SECURITIZATION ECONOMICS: THE COST OF FUNDING
Category: Risk Management in Banking
The analysis below uses an example. Its purpose is to determine the costs and benefits of the transaction and to assess the impact on return on capital. There are three steps: the description of the original situation before securitization; the calculation of the funding cost for the originating bank; the funding cost through securitization. The impact on the return on capital (Return On Equity, ROE or RaRoC) follows in the next section.
Capital Savings
In this case, we skip the determination of capital saved and simplify it by using a shortcut making capital saved proportional to amount securitized. This is valid for regulatory capital under the old scheme. The new scheme requires assessing the economic capital savings with more risk-sensitive measures. With economic capital, only portfolio models provide capital savings, given correlations and resulting risk contributions. The relationship with size of securitization is no longer proportional, because the risk contribution is not in general. However, once economic capital savings are assessed for different securitization scenarios, the same analysis as below provides the final effect on return on capital. The only change from the analysis below is in substituting the economic capital saved for the value calculated with the above shortcut. The capital saving calculation in the example uses a 4% forfeit applied to the amount sold by the seller to the securitization vehicle, in line with the old regulatory scheme.
The Original Balance Sheet
The bank has a portfolio of mortgaged loans. The regulatory weight for such assets is 50%. The outstanding balance is 10 000. The capital is 400, which is equal to the regulatory capital required, 8% x 0.5 x 10 000. The cost of equity is 25% before tax. We assume that this market required yield on stocks is equivalent to minimum accounting ROE of 25%, an assumption valid under specific conditions. The capital includes subordinated debt yielding 10.2%. The other debt cost is 10%. The bank considers a securitization, for an amount of 1000. The portfolio of loans has a theoretical duration of 10 years, but its effective duration is 7 years due to early prepayments. The return net of statistical losses and direct operating costs is 10.20%.
The capital saving with our shortcut is simply 4% x 1000 = 40, 20 of equity and 20 of subordinated debt. The economic capital saving is the marginal risk contribution of the subportfolio of assets sold, as evaluated with a portfolio model. The 4% shortcut is convenient without loss of generality. It should be evaluated as above. The resulting economic capital saving would depend on which assets the sellers select and how they correlate to the existing portfolio.
The Structure
The structure in Table 60.1 is a simple example with only two classes of notes: junior and senior. The junior securities have a BBB rating due to their risk. The senior securities are rated AAA. Given such ratings, the required return for junior securities is 10.61%, and that of senior securities is 9.80%. The latter cost less than the balance sheet debt, that pays 10%. However, to obtain a BBB rating, the rating agency imposes that the junior securities represent at least 10% of the total securitized amount. The direct costs include the initial cost of organizing the structure plus the servicing costs. The yearly servicing cost is 0.20% of the securitized amount.
With an amount of 1000 securitized, the senior securities fund 900 and the junior securities fund 100. The outstanding balance of the loan portfolio of the bank drops from
10000 to 9000. The weighted assets are 0.5 x 9000 = 4500. The capital required against this portfolio is 8% x 4500 = 360. With an initial capital of 400, the transaction saves and frees 40 for expansion (Table 60.2).
The Cost of Funds for the Bank (On-balance Sheet)
The cost of funding is the average cost of all funds, or waccon-BS. The funding structure is capital, 4%, divided into 2% equity at 25% and 2% subordinated debt at 10.20%, and 96% debt at 10%. We use book values for weights, which is equivalent to assuming that debt is at par. The weighted cost of funding is:
waccon-BS = 96% x 10.00% + 8% x 50% x (25% x 50% + 10.20% x 50%) = 10.304%
This average rate is consistent with the 25% before tax ROE. If the assets do not generate this required return, the ROE adjusts. Since the assets generate only 10.20%, lower than the above target of 10.304%, the actual return on equity is lower than 25%. The return actually obtained by shareholders is such that the average cost of funds is identical to the 10.20% return on assets (ROA%). Writing that this effective ROA equates to the average cost of funding on-balance sheet determines the effective ROE%:
ROA% = 96% x 10.0% + 8% x 50% x (ROE% x 50% + 10.20% x 50%)
After calculation, the effective ROE is 19.800% before tax, lower than the 25% required return.
In theory, it would be impossible to raise new capital since the portfolio return does not compensate its risk. Therefore, the bank cannot originate any additional asset without securitization. In addition, the securitization needs to improve the return to shareholders from the remaining portfolio of assets.
The Cost of Funding through Securitization
The potential benefit of securitization is a reduction in the cost of funding. The cost of funding through securitization (waccsec) is the weighted cost of the junior securities and of the senior securities, plus any additional cost of the structure (0.20%). The cost of senior securities is 9.80% and that of junior securities is 10.61% (ignoring differences in duration). The weighted average is the waccsec before operating costs:
90% x 9.80% + 10% x 10.61% = 9.881%
The overall cost of securitization is this weighted average plus the yearly 0.20% of structure costs averaged over the life of the transaction. This overall cost becomes the all-inclusive weighted cost of funds through securitization, or:
waccAI-sec = waccsec + 0.200% = 9.881% + 0.200% = 10.081%
From this finding, we draw some preliminary conclusions:
• The overall cost is less than the cost of funding on-balance sheet, which is 10.304%. This is sufficient to create a financial benefit for securitization.
• In addition, the cost of funding through securitization is lower than the portfolio yield. Therefore, selling the original loans to the structure that issues the securities generates a capital gain. This gain improves the profitability of the bank.
• However, the change in ROE or RaRoC remains to be quantified.
In general, not all effects will be positive because it could be that the cost of funding through securitization falls below the cost on-balance sheet, but is still higher than the portfolio yield, thereby generating a loss when selling the assets to the SPV. Even if the cost of funding through securitization was higher than on-balance sheet, there would be room to improve the sellers portfolio RaRoC because of capital savings. Hence, this example is not representative of all possible situations.