Introduction to Securitization E-Book

Frank J. Fabozzi

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Frank J. Fabozzi Series
• Sprache: Englisch

Seitenzahl: 548

Veröffentlichungsjahr: 2008

Beschreibung

Introduction to Securitization outlines the basics of securitization, addressing applications for this technology to mortgages, collateralized debt obligations, future flows, credit cards, and auto loans. The authors present a comprehensive overview of the topic based on the experience they have gathered through years of interaction with practitioners and graduate students around the world. The authors offer coverage of such key topics as: structuring agency MBS deals and nonagency deals, credit enhancements and sizing, using interest rate derivatives in securitization transactions, asset classes securitized, operational risk factors, implications for financial markets, and applying securitization technology to CDOs. Finally, in the appendices, the authors provide an essential introduction to credit derivatives, an explanation of the methodology for the valuation of MBS/ABS, and the estimation of interest rate risk. Securitization is a financial technique that pools assets together and, in effect, turns them into a tradable security. The end result of a securitization transaction is that a corporation can obtain proceeds by selling assets and not borrowing funds. In real life, many securitization structures are quite complex and enigmatic for practitioners, investors, and finance students. Typically, books detailing this topic are either too lengthy, too technical, or too superficial in their presentation. Introduction to Securitization is the first to offer essential information on this topic at a fundamental, yet comprehensive level-providing readers with a working understanding of what has become one of today's most important areas of finance. Authors Frank Fabozzi and Vinod Kothari, internationally recognized experts in the field, clearly define securitization, contrast it with corporate finance, and explain its advantages. They carefully illustrate the structuring of asset-backed securities (ABS) transactions, including agency mortgage-backed securities (MBS) deals and nonagency deals, and show the use of credit enhancements and interest rate derivatives in such transactions. They review the collateral classes in ABS, such as retail loans, credit cards, and future flows, and discuss ongoing funding vehicles such as asset-backed commercial paper conduits and other structured vehicles. And they explain the different types of collateralized debt obligations (CDOs) and structured credit, detailing their structuring and analysis. To complement the discussion, an introduction to credit derivatives is also provided. The authors conclude with a close look at securitization's impact on the financial markets and the economy, with a review of the now well-documented problems of the securitization of one asset class: subprime mortgages. While questions about the contribution of securitization have been tainted by the subprime mortgage crisis, it remains an important process for corporations, municipalities, and government entities seeking funding. The significance of this financial innovation is that it has been an important form of raising capital for corporations and government entities throughout the world, as well as a vehicle for risk management. Introduction to Securitization offers practitioners and students a simple and comprehensive entry into the interesting world of securitization and structured credit.

Leseprobe

Table of Contents

The Frank J. Fabozzi Series

Title Page

Copyright Page

Dedication

Preface

About the Authors

PART One

CHAPTER 1 - Introduction

WHAT IS A SECURITIZATION?

ILLUSTRATION OF A SECURITIZATION

SECURITIES ISSUED IN A SECURITIZATION

KEY POINTS OF THE CHAPTER

CHAPTER 2 - Issuer Motivation for Securitizing Assets and the Goals of Structuring

