Obscure just 20 years ago, loan portfolio securitization by private and government-sponsored enterprises is a $5 trillion business today. This Commentary explains the reasons behind the spectacular growth of asset-backed securities.Asset-backed financing

O. Emre Ergungor

English

Research Papers in Economics

purpose entity. Because investors don’t
originate the loans, they cannot verify the
quality of every loan being securitized. To
reassure investors, the lender asks a
credit-rating agency to certify the quality
of the loan portfolio. The rating agency
estimates the default risk of the portfolio
relative to that of an investment-grade
(low-risk) security and decides how much
default protection the lender must provide
to investors to make the asset-backed
security investment grade. The lender can
enhance the quality of the loan pool in
several ways. It can create a reserve fund
that makes up for defaults; it can post
excess collateral by setting some loans
aside to replace loans that default; or it
can purchase loan-default insurance up to
a prespecified percentage of the pool. For
example, a 10 percent credit enhancement
would pay for the defaults up to 10 per-
cent of the value of the loan pool. In any
case, a credit-enhanced, asset-backed
security can be made investment grade
and more easily sold to investors.
As one can easily imagine, each step in
this securitization process costs the
lender money. There are legal costs asso-
ciated with the formation of the special-
purpose entity. Dealing with a rating
agency and credit enhancement also cost
money. Then, there is the cost of issuing
securities. How do lenders benefit from
such a deal? Let’s consider the case of
banks for an explanation. 
August 15, 2003
Federal Reserve Bank of Cleveland
Securitization
by O. Emre Ergungor
ISSN 0428-1276
Obscure just 20 years ago, the securi-
tization of loan portfolios by private
and government-sponsored enter-
prises is a $5 trillion business today.
This Commentary explains why the
use of asset-backed securities has
grown so spectacularly.
Securitization is the process of pool-
ing and repackaging loans into securities
that are then sold to investors. Although
the practice of selling loans among banks
is quite old—beginning in the late nine-
teenth century—sales to investors are
more recent, dating back to 1970 when
the Government National Mortgage Asso-
ciation (Ginnie Mae) offered investors a
new type of bond—a mortgage pass-
through. This security promised investors
the principal and interest payments gener-
ated by a pool of Federal Housing Admin-
istration and Veterans Administration 
single-family mortgage loans. Beginning
with this first Ginnie Mae pass-through,
the list of securitized assets has expanded
to commercial mortgage loans, car loans,
computer and truck leases, loans for
mobile homes, credit card receivables,
trade receivables, and student loans.
Despite the wide variety of assets that 
can be securitized today, government
agencies and government-sponsored
enterprises were the main issuers of asset-
backed securities early on (see figure 1).
Ginnie Mae began doing so as a way to
increase homeownership: By buying
banks’mortgage loans and selling them to
investors, it provided the banks with fresh
funds to make additional mortgages.
Bank of America issued the first private-
sector pass-through backed by conven-
tional mortgages in 1977, but other finan-
cial institutions showed little interest in
the area until the mid-1980s. In 1983, pri-
vately securitized assets totaled less than
$4 billion. Then, private issues took off
sharply, reaching more than $2 trillion in
total assets at the end of 2002—a more
than 600-fold increase in 19 years. 
Such remarkable growth would not have
been possible without some economic
and regulatory incentives. This Economic
Commentary describes the mechanics of
asset-backed securities. In doing so, it
reviews how regulatory changes bolstered
the privately issued asset-backed-security
industry by allowing the creation of new
securities that benefit both issuers and
investors.
■ What Is an Asset-Backed
Security?
“Asset-backed security” is a broad name
given to a wide variety of financial
instruments that give investors a claim
on the interest and principal payments
generated by a pool of loans. The securi-
tization process begins when a lender
(usually a bank or a finance company)
creates a special-purpose entity, such as
a corporation, a limited liability corpora-
tion, or a business trust, and transfers to
it the ownership of a portfolio of loans
that are similar in type (mortgage, auto
loan, and so on), maturity, interest rate,
and their likelihood of default. Owner-
ship shares in the special-purpose entity
can be sold to investors (a pass-through
security), or, alternatively, the bank can
retain ownership but issue securities that
promise investors interest and principal
payments after these are collected from
borrowers (a pay-through security).
