Credit Analysis for Securitized Debt

Securitized debt allows the issuers to finance a specific set of assets such as mortgages and auto loans rather than the entire balance sheet, unlike other risky bonds.

Investors of securitized debt benefit from greater diversification, more stable and predictable underlying cash flows, and returns higher than securities with a similar rating.

Factors to consider when analyzing asset-backed securities (ABS) include (1) the collateral pool, (2) the origination and servicing of assets, and (3) the structure of the transaction.

Collateral Pool

Structured finance instruments can be described in terms of homogeneity and granularity. Homogeneity is the degree of similarity of the underlying debt characteristics across individual obligations within structured finance security. Conversely, heterogeneity implies that every debt issue requires an individual analysis as different loans have different characteristics.

Granularity refers to the actual number of obligations making up the overall structured finance instrument. A highly granular portfolio would have hundreds of underlying creditors, making it suitable to draw conclusions based on portfolio summary statistics instead of investigating each borrower. On the other hand, a discrete or non-granular portfolio would warrant scrutiny of each obligation.

Different credit analysis approaches are applied to different collateral pools.

• The book of loans approach can be used to evaluate short-term structured finance vehicles, which have granular, homogeneous obligations.
• On the other hand, a portfolio-based approach evaluates medium-term granular and homogeneous obligations because the portfolio is dynamic.
• Finally, a loan-by-loan approach is used to analyze a discrete or non-granular heterogeneous portfolio.

The suitable credit analysis approach will depend on the type of the obligation, term, and homogeneity/granularity of the underlying.

Origination and Servicing of Assets

Once the transaction is initiated, investors rely on the originator/servicer to manage and service the portfolio over the life of the transaction.

Investors are exposed to operational and counterparty risk over the life of the ABS.

The servicer’s track record can be used to gauge their quality.

Structure of the Transaction

The structure of the securitized debt deals with the relationship between the issuer and the originator. It refers to the type of obligor, often a special purpose entity (SPE). The SPE is bankruptcy remote from the originator. Structural enhancements, including tranching of credit risk, over-collateralization, and excess servicing spread, can be put in place.

A covered bond is a senior debt obligation of a financial institution that gives recourse to the originator and a predetermined underlying collateral pool, often commercial or residential mortgages. Each specific jurisdiction specifies the eligible collateral types and the specific structures permissible in the covered bond market.

Question

The credit analysis approach most suitable for evaluating a discrete or non-granular heterogeneous portfolio is:

1. A loan-by-loan approach.
2. A portfolio-based approach.
3. A book of loans approach.

Solution

The correct answer is A.

Discrete and non-granular portfolios MUST be evaluated at the individual loan level. Hence a loan by loan approach is the most suitable method.

B is incorrect. A portfolio-based approach is used to evaluate medium-term granular and homogenous obligations as the portfolio composition is dynamic.

C is incorrect. Book of loans approach is used to evaluate short-term structured finance vehicles, which have granular, homogeneous obligations.

Reading 31: Credit Analysis Models

LOS 31 (h) Compare the credit analysis required for securitized debt to the credit analysis of corporate debt.