REASONS SECURITIZATION IS USED FOR FUNDING

STRUCTURING GOALS

KEY POINTS OF THE CHAPTER

PART Two - Structuring ABS Transactions

CHAPTER 3 - Structuring Agency MBS Deals

PREPAYMENTS AND PREPAYMENT CONVENTIONS

SEQUENTIAL PAY STRUCTURES

PLANNED AMORTIZATION CLASS BONDS AND SUPPORT BONDS

TARGETED AMORTIZATION CLASS BONDS

ACCRUAL BONDS AND ACCRETION-DIRECTED BONDS

FLOATING RATE BOND CLASSES

NOTIONAL INTEREST-ONLY BOND CLASSES

KEY POINTS OF THE CHAPTER

CHAPTER 4 - Structuring Nonagency Deals

IDENTIFICATION OF THE ASSET POOL

SELECTION OF THE ASSETS

IDENTIFICATION OF RISKS

DETERMINATION OF THE SOURCES AND SIZE OF CREDIT SUPPORT

DETERMINATION OF THE BOND CLASSES

TIME TRANCHING OF BOND CLASSES

SELECTING THE PAY-DOWN STRUCTURE FOR THE BOND CLASSES

DETERMINATION OF THE AMOUNT AND SOURCES FOR LIQUIDITY SUPPORT

DETERMINING IF ANY PREPAYMENT PROTECTION IS NEEDED

INCLUSION OF STRUCTURAL PROTECTION TRIGGERS

KEY POINTS OF THE CHAPTER

CHAPTER 5 - Credit Enhancements

CREDIT ENHANCEMENT MECHANISMS

SIZING OF CREDIT ENHANCEMENTS

KEY POINTS OF THE CHAPTER

CHAPTER 6 - Use of Interest Rate Derivatives in Securitization Transactions

INTEREST RATE SWAPS

CAPS AND FLOORS

COUNTERPARTY RISK

KEY POINTS OF THE CHAPTER

CHAPTER 7 - Operational Issues in Securitization

THE SERVICING FUNCTION

TYPES OF SERVICERS

SERVICER STRENGTHS

SERVICER QUALITIES

SERVICING TRANSITION

BACKUP SERVICER

REPORTING BY THE SERVICER

ROLE OF TRUSTEES IN OPERATION OF THE TRANSACTION

FRAUD RISK

KEY POINTS OF THE CHAPTER

PART Three - Review of ABS Collateral

CHAPTER 8 - Collateral Classes in ABS: Retail Loans

COLLATERAL CLASSES: BASIS OF CLASSIFICATION

COLLATERAL CLASSES: MAIN TYPES

CREDIT CARD RECEIVABLES

AUTO LOAN SECURITIZATION

KEY POINTS OF THE CHAPTER

CHAPTER 9 - Asset-Backed Commercial Paper Conduits and Other Structured Vehicles

TYPES OF ABCP CONDUITS

TRADITIONAL SECURITIZATION AND ABCP

ABCP COLLATERAL

CREDIT ENHANCEMENT STRUCTURE

LIQUIDITY SUPPORT

PARTIES TO AN ABCP PROGRAM

RATING OF ABCP CONDUITS

KEY POINTS OF THE CHAPTER

CHAPTER 10 - Securitization of Future Cash Flows: Future Revenues, Operating ...

FUTURE REVENUES SECURITIZATION

WHOLE BUSINESS OR OPERATING REVENUES SECURITIZATION

SECURITIZATION OF INSURANCE PROFITS

KEY POINTS OF THE CHAPTER

PART Four - Collateralized Debt Obligations

CHAPTER 11 - Introduction to Collateralized Debt Obligations

WHY STUDY CDOs?

TERMINOLOGY: CDO, CBO, CLO

TYPES OF CDOs

TYPICAL STRUCTURE OF A CDO

BASIC ECONOMIC DRIVERS OF CDOs

CDO MARKET AND THE HEALTH OF BANKING

GROWTH OF THE CDO MARKET

KEY POINTS OF THE CHAPTER

CHAPTER 12 - Types of Collateralized Debt Obligations

BALANCE SHEET CDOs

ARBITRAGE CDOs

RESECURITIZATION OR STRUCTURED FINANCE CDOs

INDEX TRADES AND INDEX TRACKING CDOs

KEY POINTS OF THE CHAPTER

CHAPTER 13 - Structuring and Analysis of CDOs

MEASURES OF POOL QUALITY

ASSET AND INCOME COVERAGE TESTS

RAMP-UP PERIOD

THE CDO MANAGER

INVESTING IN CDOs

COLLATERAL AND STRUCTURAL RISKS IN CDO INVESTING

KEY POINTS OF THE CHAPTER

PART Five - Implications for Financial Markets

CHAPTER 14 - Benefits of Securitization to Financial Markets and Economies

SECURITIZATION AND FUNDING COSTS

SECURITIZATION AND FINANCIAL INTERMEDIATION

BENEFITS OF SECURITIZATION IN AN ECONOMY

KEY POINTS OF THE CHAPTER

CHAPTER 15 - Concerns with Securitization’s Impact on Financial Markets and Economies

