • Prepayment optimal when
  • Assume Xip is drawn from a beta distribution,
    R REMIC indicator

Relative Hazard Functions
  • nonREMIC PCs
  • DPt dummy variable that is one when the
    prepayment option is in-the-money, zero
  • DDt dummy variable that is one when the default
    option is in-the-money, zero otherwise.
  • ß1, background hazard,
  • ß2,ß6 seasoning component when Dt and Pt are
  • ß3 coefficient on indicator variable, R1, for
    REMIC Pools

Fixed Default Transaction Cost, XiD
  • Default optimal when
  • Assumed to be fixed at 5 of house value, H(t).
  • Needed for computational tractability
  • Defaults are rare events of lt 1.

Summary of Structural Model Results REMIC PC
More Efficient
  • Background termination rates .1 of pool balance
    per month.
  • Seasoning effects on prepayment REMIC PC more
  • 1 Year 5 Years
    10 Years
  • REMIC 6.2 6.9
  • Non-REMIC 6.3 6.8
  • Transaction cost differentials
  • Mean
  • REMIC 14.12
  • Non-REMIC 16.39

Relative Pricing Results REMIC PCs Lemon
  • Do market prices for PCs reflect the systematic
    differences between REMIC and Non-REMIC pools?
  • In other words, do PCs destined for REMIC pools
    carry a discount relative to other PCs?
  • We examine the average speed difference between
    REMIC and non-REMIC pools over the period.
  • Use coupon and 10-Year Rate matched REMIC and
    NonREMIC PCs
  • Valuation discount for REMIC PCs
  • 0.39/100 discount, on average.
  • About 3-5bp in terms of YTM.

  • Theoretical prediction that SPVs finance lemons
    is not rejected by analysis of REMIC PC
  • Reduced form models of relative termination
  • Structural model estimates of prepayment option
  • Lemon-ness of REMIC PCs produces significant
    price differentials according to our structural
  • But exactly how efficiently REMIC lemons are
    priced in the capital market remains an open
  • Next step Examination of link between SPV
    financial structure and asset quality.