From the investor’s point of view, the
former is similar to owning the stock of
the special-purpose entity, and the latter
is similar to owning a debt security. In
either case, the lender uses the sale pro-
ceeds to make new loans or for other
corporate purposes. It also continues to
service the loans—collect principal and
interest from borrowers—for which it
deducts a servicing fee (see figure 2).
As described thus far, investors would
quickly recognize a major conflict of
interest in this structure. The lender could
keep all the good loans for itself and
dump all the bad ones into the special-■ Why Securitize?
Banks began to securitize a large vol-
ume of their loan portfolios in response
to changing regulations and market
forces during the 1980s. Starting with
the International Banking Act of 1978,
and partially in response to debt prob-
lems of the less-developed countries
during the early 1980s, federal regula-
tors ratcheted up minimum capital
requirements for commercial banks. By
the mid-1980s, banks were required to
hold primary capital (basically share-
holder equity and reserves set aside for
future loan losses) of at least 5.5 cents
for every dollar of assets carried on the
balance sheet. Capital requirements
limit the risks banks will take by putting
bank owners’own money at risk. How-
ever, raising capital is costly for the
bank owners. For example, regulators
may force the bank to raise equity when
stock market conditions are not favor-
able for a new stock issue, or the bank
may have to retain its earnings instead
of distributing them to shareholders as
dividends.
But there is a way to circumvent capital
requirements, and it hinges on the fact
that the bank does not have to hold 
capital against the loans it originates,
only those it actually carries on its 
balance sheet. So, there is no capital
requirement if the bank originates loans
and transfers their ownership to a 
special-purpose entity, effectively
removing them from its balance sheet.
Unless there is an arrangement in the
securitization deal whereby investors
can demand compensation from the
bank for loan defaults in the securitized
asset pool (recourse), regulators allow
banks to keep these loans off the bal-
ance sheet, reducing the need for addi-
tional capital.
The ability to remove loans from the
balance sheet was especially handy for
credit card banks because the Competi-
tive Equality Banking Act of 1987 lim-
ited their total asset growth to 7 percent
a year. Major lenders in this market had
to find a way to remove their credit card
receivables from their balance sheets.
Securitizing those receipts helped banks
to keep their asset growth under control,
while they collected fees for servicing
the securitized loans. It should not come
as a surprise that credit card asset-
backed securities first appeared in the
public debt market in 1987.
In addition to these changes in the regula-
tory environment, the deposit market—
banks’traditional funding source—went
through significant changes in the 1980s.
With the Great Depression and bank fail-
ures a distant memory, depositors were
willing to take more risk in return for
higher rewards by shifting their money
into money market funds and other unin-
sured investments. As deposits became
increasingly scarce and expensive, banks
had few options. One was to give up lend-
ing opportunities—not a first choice.
Another was (and still is) to finance loans
with short-term borrowings from the
money markets. Yet, unlike deposits,
these are not a stable source of financing.
Short-term lenders in this highly liquid
market chase the highest rate of interest
and pull their money out at the slightest
sign of trouble. Under these circum-
stances, recycling existing resources—by
selling existing loans and using the pro-
ceeds to make new loans—is an invalu-
able capability.
Yet even with the impetus from regulatory
costs and funding constraints, securitiza-
tion by private issuers remained subdued
until the mid-1980s; there were only 
$10 billion in private-sector pass-throughs
outstanding at the end of 1984, amounting
to just 3.5 percent of the value of all 
federal agency pass-throughs outstanding
at the time. A major inhibiting factor was
uncertainty about whether securitization
was banned by the Glass-Steagall Act’s
prohibition of commercial banks’under-
writing of corporate securities. This
uncertainty was resolved by the Office 
of the Comptroller of the Currency
when it decided that banks could sell
interests in a pool of loans. A court of
appeals upheld that decision in 1985 and
ruled that these instruments were not
corporate securities but investments in
the underlying loans; therefore, Glass-
Steagall did not apply. This ruling and
the Supreme Court’s refusal to hear an
appeal by the Securities Industry Asso-
ciation opened the floodgates. By 2002,
private issuers had securitized more 
than $2 trillion in assets compared with 
$37 billion in 1985.