REDUCES THE EFFECTIVES OF MONETARY POLICY

ADVERSE IMPACT ON BANKS

LAX UNDERWRITING STANDARDS AND POORLY DESIGNED SECURITIES

INCREASES OPAQUENESS OF BANK RISK

KEY POINTS OF THE CHAPTER

APPENDIX A - Basics of Credit Derivatives

APPENDIX B - Valuing Mortgage-Backed and Asset-Backed Securities

References

Index

The Frank J. Fabozzi Series

Fixed Income Securities, Second Edition by Frank J. Fabozzi

Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate

Handbook of Global Fixed Income Calculations by Dragomir Krgin

Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi

Real Options and Option-Embedded Securities by William T. Moore

Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi

The Exchange-Traded Funds Manual by Gary L. Gastineau

Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi

Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu

Handbook of Alternative Assets by Mark J. P. Anson

The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

The Handbook of Financial Instruments edited by Frank J. Fabozzi

Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. Fabozzi

Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi

Investment Performance Measurement by Bruce J. Feibel

The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi

The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz

Foundations of Economic Value Added, Second Edition by James L. Grant

Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson

Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi

The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry

The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry

The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi

Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi

The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer

Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy

Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann

Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi

Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M. Focardi, and Petter N. Kolm

Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet

Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi

Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi

Handbook of Alternative Assets, Second Edition by Mark J. P. Anson

Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry

Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic

Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning

Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm, Dessislava A. Pachamanova, and Sergio M. Focardi

Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev, Stogan V. Stoyanov, and Frank J. Fabozzi

How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell, and Glenn E. Ross

Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi

The Handbook of Municipal Bonds edited by Sylvan G. Feldstein and Frank J. Fabozzi

Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas, Thomas A Zimmerman, and Frank J. Fabozzi

Copyright © 2008 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Fabozzi, Frank J. Introduction to securitization / Frank J. Fabozzi, Vinod Kothari. p. cm.—(The Frank J. Fabozzi series) Includes bibliographical references and index.

eISBN : 978-0-470-41957-1

1. Asset-backed financing. 2. Securities. I. Kothari, Vinod. II. Title.HG4028.A84F325 2008 332.63’2--dc22 2008014508.

FJFTo my wife Donna, and my children Francesco, Patricia, and Karly

VK To Acharya Mahaprajna with deepest reverence

Preface

There is a choice of books on securitization, collateralized debt obligations (CDOs), and structured credit products. In fact, both of us have written other books on the subject. This book, however, was conceived as a short, handy and easy-to-comprehend guide to securitization, minus technical details. The idea originated while both of us were working on a comprehensive article on securitization: One which says it all in a limited space and serves as a curtain-raiser on the subject. As we were both very happy with the result of our efforts, we realized that practitioners as well as students need a simpler introduction to securitization than what they are being served in compendious volumes full of details that they may not need. Hence, the caption Introduction to Securitization.

When we were writing this book, the subprime crisis had already started erupting from various quarters. Different commentators had already started criticizing securitization for the subprime losses and consequent repercussions on the global economy. By the time we completed the book, securitization seemed to have become a hated word by several people. Though we have seen financial innovation over several years and we may easily distinguish between a temporary fad and a basic bad, we asked ourselves serious questions about the fundamental logic of securitization. Our analysis has been that securitization as a tool tries to weave a structured fabric, picking up threads from the financial assets originated by banks and others. If the underlying assets are bad, one cannot expect to weave gold out of it. We have taken up the gains and concerns in securitization at length in this book.

In short, the book is concise, comprehensive, and contemporary. Since there has been a coming together of the principles of structured finance with credit derivatives, we have included the fundamentals of structured credit products and CDOs in this book.

The book is divided into five parts. The two chapters in Part One provide the background for securitization. In Chapter 1 we explain what securitization is, the relationship between securitization and structured finance, how securitization differs from traditional forms of financing, the types of securities issued (asset-backed securities), and the parties to a securitization. We explain the six primary reasons why a corporation might prefer to use securitization as a vehicle for raising funds rather than issuing corporate bonds and the goals when a corporation structures a securitization transaction in Chapter 2.

