Securitization

Until recently, financial intermediaries were the only means to channel funds from national capital markets to smaller local ones. Securitization, however, now allows borrowers to enter capital markets directly. In this procedure pools of loans typically are aggregated into pass-through securities, such as mortgage pool pass-throughs. Then, investors can invest in securities backed by those pools. The transformation of these pools into standardized securities enables issuers to deal in a volume large enough that they can bypass intermediaries. We have already discussed this phenomenon in the context of the securitization of the mortgage market. Today, most conventional mortgages are securi-tized by government mortgage agencies.

Another example of securitization is the collateralized automobile receivable (CAR), a pass-through arrangement for car loans. The loan originator passes the loan payments through to the holder of the CAR. Aside from mortgages, the biggest asset-backed securities are for credit card debt, car loans, home equity loans, and student loans. Figure 1.2 documents the composition of the asset-backed securities market in the United States in 1999.

Securitization also has been used to allow U.S. banks to unload their portfolios of shaky loans to developing nations. So-called Brady bonds (named after Nicholas Brady, former secretary of the Treasury) were formed by securitizing bank loans to several countries in shaky fiscal condition. The U.S. banks exchange their loans to developing nations for bonds backed by those loans. The payments that the borrowing nation would otherwise make to the lending bank are directed instead to the holder of the bond. These bonds are traded in capital markets. Therefore, if they choose, banks can remove these loans from their portfolios simply by selling the bonds. In addition, the United States in many cases has enhanced the credit quality of these bonds by designating a quantity of Treasury bonds to serve as partial collateral for the loans. In the event of a foreign default, the holders of the Brady bonds would have claim to the collateral.

Figure1.2 Asset-backed securities outstanding by major types of credit (as of December 31, 1999).

Credit Card Receivables $320 B

Other $130 B

Other $130 B

Home Equity $142 B

Auto Loans $87 B

3.2% Student Loans $24 B Total $744 Billion

Source: Research, The Bond Market Association, March 2000.

Manufactured housing $40 B

Home Equity $142 B

Auto Loans $87 B

3.2% Student Loans $24 B Total $744 Billion

Source: Research, The Bond Market Association, March 2000.

Manufactured housing $40 B

20 PART I Introduction

When mortgages are pooled into securities, the pass-through agencies (Freddie Mac and Fannie Mae) typically guarantee the underlying mortgage loans. If the homeowner defaults on the loan, the pass-through agency makes good on the loan; the investor in the mortgage-backed security does not bear the credit risk.

a. Why does the allocation of risk to the pass-through agency rather than the security holder make economic sense?

b. Why is the allocation of credit risk less of an issue for Brady bonds?

CONCEPT CHECK ^ QUESTION 5

Figure 1.3 Bundling creates a complex security.

3,000,000 Shares The Chubb Corporation

$4.25 Convertible Exchangeable Preferred Stock

(Stated Value $50 Per Sham)

The $4.20 Convertible Exchangeable Preferred Stuck l.tbf "Preferred Stock"), 41 -0(1 par value, i>f The Chubfr Cuipfl ration {the "Corporation") ottered hereby is convertible at the option oi the holder at Anytime, unless previously Tuitairrwcl, intn Cum muri Siin:k, SI. Oft par value, of LheCorprraLioii (ibe "Common St(ipi"i af thu rate of .722 shares of Common SLoek for each share of Preferred Stock (equivalent lo a conversion priw oi ftif}.35 per snuri:}, svhjecrt tu adjustment untrer efcrtsicj uüüdlt tools. C)q March 25, lftB!3_ Llic IüjI repo.'Led sale price of Lbe Common Stock on the New York Stock Exchange v.-»* (57''-i pei share.

Ti i FrrlVrri :il fjhjrlr almi is cxL-htiii¿cubic in whole At the sole cptioii of the Corporation oh any dividend payment date boy ruling Apiil l.i, lHfiB fur I lit: Cmpocatiucis ft'.-'ü'A Conv ertible Subordinated Debenture Mm: Aprjl 15, 2C110 ft hi: "rtatafctu res"! ai the rale ol 8ISI) principal amount of Debentures lor each share oi Preferred Stock. See "Descriptinii ot IJcbeuhina"'.

'lljt Preferred SLoek is redeemable for cash at -any tirje. in whole or >™ part, at the :iption uf the Corporattoji at redemption prices declining to J30 on April 15. 199.5. pins accrued unri unpaid dividends to the redemption date. IJowevur, the Preferred Stoek w rial redeemable prior to April 15. LSfifl uiilfSM [lie dosing piice of the Common Stuck cm "the New Turk Stuck E.iobiingc shal; htjvr equal «1 or exceeded 140^ of the then effective ounvFixltiii prut: per aI-ihth: fur lead 21; lxxmxüjIIve trailing days pndiog w iL bin S days prior lo the nolicc o: redemption. Dividend* on the Preferied Stuek will be cuiriuiative and si? payable quarter! v on Jartuarv 15, April l.i, Juh' 15 and October 15, The initial dividend will be payable on July In. liRS anil will sua: me fruin I lie chic of inMiacoi:. See "I Jener ¡¿iLiou of Preferred Stock",

Ap^MüflHüii will he m-jde Lo llsl Lhe Preferred SLodk on the New ¥<wtStock Exchange.

THESE SECURITIES HAVE NOT BEEN APPROVED Oil DISAPPROVED UY THE SECURITIES AND FSCII.WTiE COMMISSION NOR HAS THE COMMISSION' PASSFn I: PON THE-: ACCl.HACV OR ADEQUACY OF THIS PROSPECTUS, ANY HKPltKSE N'l ATI I) N It) THL CONTHAHI IS A CRIMINAL OFFENSE,

Initial L>lk- Underv-iJii LI44 Wm^&th I o

OFl'errii^ Piice Diiuiuutt Conww alien,; 11

[I) Before deducting expenses payable by the Corporation e-sHinaterd aI $.îflO,l)Otl.

The shares of I'rcfmcd Stuuk are offen:*! Mwerally by ihe Underwriters, as juxcLüed herein, subjwt (r; receipt anc acceptance by ttiera and subject tu their ri^hl to lejwl uny order in wIioIa or in j)a;L_ II is enpeeted that gurtiEiiS*« for Lbc .iharfA of Preferred Stock will be ready lor delivery at the riffic*» of Goldman, Sach s & Co., New Ybrk, New York on or about April i, 10S5.

Goldman, Sachs & Co,

The date of tbis Pruspeetus i.S March äfi, 19P5.

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