agency conflicts, asset substitution, and securitization yingjin hila gan (lehman brothers)...
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Agency Conflicts, Asset Substitution, and Securitization
Yingjin Hila Gan (Lehman Brothers)
Christopher Mayer (Columbia Business School & NBER)
June 2007
Motivation
As of end of 2006, the ABS (asset backed securities)
market totaled $7.6 trillion*
About ½ of mortgages, ⅓ of trade receivables, and ¼ of
consumer credit are securitized *
Little research on how securitization structures perform
Securitizations face some of the same organizational
conflicts as corporations do
* ABS and mortgage pools, Federal Reserve Flow of Funds, Tables L1, L4, L125, L126
Private ABS outstanding, by type of collateralasset class # of deals amt oustanding(mm$)
Home Equity 2,596 1,113,871.66Residential MBS 2,731 902,821.62Commercial MBS 1,036 568,665.34Automobile Loans 706 561,191.50Credit Cards 889 518,119.15Student Loans 84 109,969.67Equipment Lease 261 96,710.38Manufactured Housing 272 95,556.87Dealer Floorplans 98 92,958.97CDOs 248 70,403.39Automobile Lease 46 48,292.97Other Consumer Loan 116 26,631.28Recreational Vehicles 36 11,526.64Truck Loan 19 10,546.88Franchise Loans 45 9,397.57Motorcycle Loan 27 7,285.76Small Business Loan 28 3,967.44Marine/Boat Loan 11 2,855.25Time Share Loan 10 2,066.79Trade Receivables 11 1,968.05Insurance Premium Loan 3 1,146.30Other 9 250Total 9,282 4,256,203.48
CMBS Market is Growing Quickly! Volume of CMBS New Issues
1990 - 2006-Q1*
$0
$50
$100
$150
$200
$250
$300
1990 1992 1994 1996 1998 2000 2002 2004 2006*
Year
$ B
illi
on
s
Source: Commercial Mortgage Alert*Quarter 1 Multiplied by 4 to reflect year 2006
What is a Mortgage-Backed Security? Mortgage is approved by an originator Underwriter purchases mortgages
Pools mortgages in a trust Trust issues bonds backed by the underlying principal and
interest payments Underwriter sells multiple classes of bonds(senior-
subordinated structure) Earns difference between cost of mortgages and value of
bonds
Investors purchase securities Servicer, trustee, special servicer manage structure
Borrowers (Mortgagors)
Originators (Sellers)
Depositor (SPV)
Trust (Mortgage
Pool)
Underwriter (Investment Bank)
Investors Divided into
Tranches
Rating Agency
Custodian
Trustee
Master Service
r
Special Servicer
Primary Servicer
Loan Proceeds
Loans
Loans Offering Proceeds
Loans Certificates
Delivery of Loan Documents
Confirmation of Document Delivery
Offering Proceeds
Certificates
Certificates Offering Proceeds
Often purchasers of first class bonds/Controlling Class representative
Pooling and Servicing Agreement
Property Inspection
Monthly P & I
Monthly P & I
Property Inspection
Monthly P & I
Payment on Certificates
Typical CMBS Structure
A Typical Multi-Tranche CMBS Deal
Los
ses
Paym
ents
Example: $1 billion issuanceClass Rating PrincipalA-1 AAA 150 mmA-2 AAA 250 mmA-3 AAA 300 mmB AA 50 mmC A 50 mmD BBB 80 mmE BB 60 mmF B 20 mmG unrated 40 mm
Benefits of Securitization
Complete Market: Match risk/return characteristics of securities with buyer preferences
Liquidity: Securitization potentially allows buyer/sellers to more easily trade securities
Transparency: More public information available and easier to value securities
Better legal protections: Stricter cash flow prioritization
Specialization: Possible economies of scale associated with performing individual functions
Organizational Costs of Securitization
Principal-Agent Conflicts: ABS separates ownership and control of assets (versus a vertically integrated lender) Better informed managers may maximize own fees
versus profits of securities holders Managers may not exert optimal effort in identifying and
managing troubled loans and liquidating assets
Asset Substitution: Junior and senior securities holders may prefer different actions ABS divides economic interests into thin tranches The manager may only hold a narrow equity stake
Organizational Costs of Securitization Focus on special servicer (SPS), who performs key
managerial functions in a CMBS securitization Transfer (in conjunction with master servicer): Should a
loan be transferred to costly special servicing? Liquidation: When a loan gets in trouble does the special
servicer wait, renegotiate the loan, or foreclose?