Part Two has five chapters that look more closely at how to structure a securitization transaction. We begin in Chapter 3 with the securitization of conforming loans that result in the creation of agency mortgage-backed securities and the redistribution of cash flows to create collateralized mortgage obligations (CMOs). After explaining prepayments and prepayment conventions, we describe the different types of bond classes or tranches in a CMO structure. We begin with agency products because it allows us to clearly demonstrate how the risk of the collateral of a pool of assets is redistributed amongst the different bond classes. The risks redistributed in the case of agency CMOs is prepayment risk and interest rate risk. We then move into the structuring nonagency deals which include the securitization of prime mortgages and subprime loans in Chapter 4. In the case of nonagency deals involving residential mortgage loans, structuring involves the redistribution of prepayment and interest rate risks and credit risk. We explain the difference in structuring considerations for a prime and subprime transaction.

We cover credit enhancement mechanisms in a securitization transaction in Chapter 5. We explain that (1) the amount of credit enhancement required to obtain a targeted credit rating is set by the rating agencies, (2) the amount of credit enhancement will depend on the type of collateral, (3) some forms of credit enhancement are more suitable for certain types of assets but would be totally inappropriate for other types, and (4) all credit enhancement has a cost associated with it so an economic analysis of the cost of further enhancement of a structure versus the improved execution of the transaction must be analyzed in considering why additional credit enhancement is justified.

A securitization transaction may require the use of an interest rate derivative for asset-liability management or yield enhancement. We describe the different types of interest rate derivatives used (interest rate swaps, interest rate caps, and interest rate corridors) in Chapter 6. Since these instruments are over-the-counter financial products, this exposes a transaction to counterparty risk. After providing the basics about interest rate derivatives, we explain how they are used in a securitization providing examples from prospectus supplements.

Operational risk refers to the various risks that any of the agents responsible for the various operations or processes that lead to transformation of the securitized assets into investors’ cash flows may not do what they are supposed to do, or there might be failure of systems, equipments, or processes that may lead to leakages, costs, delays, etc. Because operational issues in securitization have attracted quite some attention in recent years, we devote Chapter 7 to this topic.

The three chapters in Part Three review the different types of assets that have been securitized. In Chapter 8, we make a distinction between the securitization of existing assets and future assets and a distinction between a cash securitization and a synthetic securitization. We then go on to discuss the two main types of retail assets that have been securitized (in addition to residential mortgage loans that we covered in Part Two): credit card receivables and auto loans. Asset-backed commercial paper conduits, structured investment vehicles, etc. have been hotly talked about lately. We discuss the structure of these conduits and how it differs from term securitization, in Chapter 9. In addition, in that chapter, we explain other structured vehicles (conduits based on liquidity support, the number of sellers, and on asset type). In Chapter 10 we cover the securitization of future cash flows, whole business securitization (also referred to as operating revenues securitization), and securitization of embedded profits in insurance businesses.

In Part Four we look at the application of securitization technology to structured credit portfolios, more specifically collateralized debt obligations (CDOs). In Chapter 11, we provide an introduction to CDOs, explaining the economic motivation for their creation, the terminology used in CDOs, the structure of CDOs, and the types of CDOs. More details about the types of CDOs, including their structure and special features, are described in Chapter 12. This includes balance sheet CDOs (cash and synthetic), arbitrage CDOs (cash and synthetic), the resecuritization or structured finance CDOs, and index trades and indexing tracking CDOs. We devote Chapter 13 to a variety of issues concerning CDOs involving structuring and their analysis. In that chapter we look at measures of pool quality (asset quality tests, diversity tests), asset and income coverage tests (overcollateralization tests and interest coverage tests), the ramp-up period, the CDO manager, investing in CDOs, and collateral and structural risk in CDO investing.

Part Five looks at the implications of securitization for financial markets and economies. We set forth the benefits of securitization in Chapter 14 and the concerns with securitization in Chapter 15.

There are two appendices. Appendix A provides the basics of credit derivatives. We provide coverage on this latest type of derivative product because of its use in creating synthetic CDOs. In Appendix B, we explain the fundamental of valuing MBS and ABS.

