Disparate investor demands elicit a supply of exotic securities. Creative security design often calls for bundling primitive and derivative securities into one composite security. The Chubb Corporation, with the aid of Goldman, Sachs, has combined three primitive securities—stocks, bonds, and preferred stock—into one hybrid security. Chubb is issuing preferred stock that is convertible into common stock, at the option of the holder, and exchangeable into convertible bonds at the option of the firm. Hence this security is a bundling of preferred stock with several options.
Quite often, creating a security that appears to be attractive requires unbundling of an asset. The process of bundling and unbundling is called financial engineering, which refers to the creation and design of securities with custom-tailored characteristics, often regarding exposures to various source of risk. Financial engineers view securities as bundles of (possibly risky) cash flows that may be carved up and repackaged according to the needs or desires of traders in the security markets.
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Financial Engineering
Securitization
Until recently, financial intermediaries were the only means to channel funds from national capital markets to smaller local ones. Securitization, however, now allows borrowers to enter capital markets directly. In this procedure pools of loans typically are aggregated into pass-through securities, such as mortgage pool pass-throughs. Then, investors can invest in securities backed by those pools. The transformation of these pools into standardized securities enables issuers to deal in a volume large enough that they can bypass intermediaries. We have already discussed this phenomenon in the context of the securitization of the mortgage market. Today, most conventional mortgages are securitized by government mortgage agencies.
Another example of securitization is the collateralized automobile receivable (CAR), a pass-through arrangement for car loans. The loan originator passes the loan payments through to the holder of the CAR. Aside from mortgages, the biggest asset-backed securities are for credit card debt, car loans, home equity loans, and student loans. Securitization also has been used to allow U.S. banks to unload their portfolios of shaky loans to developing nations. So-called Brady bonds (named after Nicholas Brady, former secretary of the Treasury) were formed by securitizing bank loans to several countries in shaky fiscal condition. The U.S. banks exchange their loans to developing nations for bonds backed by those loans. The payments that the borrowing nation would otherwise make to the lending bank are directed instead to the holder of the bond. These bonds are traded in capital markets. Therefore, if they choose, banks can remove these loans from their portfolios simply by selling the bonds. In addition, the United States in many cases has enhanced the credit quality of these bonds by designating a quantity of Treasury bonds to serve as partial collateral for the loans. In the event of a foreign default, the holders of the Brady bonds would have claim to the collateral.
Financial Innovation and Derivatives
The investment diversity desired by households is far greater than most businesses have a desire to satisfy. Most firms find it simpler to issue “plain vanilla” securities, leaving exotic variants to others who specialize in financial markets. This, of course, creates a profit opportunity for innovative security design and repackaging that investment bankers are only too happy to fill.
Consider the astonishing changes in the mortgage markets since 1970, when mortgage pass-through securities were first introduced by the Government National Mortgage Association (GNMA, or Ginnie Mae). These pass-throughs aggregate individual home mortgages into relatively homogenous pools. Each pool acts as backing for a GNMA pass-through security. GNMAsecurity holders receive the principal and interest payments made on the underlying mortgage pool. For example, the pool might total $100 million of 10 percent, 30-year conventional mortgages. The purchaser of the pool receives all monthly interest and principal payments made on the pool. The banks that originated the mortgages continue to service them but no longer own the mortgage investments; these have been passed through to the GNMAsecurity holders.
Pass-through securities were a tremendous innovation in mortgage markets. The securitization of mortgages meant that mortgages could be traded just like other securities in national financial markets. Availability of funds no longer depended on local credit conditions; with mortgage pass-throughs trading in national markets, mortgage funds could flow from any region to wherever demand was greatest.
The next round of innovation came when it became apparent that investors might be interested in mortgage-backed securities with different effective times to maturity. Thus was born the collateralized mortgage obligation, or CMO. The CMO meets the demand for mortgage-backed securities with a range of maturities by dividing the overall pool into a series of classes called tranches. The so-called fast-pay tranche receives all the principal payments made on the entire mortgage pool until the total investment of the investors in the tranche is repaid. In the meantime, investors in the other tranches receive only interest on their investment. In this way, the fast-pay tranche is retired first and is the shortest-term mortgage-backed security. The next tranche then receives all of the principal payments until it is retired, and so on, until the slow-pay tranche, the longest-term class, finally receives payback of principal after all other tranches have been retired.
Although these securities are relatively complex, the message here is that security demand elicited a market response. The waves of product development in the last two decades are responses to perceived profit opportunities created by as-yet unsatisfied demands for securities with particular risk, return, tax, and timing attributes. As the investment banking industry becomes ever more sophisticated, security creation and customization become more routine. Most new securities are created by dismantling and rebundling more basic securities. For example, the CMO is a dismantling of a simpler mortgage-backed security into component tranches. AWall Street joke asks how many investment bankers it takes to sell a lightbulb. The answer is 100—one to break the bulb and 99 to sell off the individual fragments.
This discussion leads to the notion of primitive versus derivative securities. A primitive security offers returns based only on the status of the issuer. For example, bonds make stipulated interest payments depending only on the solvency of the issuing firm. Dividends paid to stockholders depend as well on the board of directors’assessment of the firm’s financial position. In contrast, derivative securities yield returns that depend on additional factors pertaining to the prices of other assets. For example, the payoff to stock options depends on the price of the underlying stock. In our mortgage examples, the derivative mortgage backed securities offer payouts that depend on the original mortgages, which are the primitive securities. Much of the innovation in security design may be viewed as the continual creation of new types of derivative securities from the available set of primitive securities. Derivatives have become an integral part of the investment environment. One use of derivatives, perhaps the primary use, is to hedge risks. However, derivatives also can be used to take highly speculative positions. Moreover, when complex derivatives are misunderstood, firms that believe they are hedging might in fact be increasing their exposure to various sources of risk.
While occasional large losses attract considerable attention, they are in fact the exception to the more common use of derivatives as risk-management tools. Derivatives will continue to play an important role in portfolio management and the financial system. We will return to this topic later in the text. For the time being, however, we direct you to the primer on derivatives in the nearby box.