Special servicer earns a monthly fee plus a fixed percentage of loan balances subject to special servicing Incentives to push “too many” loans into special servicing May slow the foreclosure process
Loan becomes delinquent (exogenous event):e.g., Late payment(s) or default on covenants
Loan cures Loan goes to Special ServicingSPS earns additional fees
Renegotiate Loan
LiquidateGreater effort,No more fees
Special servicer makes important decisions
Watch theLoan
Exert effort to decide If the loan is really in troubleand work with borrower to avoid special servicing
How to mitigate agency costs
Special servicer might want to maintain a strong reputation to earn future business Information asymmetries make it hard to monitor
performance Cannot observe effort
Special servicer holds lowest rated security: B-piece SPS becomes residual claimant (owns worst loans) The SPS pays the full cost of placing a loan into special
servicing SPS gets full benefits from efficiently handling troubled
loans What if losses get too large?
Why not always have SPS own B-Piece? Special servicer may be more risk averse than other
investors Specialized skills make it hard for special servicers to
diversify risks Special servicers must be publicly rated and hold capital Exposed to large risks if they hold all of the first-loss
positions (defaults are likely correlated across deals)
Largest Special Servicers
Lennar Arcap
GMAC Banc One
Midland Lend Lease
Orix Amresco
Crimmie Mae Clarion
Why not always have SPS own B-Piece? Asset substitution problem: securitization
exacerbates conflicts between owners of junior and senior tranches If the special servicer owns the B-piece, she may take
additional risks (extend a loan instead of foreclosing) The incentive to take additional risk is bigger when the B-
piece is at substantial risk of being entirely wiped out Similar to the incentives of managers of troubled S&Ls
Typical B-piece represents 3% of less of the nominal balances in a deal
Less than the capital held by many S&Ls in 1980s
Empirical Predictions
Underwriter is more informed than investors; chooses structure to enhance success
High powered incentives are more valuable when: Agent must exert more unobservable effort Monitoring actions by investors is more difficult
H1: The special servicer is more likely to own the B-piece in deals with: Higher expected delinquencies More asymmetric information—proxy with realized
delinquency rates after controlling for observable information
Empirical Predictions
As an agent, SPS is conflicted Earns higher fees for loans in special servicing Exert costly effort to help ensure that only truly risky loans
are placed in special servicing
When SPS owns the B-piece, she is residual claimant Effectively pays fees to herself Realizes losses if she does not manage a loan properly
H2: When special servicer owns the B-piece, she will work to avoid unnecessary transfer of delinquent loans into special servicing
Empirical Predictions
Once a loan is in special servicing, SPS must decide when to liquidate Liquidation locks-in some losses Delaying liquidation allows SPS to earn more fees, but
with greater risk for investors Owners of highly leveraged assets cut back on
maintenance Owners take greater risks with property
Ultimate action of the SPS depends on the extent of potential losses in a deal
Empirical Predictions
H3A: When potential losses are small, the SPS who owns the B-piece will liquidate loans more quickly SPS must exert costly effort to decide when to liquidate Greater fees are effectively paid by SPS SPS realizes any losses
H3B: When potential losses are large, the SPS who owns the B-piece will liquidate loans more quickly Classic asset substitution problem
Empirical Predictions
H4: Bond prices (yields) should reflect the benefits of incentive alignment Yields should be lower on deals in which the SPS owns
the B-piece Yields effects should be most pronounced for the lowest
rated tranches which suffer the greatest losses if the SPS does not perform efficiently
Rating agencies do not consider whether the SPS owns the B-piece in determining ratings Ratings are determined prior to the marketing of the bonds Underwriter cannot guarantee that the SPS will not sell the
B-piece
Potential empirical problems
Do not observe losses, only actions of the agents Unobserved quality of deals: If the SPS is well-