In order to ensure that each chapter can be condensed into key learnings, we provide a list of the key points covered in the chapter for all the chapters. We believe that these key points will allow the reader to quickly assimilate the “take home” value after reading a chapter.

We hope this book will be a valuable addition to the existing literature on the subject.

Frank J. Fabozzi

Vinod Kothari

About the Authors

Frank J. Fabozzi is Professor in the Practice of Finance and Becton Fellow in the School of Management at Yale University. Prior to joining the Yale faculty, he was a Visiting Professor of Finance in the Sloan School at MIT. Professor Fabozzi is a Fellow of the International Center for Finance at Yale University and on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University. He is an affiliated professor at the Institute of Statistics, Econometrics and Mathematical Finance at the University of Karlsruhe (Germany). He is the editor of the Journal of Portfolio Management and an associate editor of the Journal of Fixed Income and the Journal of Structured Finance. He earned a doctorate in economics from the City University of New York in 1972. In 2002, Professor Fabozzi was inducted into the Fixed Income Analysts Society’s Hall of Fame and is the 2007 recipient of the C. Stewart Sheppard Award given by the CFA Institute. He earned the designation of Chartered Financial Analyst and Certified Public Accountant. He has authored and edited numerous books about finance.

Vinod Kothari, chartered accountant and chartered secretary, is an established author, trainer, and consultant on asset-based financing, structured finance, and structured credit. Mr. Kothari has been a rank holder throughout his academic career and was awarded the Outstanding Young Person Award in the field of Finance and Taxation by a voluntary organization. He wrote his first book at the age of 23; he has authored books on leasing, securitization, credit derivatives, and security interests. Mr. Kothari is a visiting faculty at Indian Institute of Management, Kolkata, where he teaches structured finance, and a visiting faculty at National University of Juridical Sciences, Kolkata, where he teaches corporate insolvency.

PART One

Background

CHAPTER 1

Introduction

What do David Bowie, James Brown, the Isley Brothers, and Rod Stewart have in common? The obvious answer is that they are all recording artists. The financial professional would go beyond this obvious commonality by adding: All of them have used a financing technique known as securitization to obtain funding from their future music royalties. The first was David Bowie who in 1997 used securitization to raise $55 million backed by the current and future revenues of his first 25 music albums (287 songs) recorded prior to 1990. These bonds, popularly referred to as “Bowie bonds” and purchased by Prudential Insurance Company, had a maturity of 10 years. When the bonds matured in 2007, the royalty rights reverted back to David Bowie. Despite the attention drawn to securitization by the popular press because of the deals done by these recording artists, the significance of this financial innovation is that it has been an important form of raising capital for corporations and government entities throughout the world, as well as a tool for risk management.

Prior to the 1980s, the meaning of securitization was used to describe the process of substituting the issuance of securities to obtain debt financing for bank borrowing. Economists referred to this process for fund raising as disintermediation. For example, the former chairman of Citicorp offered the following definition for securitization: “the substitution of more efficient public capital markets for less efficient, higher cost, financial intermediaries in the funding of debt instruments” (Kendall and Fishman, 1996). The development of the high-yield bond market in the late 1970s and early 1980s can be viewed as a securitization under this broad definition because bank loans to speculative-grade-rated corporations were replaced by the issuance of public bonds by these borrowers.

Today, however, the definition of securitization has taken on a more specific meaning. As stated by Lumpkin (1999, p. 1):

More recently, the term has been used to refer to so-called “structured finance,” the process by which (relatively) homogeneous, but illiquid, assets are pooled and repackaged, with security interests representing claims to the incoming cash flows and other economic benefits generated by the loan pool sold as securities to third-party investors.

Admittedly, defining securitization in terms of structured finance begs the question of what is meant by structured finance. There is no universal definition of structure finance. Fabozzi, Davis, and Choudhry (2006) note that the term covers a wide range of financial market activity. Based on a survey of capital market participants, they provide the following working definition for structured finance:

… techniques employed whenever the requirements of the originator or owner of an asset, be they concerned with funding, liquidity, risk transfer, or other need, cannot be met by an existing, off-the-shelf product or instrument. Hence, to meet this requirement, existing products and techniques must be engineered into a tailor-made product or process. Thus, structured finance is a flexible financial engineering tool.