The incentives banks have to sell their
loan portfolios to investors is, however,
only half of the story. The spectacular
growth of asset-backed securities is also
explained by the reasons investors have
for embracing this instrument.
■ Why Buy Asset-Backed
Securities?
In general, investors do not like to put
all their eggs in the same basket lest
something awful happen to that basket
and they lose all their eggs. Therefore,
they diversify their holdings among a
number of unrelated baskets that are not
all likely to get knocked down at the
same time. Now, suppose an investor
wishes to invest some money in a bank’s
credit card business for diversification
purposes. In the absence of asset-backed
securities, what are the investor’s alter-
natives? The easiest thing to do is to buy
the bank’s stock. But the return on the
0
500
1,000
1,500
2,000
2,500
3,000
3,500
1970 1975 1980 1985 1990 1995 2000
Billions of dollars
Federally related mortgage pool securities
Privately issued pool securities
SOURCE:  Board of Governors of the Federal Reserve System, “Flow of Funds Accounts of the United States,”
Z.1, Federal Reserve Statistical Releases.
NOTE:  Privately issued pool securities include those that are backed by federally related mortgage pools.
FIGURE 1 TOTAL FINANCIAL ASSETS OF ABS ISSUERSstock will depend not only on the suc-
cess of the credit card business, but also
a whole bunch of other activities, from
commercial and real-estate loans to off-
balance-sheet activities. If the investor
is only interested in the credit card
business, he needs to create a “home-
made” credit card portfolio; that is, he
needs to find a way of undoing the
effect of the unwanted bank activities
on the stock price.
In practice, this is not an easy task. In
the same way the investor cannot buy a
share of the bank’s credit card receipts,
he also may be unable to find a security
that will undo the effect of, say, real
estate loans on the stock price. Conse-
quently, the investor may never be able
to build an exact replica of the bank’s
credit card business. Even if we assume
that the homemade portfolio is good
enough in the absence of a better alter-
native, there are transaction costs asso-
ciated with buying and selling multiple
securities. So, the presence of a security
that represents an ownership claim on a
certain class of the bank’s assets is
advantageous to the investor because it
is exactly what he wants, it is a security
he could not have created by himself,
and it can be purchased and sold in one
transaction.
■ More Than an Ownership
Claim
So far, we have described an asset-
backed security as a certificate that
allows the investor to collect payments
from an asset pool. But this is an over-
simplification because this type of
security has many quality enhance-
ments that would, once again, be too
costly for the investor to achieve by
himself. In order to understand how
securitization adds value, let’s review
the various risks associated with the
ownership of a credit card portfolio.
By assuming ownership of the credit
card receipts, the investor takes on two
types of risk. First, he bears the default
risk; every uncollectible credit card
debt is money out of his pocket. Sec-
ond, he assumes the prepayment risk;
when interest rates go down, consumers
prepay their credit card bills by switch-
ing to a lower-interest credit card. So,
an income-generating credit card
receipt converts into cash, which the
investor must reinvest and thereby incur
additional transaction costs.
An asset-backed security lessens the
impact of these two risks. As a protec-
tion against default risk, banks issue
securities against only a fraction of the
asset pool. The rest of the pool is used to
absorb any loan defaults. For example,
the bank may put $300 million worth 
of credit card receipts in the special- 
purpose entity and sell securities against
$260 million. The remaining $40 million
is excess collateral that loan defaults 
are deducted from, while the investors’
claim remains intact. At maturity, what-
ever is left from the excess collateral
goes back to the bank. This kind of 
overcollateralization protects the
investor from the occasional loan
default, although the investor still has 
an exposure to the large, industywide
fluctuations in the credit card business. 
