Key Post Securitisation and covered bonds explained .

[IdesofMarch]

A rate of 3.28% is 1.48% higher than 1.8%.

1.48% is 82/100 of 1.8%

In other words the Irish average rate is 82% higher than the Eurozone average rate.

Yes , this is correct, the banks would tell you that this extortionate interest rate is due to NPL's and associated costs, but the NPL's would, at a maximum, only account for a 15% higher Irish interest rate than the Eurozone average rate. The rest of the money goes into a black hole. In Ireland, the banks also issued a large proportion of covered bonds in respect of these mortgage loans, so the Irish banks were merely the loan originator and servicer and not the beneficial owner of the mortgage loan (whether these mortgages be profit or loss making), so these loans would not impact on profit and loss, the mind boggles!

 

[RedOnion]

In Ireland, the banks also issued a large proportion of covered bonds in respect of these mortgage loans, so the Irish banks were merely the loan originator and servicer and not the beneficial owner of the mortgage loan (whether these mortgages be profit or loss making), so these loans would not impact on profit and loss, the mind boggles!

You appear to be confusing covered bonds with something else, because that's not how covered bonds work. The mind boggles indeed.

 

[Brendan Burgess]

Yes , this is correct, the banks would tell you that this extortionate interest rate is due to NPL's and associated costs, but the NPL's would, at a maximum, only account for a 15% higher Irish interest rate than the Eurozone average rate.

Hi Ides

I fully agree with you here. I have argued that while the problems with repossessions can justify a higher rate for >80% LTV loans at 5 times the income, that they should not have any impact on 50% LTV loans where the losses were close to zero.


However, I have not really understood why Irish banks lost so much when they had securitised so much of their mortgage book.

The answer I got was that the securitisation process was very complicated. And lenders actually replaced bad loans with good loans. This was to keep access to these markets, I presume.

Red - does that sound right?

Brendan

 

[IdesofMarch]

Brendan,

Yes I might have misquoted covered bonds for asset backed securities, the fact remains that there was a hell of a lot of securitisation of mortgages by Irish banks during the boom, so why do Irish banks charge so much variable and fixed rate interest on their mortgages ? Still waiting for a straight answer ? Maybe Red Onion will enlighten us instead of splitting hairs? We will wait for his response with bated breath ?

 

[RedOnion]

In a covered bond, the ownership of the mortgage remains with the lender, but it's given as security. In other words, even if the mortgages go bad, the bank still owes the money to the bond owner

Bank issues a bond. They're on the hook for it. But they provide a portfolio of mortgages as collateral (a covered pool). If the bank becomes insolvent, or unable to repay the bond, then the bond holders have a right to the cash flows from the mortgages.

So the mortgages stay on the balance sheet of the bank, the banks P&L is impacted by any NPL impairments, and they own the difference between the interest income and the coupon on the bond.

It gets a bit more complicated because it's generally not the bank issuing the bond, but a special purpose vehicle, and the mortgages can be equitably assigned from the bank to the SPV.

To improve the credit rating of the bond, and reduce costs, it's the very best mortgages that are used. That's why bad loans were replaced with good, to meet the terms of the original bond.

 

[RedOnion]

However, I have not really understood why Irish banks lost so much when they had securitised so much of their mortgage book.

Simplified securitisation summary:
The Bank transfers legal ownership of mortgage portfolio to SPV entity. That entity issues Senior Bonds, Junior Bonds, and subordinated debt. So if all the bonds / debt are purchased by external parties, the bank just earns a fee for servicing the portfolio and passing on the funds. There isn't much money in that game.
So, when the SPV issues it's bonds, the senior bonds get a top credit rating, and earns a low interest rate. The Junior Bonds not so good, but earn a large interest rate. The subordinated debt even higher interest. But, when things go sour the subordinated debt takes first loss, then the junior debt, and finally the senior debt. Typically only the Senior debt (could be 80%+ of total) is sold to external parties, and the junior and subordinated debt is bought back by the same bank. Now they've a much smaller balance, but earning a huge return. However, they bear the first loss. That's how the banks took a big hit, even on securitised portfolios.

 

[Brendan Burgess]

That is a great explanation which I had not heard or understood before.

Is the following correct?

Let's say that they have a mortgage book of €100 @ 4% on which they earn €4 .

They sell that to their own SPV.
The SPV issues a bond as follow:

€60 Senior at 2%
€30 Junior @ 4%
€10 Subordinated at 10%

So they are left with a return of
€100 @4% = €4
less €60 @2% = €1.2
Net return: €2.8

But on €40 of bonds

So their return is now 7%

Brendan

 

[RedOnion]

That's pretty much it, yes. It can get more complex in cases, but that's the basic concept.

 

[Brendan Burgess]

Hi Red

Thanks again.

I have edited some of the errors out of the original posts to make it easier to follow.

Brendan

 

[RedOnion]

The follow on question that Ides rightly asked earlier, was if banks essentially increased their risk by using such funding vehicles. I know I'm explaining this badly, so open to correction on it if someone can explain better.

If we take the example above of the bank lending 100.

Now if there's an impairment and the loans are only worth 80.

Whatever funding method, the bank suffers first loss, so will always lose 20 even if its their own capital funding. In absolute terms loss is the same, but as a percentage of exposure it's vastly higher.

But, such funding vehicles allowed banks access cheaper funding, and lend more increasing their total lending. So when they suffered a loss it was bigger.

It wasn't really their exposure to the subordinated / junior debt that increased their losses, but the fact that their balance sheets were bigger.

 

[Brendan Burgess]

Hi Red

That makes sense.

I think what confused me in my understanding was that the international financial crisis was precipitated/accentuated by American banks selling Mortgage Backed Securities to European banks. The Europeans just bought all sorts of junk mortgages and took huge losses.

But the Irish banks sold their good mortgages, but took the losses on the bad ones.

Brendan

 

[RedOnion]

Yes, so the US banks also sold on the junior debt, but at a lower rate than the risk suggested so they were making more money. They were also treating over 90% as senior debt.

Everyone underestimated the risk.

The risk of me lending all my money to a single person is high. But if I lend 1% to each of 100 people the risk is much lower, because even if 10% default I still get 90% back. What happened was the assets were concentrated in sub prime, so all 100 defaulted.

Wall Street banks had also created ' bond of bond' type securities where they had bought the junior debt from lots of banks, and put them into a single bond. Again, the idea was that even if 1 bank had a loss making portfolio, they wouldn't all at the same time. But they did, and the bonds were all worthless.