Goldman-Sachs, Securitization

Mortgaged backed securitizations. The very name of these financial instruments most likely brings up bad memories for the average citizen in the United States. This last week we were visited by Peter Christensen, a VP in Goldman's BHC Regulatory Capital Group, and we learned more about what structured finance is all about.

A structured finance is a bond that is backed by cash flows made by a specific asset. You can securitize anything with a cash flow, residential and commercial mortgages, credit card receivables, and auto loans. You can choose how risky or reserved the structured finance bonds are by what you decide to securitize to make the structured bonds. A more advances form of a structured finance is called a collateralized debt obligation (CDO). This is where you take a lot of securitization bonds and securitize them into one bond.

The reason why it is possible to make a structured finance bond is a principle called “bankruptcy remote.” To achieve this, banks created special purpose vehicles to buy the loans from the banks to keep the assets safe from the chance that the banks go bankrupt before the bond is matured. This also allows the investors to focus on the bond risk alone, and not the risk that is tied to the bank.

Securitization is a way for the banks to raise capital for banks without issuing new debt or equity. This allowed the banks to be able to make more loans with cash that was on hand. In 2006 banks had been securitizing tons of home mortgages into these bonds. Most of these bonds held mortgages in California, Arizona, and Florida, where the economy of the state relied heavily on the health of the housing industry. When the bubble burst in 2007 the bonds started to go bad. No one was able to pay their mortgages, so the bonds did not receive the cash flow that was required.

The reason why the securitization bonds were so popular is because to the banks they seemed like a good investment to reinvest their money in. They felt like they understood the risks associated with the mortgage backed securities. Due to the traunching of securities, where there is a rating level to the risk you are taking, banks were able to make huge returns by reinvesting in the riskiest unrated class. Traunching is a rating system, the highest grade is the AAA ranking, followed by AA, A, BBB, BB, B, Unrated Class, where the AAA rating gets paid a lower interest rate for the money invested. The unrated class gets the highest interest rate, but when the cash flow starts to fail, their investment is the first to go. When people do not pay their mortgage or auto loan, then the unrated class, does not get paid, then B, BB, BBB, and so on until no one gets a return on their investment. In 2007 so many loans were defaulting that AAA investments were starting to drop off, it did not help that most investors had an AAA rating. Businesses that had investments in these securities were required by law to sell the investment. With the saturation of securities, and the declining price, a perfect storm was created in the economy.

There were a few companies that saw the storm on the horizon. A man at Deutsche bank was able to get on the other side of the transactions and made millions of dollars for his company. Also at Goldman – Sachs, who fair values all of their assets, they were able to see trouble and make money through the bursting bubble.

Securitizations today are more diverse and hopefully will not run into the same problems that were seen five years ago. Peter Christensen feels that to keep bank interest rates low, it is important that banks start using securitized bonds again. “The Fed cannot keep their interest rates at a minimum forever.”