An Introduction to Securitization

In this chapter, an in-depth definition of securitization is given and its process is described. The role of participants in the securitization process is explained, along with terminologies that include over-collateralization, first-loss piece, equity piece, and cash waterfall within the collateralization process. Thereafter, we learn how to calculate the constant prepayment rate (CPR) and public securities association (PSA) rate.

Furthermore, we shall do an analysis of the differences in the mechanics of issuing securitized products via trust as opposed to a special purpose vehicle (SPV) and a distinction of the three main SPV structures shall be given. Delinquency ratio, default ratio, monthly payment rate (MPR), debt service coverage ratio (DSCR), the weighted average coupon (WAC), the weighted average maturity (WAM), and the weighted average life (WAL) for relevant securitized structures are also defined and computed.

The Concept of Securitization

Securitization can be defined as the process of selling assets from one firm to another firm specifically set up to acquire them. This other firm then issues notes. The assets in question generate cash flows from the institutions that own them and the notes are backed by cash flows from the original assets.

Through securitization, assets that are not readily marketable can be converted into tradable securities in the secondary market. This process leads to the creation of asset-backed securities.

Reasons for Undertaking Securitization

The need to realizing the value of assets on the balance sheet by banks has always been the motivating factor behind securitization. The following are some of the factors that might cause a financial institution to securitize a part of its balance sheet:

  1. The return to equity ratio rising due to a reduction in the size of assets while the revenues generated by the said assets remain roughly constant.
  2. A reduction in the level of capital necessary for supporting the balance sheet, hence saving on expenses, and the institution will be allowed to allocate the capital to other profitable endeavors.
  3. To get cheaper funding. The level payables on the underlying loans frequently surpass the interest payable on asset-backed securities, therefore creating a surplus for the originating entity.

Therefore, due to the following reasons, a part of a bank’s balance sheet will be securitized:

  1. To fund the assets the bank owns
  2. To manage the capital of the balance sheet
  3. To transfer credit risk and manage the risk.

Funding

Supporting the rapid growth of assets, diversification of the banks funding mix, reduction in the cost of its funding and reducing maturity mismatches are some of the reasons for securitization by banks.

By securitizing assets, banks can diversify their funding mix as they are never comfortable relying on only a few funding sources. Therefore, the securitization process will enable the banks to reduce funding expenses by delinking credit rating of the organizing institutions from the credit rating of the issued notes.

Lastly, maturity mismatches prove to be a challenge, due to the funding of the long-term assets using short-term asset liabilities.

Balance Sheet Capital Management

Through the application of securitization, balance sheet capital management can be improved by providing: regulatory capital relief, diversified capital sources, and economic capital relief.

This is in line with Basel I capital rules which stipulate that the minimum capital a bank should hold for every $100 of risk-weighted assets is $8. The designation of each asset’s risk-weighting is however restrictive.

Risk Management

Non-performing assets can be removed from the bank’s balance sheets by securitization and therefore the removal of credit risk and a potentially negative sentiment and freeing up regulatory capital. This creates a considerable reduction of credit risk exposure for the originating bank.

Benefits of Securitization to Investors

The asset-backed security (ABS) market has experienced considerable investor interest since its inception. Investors consider the market to have the following benefits: diversified interest sectors, access to different risk-reward profiles, and access to sectors closed to them.

The ability of securitization notes to tailor risk-return profiles is a key benefit of securitization notes as they frequently offer better risk-reward performance compared to a corporate bond with a similar rating and maturity. This is because the structure’s first loss piece is held by the originator.

Securitization Process

A number of participants are involved in the securitization process. We begin with the originator which happens to be firm whose assets are securitized. An issuer will then acquire the originators’ securitized assets.

The issuer can be defined as the firm specially set up for securitization purposes and is an SPV that is domiciled offshore. The underlying asset’s pool is therefore held from the originator’s other assets by the creation of the SPV.

The originator’s credit rating and financial status become almost irrelevant to the bondholders when assets are held within an SPV framework.