informed, she might only purchase the B-piece in deals with unobserved high quality loans We will show that delinquencies and liquidations are
higher in deals in which the SPS owns the B-piece Bond yields reflect market’s perception of value
We condition on bond ratings to control for expected losses (quality)
Investors should price impact of incentive alignment
Data
Trepp Annual performance data from 1998-2003
Deal and loan level information
Commercial Mortgage Alert Name of B-piece buyer
Initial pricing data and yields for some bonds
Restrict sample to non-agency deals in which we know the name of the SPS and B-piece buyer 357 (out of 839 deals in Trepp)
46,000 loans
Deals, By Year
Year Number of
Deals SPS Holds
B-piece
SPS Not Hold
B-piece
Pct in which SPS Holds B-
piece
Total Issuance
($million)
Avg Deal Size
($million)
Avg # Loans
Per Deal
1993 1 1 0 100% $21 $21 197
1994 4 2 2 50% $1,110 $278 90
1995 18 8 10 44% $5,260 $292 80
1996 25 20 5 80% $11,100 $442 140
1997 31 24 7 77% $24,700 $796 145
1998 43 27 16 63% $50,100 $1,164 210
1999 43 21 22 49% $39,800 $925 232
2000 53 33 20 62% $41,600 $786 130
2001 47 25 22 53% $39,600 $842 124
2002 44 32 12 73% $37,700 $858 105
2003 48 28 20 58% $51,300 $1,069 106
Total 357 221 136 62% $302,291 $847 144
SPS owns B-piece in deals with higher ex-post delinquencies (H1)
Deals in which SPS Does Not
Hold B-piece
Deals in which SPS Holds
B-piece T-stat for difference
Balance ($mil) $819 $864 -0.84
Number of Loans 128 154 -1.38
Loan-to-Value Percent 67.1% 66.4% -1.01
Debt Service Coverage Ratio 1.59 1.57 0.28
Weighted Average Coupon yield 7.58% 7.72% 1.02
AAA Subordination Level 23.4% 22.2% 1.33
% Loans > 30 days delinquent 0.25% 0.34% -1.02
% Loans > 60 days delinquent 0.09% 0.19% -1.90
% Loans > 90 days delinquent 0.39% 0.74% -1.95
% Loans with any delinquency 0.73% 1.95% -2.21
List of Special Servicers
Special Servicer # of Deals
Total Balance ($ millions)
# of Deals in which SPS
Holds B-piece
# of Deals in which SPS Not
Hold B-piece
Lennar 80 $74,600 64 16
GMAC 67 $53,600 55 12
Midland 33 $27,800 2 31
Orix 25 $22,800 4 21
Criimi Mae 24 $23,700 23 1
ARCap 18 $20,500 16 2
Banc One 14 $13,200 6 8
Lend Lease 11 $10,100 7 4
Amresco 10 $9,430 8 2
Clarion 7 $6,850 6 1
J.E. Robert 7 $2,450 5 2
GE Capital 6 $3,260 5 1
First Union 5 $5,370 1 4
Gespa 5 $1,740 0 5
Wells Fargo 5 $3,590 1 4
Total 317 $278,990 203 114
SPS holds B-piece in deals w/low unobserved quality (H1)
Dependent Variable: Deal delinquency rate (% of balance that is delinquent) (1) (2) (3) (4) (5) (6)
SPS owns B-piece 0.92 0.94 0.81 0.82 1.09 1.02 [2.86]** [2.90]** [2.40]** [2.52]** [2.07]** [2.13]**
Loan-to-Value -0.035 -0.047 -0.044 [0.53] [0.60] [0.61]
DSCR -1.77 -2.44 -1.67 [1.66]* [1.75]* [1.32]
LTV is 0.60 to 0.80 -0.34 0.25 -0.03 [0.25] [0.16] [0.02]
LTV > 0.80 -1.12 -2.33 -1.77 [0.75] [1.16] [1.00]
DSCR < 1.2 1.50 0.66 -1.00 [0.92] [0.47] [0.64]
DSCR is 1.2 to 1.6 0.49 0.73 0.52 [1.22] [1.58] [0.98]
Pct fixed rate loans -0.016 -0.017 -0.004 -0.004 [1.30] [1.62] [0.26] [0.26]
Constant 6.06 0.96 10.27 3.05 8.34 2.64 [1.06] [0.89] [1.39] [2.10]** [1.36] [1.74]*
Prop Type Controls Y Y Y Y Year Dummy Vars Y Y Y Y SPS Dummy Vars Y Y Observations 895 895 895 895 895 895 R-squared 0.02 0.01 0.11 0.1 0.15 0.15
SPS w/ B-piece transfers fewer loans into special servicing (H2)
Dependent variable: Dummy=1 if loan is transferred to special servicing
Note: All regressions contain dummy variables for year, deal type and property type, Probit regressions, marginal effects
Transfer to Special Servicing
within:
2 Months 4 Months 6 Months
Special Servicer owns B-piece -0.086** -0.127** -0.135**
(2.23) (2.38) (2.46)
Loan-to-Value is 0.60 to 0.80 0.02 0.031 0.042
(0.66) (0.74) (1.00)
Loan-to-Value > 0.80 -0.044 -0.165*** -0.169***
(1.15) (3.27) (3.27)
Debt Service Coverage Ratio < 1.2 0.056* 0.121*** 0.120***
(1.75) (2.94) (2.87)
Debt Service Coverage Ratio is 1.2 to 1.6 -0.003 0.009 0.009
(0.10) (0.23) (0.22)
Special Servicer Fixed Effects Y Y Y
Observations 1,327 1,342 1,342
Pseudo-R-Squared 0.06 0.07 0.08
SPS liquidates loans more quickly when she owns the B-piece (H3A)
Note: All regressions contain dummy variables for year, deal type and property type, Probit regressions. Marginal Effects
Dep var: Dummy=1 if loan is liquidated, Sample is all loans in special servicing
Liquidated in 6 Months Liquidated in 1 Year
Special Servicer 0.029** 0.031** 0.035* 0.041** 0.043** 0.06
owns B-piece (2.31) (2.46) (1.79) (2.05) (2.19) (1.63)
