agency conflicts, asset substitution, and securitization yingjin hila gan (lehman brothers)...

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


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


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


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


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 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).