Credit enhancement is often involved in the securitization process. At both the investment and triple-A grade, notes issued under the securitization will get rated since a third-party guarantee of the credit quality is obtained.

The originator is able to secure lower funding expenses that would be impossible to be obtained in the secured market. This is because issued notes carry a lower expense compared to the asset side of the SPV as ensured by the process of structuring a securitization deal.

Mechanics of a Securitization

The selling of the assets being securitized takes place in the SPV’s balance sheet through:

  1. Due diligence being undertaken on the asset’s quality and future prospects;
  2. Asset transfer to a set up an SPV;
  3. The underwriting of loans for servicing and credit quality;
  4. The determination of the notes structures according to the guidelines of the originator and investors;
  5. The loans’ rating through one or more rating agencies; and
  6. The placing of loans in the capital markets.

The sale of assets to the SPV is crucial for its recognition as a transfer that is legal, and it involves the obtaining of legal counsel by the originator. When the principal value of issued notes is exceeded by the principal value of the notes,over-collateralization happens.

The choice of the underwriting bank is the originator’s major consideration since it structures the deal and places the notes.

SPV Structures

The two main securitization structures are amortizing and revolving, with the third one being called master trust, and is the one used by frequent users.

Amortizing

Throughout the life of the security, the principal and interests are paid to investors by this structure on the basis of coupon-by-coupon. These structures are priced and traded with respect to the expected maturity and weighted average life (WAL).

Various prepayment assumptions are incorporated by this strategy and the rate at which the principal is repaid to investors will be increased or decreased by any change in the prepayment speed.

Revolving Structures

New receivables that certify the required criteria are purchased during the revolving periods by principal collections. Investors receive principal payments during the amortization period in equal installments, or until the expected maturity date the principal gets trapped in a separate amount, and then the investors get paid in a single lump sum.

Master Trust

Under a master trust, the issuance of multiple securitizations from the same SPV is possible. Assets are transferred by investors to the master trust SPV and notes get issued out of the asset pool based on their demand.

Credit Enhancement

For the credit ratings of notes issued to meet the requirements of the investors, a collection of measures can be instituted as part of the securitization process for ABS and MBS issues. These groups of measures are credit enhancement. Lower asset quality being securitized implies greater credit enhancement need, which can be achieved via the following methods: Overcollateralization, senior/junior note classes, pool issuance, margin set-up, and excess spread.

The cash generated by the asset pool is paid in payment priority order; this process is incorporated by all securitization frameworks and is usually referred to as the cash waterfall process.

The CPR and PSA rates

A conditional prepayment rate (CPR) is a loan prepayment rate equivalent to the proportion of a loan pool’s principal that is assumed to be paid off ahead of time in each period. Typically, CPR is expressed as a percentage. For example, a pool of mortgages with a CPR of 2% indicates that for each period, 2% of the pool’s outstanding principal will be paid off. The formula for calculating the CPR is simply CPR = 1 – (1 – SMM)12, where SMM is the single monthly mortality.

The PSA model is a prepayment scale developed by the Public Securities Association for analyzing American mortgage-backed securities. The PSA model assumes increasing prepayment rates for the first 30 months after mortgage origination and a constant prepayment rate thereafter. The standard model (also called “100% PSA”) works as follows: Starting with an annualized prepayment rate of 0.2% in month 1, the rate increases by 0.2% each month, until it reaches 6% in month 30. From the 30th month onward, the model assumes an annualized prepayment rate of 6% of the remaining balance. Variations of the model are expressed in percent; e.g., “150% PSA” means a monthly increase of 0.3% in the annualized prepayment rate, until the peak of 9% is reached after 30 months. The months thereafter have a constant annualized prepayment rate of 9%.

Illustrating the Securitization Process

Let’s assume an imaginary airline ticket receivables transaction originated by company \(A\) and arranged by company \(X\), to illustrate the process of securitization.

Due Diligence

Due diligence is undertaken by company \(X\) on the securitized assets. Performance data from company \(A\) is examined over a specified period of time by \(X\) and future projections are modeled.