Loan-to-Value 0.002** 0.004**
Ratio (LTV) (7.10) (6.56)
Debt Service Cvg. 0.00 -0.03
Ratio (DSCR) (0.28) (1.62)
State Uses Judicial -0.017 -0.016 -0.021 -
0.045** -0.043* -
0.051**
Foreclosure (1.21) (1.15) (1.45) (2.01) (1.90) (2.17)
LTV, DSCR categories Y Y Y Y
Special Servicer FE’s Y Y
Observations 1,524 1,524 1,363 1,524 1,524 1,363
Pseudo-R-Squared 0.11 0.12 0.14 0.09 0.09 0.12
SPS liquidates loans less quickly when she owns the B-piece and potential losses are large (H3B)
Note: All regressions contain dummy variables for year, deal type and property type
Dependent variable: Dummy=1 if loan is liquidatedProbit regression, Sample is all loans in special servicing
Level of Serious Delinquency (pct of deal
that is delinquent) >3% >6%
Special Servicer owns B-piece 0.041** 0.042** (2.12) (2.15) Deal Seriously Delinquent 0.123** 0.210** (2.51) (2.45) (Special Servicer owns B-piece) * -0.068** -0.064** (Deal Seriously Delinquent) (2.56) (2.43) State Uses Judicial Foreclosure -0.021 -0.019 (1.48) (1.36) Special Servicer FE’s Y Y Observations 1,363 1,363 Pseudo-R-Squared 0.15 0.15
Bonds in which the SPS owns the B-piece have lower spreads, especially the lowest rated bonds (H4)
Dependent Variable: Spread over benchmark (basis points or .01%)
All bonds Bonds rated BB
or less
(1) (3) SPS owns B-piece -8.2 -136.7 [1.28] [3.46]** Constant 132 667 [8.19]** [9.79]** Observations 2,271 78 R-squared 0.85 0.99 Average Spread 123.1 474.3
Note: All regressions contain dummy variables for fine ratings category, year, and quarter
Conclusions
Evidence suggests that agency conflicts are important in CMBS securitizations
SPS more likely to own B-piece in deals with higher delinquency rates and greater asymmetric information (H1)
When special servicers hold the B-piece, agency conflicts are reduced Fewer delinquent loans are transferred into special
servicing (H2)
Once in special servicing, loans are liquidated more quickly when losses are small (H3A)
Conclusions
Asset substitution is still a problem when potential losses are large—SPS liquidates loans more slowly when she owns the B-piece (H3B)
Market values structure of SPS holding B-piece (H4)
Bond spreads are lower when SPS owns B-piece
Spread effect is most pronounced in lowest rated bonds
So why does the SPS only own the B-piece in 62% of deals?
Theory suggests that most informed party and the party who makes decisions (SPS in both cases) would have the highest WTP for the B-piece
Asset substitution cannot explain this puzzle Underwriter wants to protect investors in senior classes
Yet bond yields are lower in deals when SPS owns B-piece, despite higher delinquencies & liquidations
Must be risk aversion in special servicers SPS must maintain credit ratings and cannot diversify
Evidence: SPS holds B-piece less when issuance is highest
When Does the SPS Hold the B-piece?
0
10
20
30
40
50
60
70
80
90
1996 1997 1998 1999 2000 2001 2002 2003
% of holding B deals(#)
total issuance
Policy Implications and Future Research Securitization enhances conflicts between
junior/senior credit holders with many tranches
If delinquencies rise significantly, SPS ownership of B-piece could lead to serious inefficiencies
Regulation matters: Risk-based capital requirements have helped drive securitization
Institutions often hold less capital for rated bonds than whole loans (is the risk really lower?)
Banks participate much less than insurance companies
Will liquidity and transparency continue in a downturn?
Commercial Mortgages - Market Share1991-2006-Q1
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
1991 1993 1995 1997 1999 2001 2003 2005
Year
Per
cen
t
ABS Issuers
Other
Life Insurance
Commercial Banking
Source: Federal Reserve L.220
Growth of the CMBS Market
Asset Default Risk Factors according to National Association of Insurance Company (NAIC) rules
Stocks & Bonds Risk Factor
Common Stock 30%
Preferred Stock 5%
US Government Bonds 0%
A-AAA Bonds 0.3%
CCC-BBB Bonds 1-20%
Bonds in default 30%
Growth of the CMBS Market
Real Estate Factor Risk
JV and LP interests 20%
Company Occupied & Investment Props. 10%
Foreclosed Properties 15%
Commercial Mortgages
In good standing 3%
In delinquency 15%
In foreclosure 20%
Noninsured Residential Mortgages 0.5%
For more information, see “Risk and the Capital of Insurance Companies” by Richard Kopcke (New England Economic Review, July/August, 1996, 27-42).
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