As a protection against prepayment risk,
the bank replenishes the asset pool with
new credit card receipts whenever a 
payment occurs. Again, as with default
insurance, the protection from prepay-
ments is limited—usually to a prespeci-
fied percentage of the asset pool. In
other words, the goal is to protect the
investor from the occasional prepay-
ment and not to completely eliminate
his exposure to the industry.
But how much protection is optimal?
After all, investors’taste for risk varies
over a wide spectrum. If an investor is
not very sensitive to cash flow disrup-
tions due to prepayments, for example,
and wishes to track the performance of
the credit card portfolio more closely,
the protection provided by the bank
may seem excessive. 
Banks have found a creative way to
make securities more attractive to
investors with different risk prefer-
ences: They issue securities with mul-
tiple bondholder classes against the
same asset pool, with each class
attractive to one type of investor. In 
the case of mortgages, for example,
Freddie Mac and First Boston issued
in 1983 the first collateralized mort-
gage obligation (CMO) that had three
classes of securities (A, B, and C)
against the same mortgage pool. While
all classes received regular interest
payments, Class A bonds were first to
receive principal payments and any
prepayments. Class B bondholders
began to receive principal payments
only after all Class A investors were
paid off, and Class C bondholders
received principal payments after
Class B bondholders were completely
paid off. The important point to
remember is that, at any one time, 
prepayments are directed to retiring
only one class of bonds while the
remaining classes are protected from
prepayments. So an investor who has a
long investment horizon (such as an
insurance company) and dislikes pre-
payments would be more interested in
a Class C bond, while an investor who
would like to track the real estate busi-
ness more closely would purchase the
Class A bond and expose himself to
the vagaries of mortgage prepayments.
Although CMOs were the first multiple-
class securities, multiple classes are not
a peculiarity of mortgage securitization.
They are also common in auto loan and
credit card asset-backed securities. In
addition, other multiple-class securities
allow investors to choose the degree of
default risk they prefer, with credit 
ratings ranging from investment grade
Originating 
Bank Investors
Borrowers
Special 
Purpose 
Entity
Credit 
Enhancer
Insurance fee
Principal 
and interest
Sale 
proceeds
Sale 
proceeds
Principal and 
interest minus 
service fee
Principal and 
interest on loans
Payments to make up shortfalls 
due to delinquencies and defaults
FIGURE 2 SUMMARY OF AN ABSFederal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor.
O. Emre Ergungor is an economist at the
Federal Reserve Bank of Cleveland. 
The views expressed here are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
Economic Commentary is published by the
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AAA (last to absorb the loan defaults in
the pool) to default grade C (first to
absorb defaults).
■ Engine of Growth
Pools of loans securitized by govern-
ment-sponsored enterprises and private
financial institutions are worth more
than $5 trillion today. Banks were
attracted to this business to reduce their
funding costs, whereas investors bene-
fited from the new investment opportu-
nities that did not exist before and
which offered a cheaper alternative to
homemade portfolios.
Furthermore, because securitization
also involves cash-flow partitioning and
credit enhancement, the asset-backed
security is more than a basket of bank
loans. It is a new kind of security that
caters to the diverse cash flow and risk
preferences of investors.
With these characteristics, securitiza-
tion provides an ever-growing funding
source to banks and may well be the
most important engine of growth in
bank lending.
■ Recommended Readings
Charles T. Carlstrom and Katherine A.
Samolyk, 1992, “Securitization: More
than Just a Regulatory Artifact,” Federal
Reserve Bank of Cleveland, Economic
Commentary, May 1.
Frank J. Fabozzi, 2001, “Accessing
Capital Markets through Securitiza-
tion,” Frank Fabozzi Associates, New
Hope, Pa.
Joseph G. Haubrich, 1995, “Derivative
Mechanics: The CMO,” Federal
Reserve Bank of Cleveland, Economic
Commentary, September 1.

Securitization

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