Marketing Approach

The present and all future credit card ticket receivables generated by A are transferred to an SPV. The notes placed by investment banks syndication desk across Europe are given in as an indicative pricing ahead of the issue for the investor sentiment to be gauged.

Deal Structure

The following process leads to the issue of notes:

  1. The future flow ticket receivables are sold by \(A\) to an offshore SPV that was set up to for this purpose;
  2. For the SPV’s purchase of the receivables to be funded, notes are issued by the SPV;
  3. For the benefit of the bondholders, the right to the receivables of the SPV is pledged by the SPV to a fiduciary agent who is the security trustee;
  4. Funds are accumulated by the trustee as they are received by the SPV; and
  5. On a quarterly basis, principal payments and interest are received by the bondholders in the order of priority of the notes.

Financial Modeling

For the size of the issued notes to approximated, a cash flow model is constructed by \(X\) under certain assumptions like tax levels, growth projections, and levels of inflation.

The minimum asset coverage levels required for the service of the issued loans are computed and a number of different scenarios are considered by the model. A higher the level of conservativeness in the debt coverage service ratio (DSCR), which is the key indicator in the model, implies that investors are comfortable in the notes.

Credit Rating

\(X\) can easily place the notes with investors due to a formal credit rating. Both qualitative and quantitative factors are accounted for by the methodology applied by the rating agencies and differ according to the securitized asset class. The following are the main issues in this deal:

  1. Corporate credit quality, which may be analyzed according to the following: the historical financial performance of \(A\), its status within the domicile country, the industry’s general condition of the economy, and historical and current data;
  2. Industry trends and completion;
  3. Issues to do with regulations;
  4. The SPV’s legal framework and asset transfer; and
  5. The analysis of cash flows.

ABS Structures: A Premier on Performance Metrics and Test Measures

Types of Collateral

Consumer credit performance is largely relied upon by ABS performance whose typical structures include trigger mechanisms and reserve accounts safeguarding against the poor performance of the portfolio. The difference between CDOs and ABSs/MBSs is that a CDO has 100 to 200 loans while an ABS portfolio has thousands of obligors. The following are some of the prominent asset classes:

    1. Auto loan

In the event of default by a borrower, the vehicle offers an easily sellable tangible asset and the high quality of the asset involved, therefore, attracts investors. The speed of prepayment is extremely stable and, in the prime sector, losses are relatively low.

    1. Performance analysis

In comparison to actual losses, the loss curve gives a good performance measure by showing cumulative losses through the life of the pool. Investors purchasing subordinated note classes find the resulting net forecasts to be very applicable.

    1. Credit card

Unsecured credit loans were primarily funded by the ABS market for specialized credit card banks. A single borrower has less than six months credit card debt. Therefore, there exists a difference in the structure of this particular type of ABS from other ABSs as there is a need for the control of repayment speed via a scheduled amortization, anda revolving period is thus included.

    1. Performance analysis for credit card ABS

The value of credit cards receivables overdue for more than 90 days measures the delinquency ratio as a percentage of total credit card receivables. An early indication of the portfolio’s credit card quality is provided by the ratio.

    1. Mortgages

The diversity of mortgage pools offered to investors is notable in the MBS sector. A varying duration and both fixed and floating rate debts can be offered by portfolios.

Pass-through is a popular agency-MBS structure, where investors simply buy a share in the underlying loans’ cash flow. The MBS being a non-recourse loan to the issuer is a notable distinction between residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) since the underlying property asset fully secures it.

    1. Performance analysis for MBS

The ability of an obligor to repay a loan is indicated by the debt service coverage ratio (DSCR), where a less than 1 DSCR implies a lack of sufficient cash flow the property has generated for the necessary debt payments to be covered.

The weighted average coupon (WAC) is obtained by the multiplication of the rate of the montage on each loan by its balance. It is the pool’s weighted coupon.

The weighted average maturity (WAM) is the remaining average weighted maturity in the pool.

The weighted average life (WAL) of the notes at any particular time is defined as:

$$ s=\sum { t.PF\left( s \right) } $$

Where:

$$ PF\left( s \right) =Poolfactr\quad at\quad s,t=\frac { actual }{ 365 } $$

Securitization Post-Credit Crunch

The 2007-2009 financial crisis led to a loss of interest by investors in the ABS products hence the banks found it hard to raise funds for tenors longer than one month. Therefore, the central banks announced that ABSs and other securitized products would be eligible as collateral in the daily liquidity window. These European Central Bank (ECB) led deals will be studied in this section.

Structuring Considerations

The following criteria had to be fulfilled to be eligible for repo at the ECB:

  1. Minimum requirements: A triple-A or higher public rating, only the senior tranche can be repo’d, a lack of exposure to synthetic securities, public presale, European listed bonds, and book-entry capability in Europe.
  2. Haircut considerations: Regardless of the maturity or coupon structure, a 12% haircut will be incurred for CLO securities dominated in euro. The lack of change in its price over the past 5 days leads to a 5% valuation markdown application. In the absence of trading within the said period, and usual haircuts is incurred by CLO securities denominated in US dollars.
  3. Other considerations: A revolving period can be incorporated in the deal.It can be a simple two-tranche set up, an off-market interest rate can be used to structure it, at least one rating agency should rate it, and there should be no in-house currency swap.

Securitization: Effect of the 2007/2008 Financial Crisis

The worldwide recession that was witnessed in the 2007-2009 financial crisis was due to the liquidity crunch in the market which led to an economic credit crunch. The merits of securitization have been since retained as a technique. Barriers to entry are reduced and a wide array of asset markets is opened up to investors.

Furthermore, cash-rich investors are able to participate in the funding of major projects in the broadest sense. The potential group of purchasers and sellers is widened due to its diversification and customization features. Cash borrowers and cash investors were able to benefit from the technique.

Effects of the Credit Crunch

Low-quality assets were able to be sold to investors through ABSs as banks were given the ability to move assets off the balance sheet.

The Shadow Banking System

Between the borrower and the lender, in a classic banking regime, there is a lack of detachment. However, the relationship between the obligor and the bank is cut, in securitization. The loan is packaged into different pieces and then moved to an unknown client base.

The creation of a parallel circuit called the shadow banking made the above scenario to become a potentially negative issue since no regulatory regimes bonded them.

When the commercial paper investors did not want to roll their investments anymore, it left the shadow banking system with much more risk because of the challenge of funding.

Leverage amount

There was a high leverage in the in the shadow banking system; a leverage ratio of as high as 1:50. Some of the products had extremely high leverage factors. More leverage was sought with \({ CDO }^{ 2 }\), which was a scenario of CDO structures investing in other CDOs.

Transparency or Products

Outside parties, who wanted to do an assessment of the investment’s value, found it hard to analyze some extremely sophisticated products. Some of them had started resembling the black box.

Credit Rating Agencies (CRA)

Not all investors understood that CRAs who publicized their rating methodologies had the cachet of statistical logic. The favorable overall economic conditions and the continuous increase in home prices over the past decade provided a near-term cover for the deterioration in standards of lending.

Accountancy and Liquidity

There was an overestimation of most of these assets’ liquidity thereby leading investors to trust that the triple-A rated securitized papers would have similar liquidities as plain vanilla triple-A rated papers.

Due to all of this, and general investor negative sentiments, there was a significant reduction in the size of the securitization market.

Practice Questions

1) Which of the following is NOT a major reason fora bank to securitize part of its balance sheet?

  1. To fund the assets owned by the bank
  2. To manage the capital on its balance sheet
  3. To access sectors that are otherwise not open to the bank
  4. To manage risks and transfer credit risk

The correct answer is C.

The major reasons for securitization are managing and transferring credit risk, seeking funding for assets the bank owns and managing balance sheet capital. Accessing the sectors that are otherwise not open to the bank is one of the benefits associated with collateralization and not necessarily a major reason for collateralization.


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