Structured finance by this definition would include not just securitization but also structured credits, project finance, structured notes, and leasing (large ticket leasing, particularly leveraged leases). In a survey of capital market participants, some respondents equated structured finance as securitization as in the definition by Lumpkin. In fact, a 2005 report by the Bank for International Settlements (BIS) defines structured finance as follows:

Structured finance instruments can be defined through three key characteristics: (1) pooling of assets (either cash-based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differentiates structured finance from traditional “pass-through” securitizations); (3) de-linking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through use of a finite-lived, standalone special purpose vehicle (SPV). (BIS, 2005, p. 5)

As we discuss securitization in this book, we see the importance of the three characteristics cited in the BIS definition. Moreover, while we refer to a securitization as a means of financing, as will become clear, the end result of a transaction is that a corporation can obtain proceeds by selling assets and not borrowing funds. The asset securitization process transforms a pool of assets into one or more securities that are referred to as asset-backed securities.

The purpose of this book is to explain the fundamentals of securitization. While the focus is on securitization from the perspective of the issuer, Appendix B explains the valuation and the analysis of the interest rate risk for the securities created from a securitization transaction from the investor’s perspective.

WHAT IS A SECURITIZATION?

There are some similarities between securitization and secured lending. In secured lending, also called asset-based lending, the lender requires that the borrowing firm commit specific assets of the firm as security or collateral for a lending arrangement. The assets that are used as collateral may be short-term assets such as accounts receivable or long-term assets such as equipment. For example, in accounts receivable financing the lender looks first to the accounts receivable of the borrower to fulfill the financial obligations of the lending arrangement. The amount advanced by the lender to the client firm depends on (1) what the lender deems acceptable based on the quality and nature of the receivables; (2) the type of customer the client firm sells to and the terms of the sale; and (3) the historical performance of the client firm’s accounts receivables. Moreover, certain types of receivables may not be appropriate for financing via secured lending. For longer-term assets such as equipment, secured lending can be in the form of a loan or a bond. The cost of borrowing depends on the credit quality of the borrower because lenders are looking to the ability of the borrowing firm to satisfy the terms of the borrowing arrangement.

A securitization differs from these traditional forms of financing in several important ways. The key in a securitization is that the cash flow generated by the asset pool can be employed to support one or more securities that may be of higher credit quality than the company’s secured debt. The higher credit quality of these securities is achieved by relying on the cash flow created by the pool of assets rather than on the payment promise of the borrowing firm, such cash flows having been isolated in a bankruptcy remote structure and “credit enhanced” using several credit enhancement techniques discussed in Chapter 5.1 Compare this with secured lending. In the case of accounts receivable financing, while the lender looks first to the cash flow generated by the receivables, the borrowing firm is responsible for any shortfall. In the case of secured lending where the collateral is property, the lender relies primarily on the borrowing firm’s ability to repay and only secondarily to the value at which the collateral can be liquidated in bankruptcy. Moreover, in relying on the liquidation value of the collateral, the lender assumes that in a bankruptcy proceeding the distribution of assets will be based on the principle of absolute priority (i.e., secured lenders are repaid before unsecured lenders and equity investors receive any proceeds). However, while this is the case in a liquidation of a corporation, the principle of absolute priority typically does not hold in a corporate reorganization.2

Because securitization involves the sale of assets, it is commonly compared to factoring.3 Unlike in a secured lending arrangement such as accounts receivable financing, the client firm has sold the accounts receivables to the factor. The factor’s credit risk depends on the arrangement: recourse factoring, modified recourse factoring, and nonrecourse factoring. In recourse factoring, the factor does not absorb the risk of loss for a customer account but instead obtains repayment from the client firm. In modified recourse factoring, insurance is obtained by the factor and offered to the client firm. The client firm is then not responsibile for the risk of loss for a customer account.4 In nonrecourse factoring, all of the credit risk is transferred to the factor. In terms of cost, recourse factoring is the least expensive because the factor is not exposed to the credit risk of the customer accounts and nonrecourse factoring is the most expensive because the credit risk is transferred to the factor. Hence, unlike recourse financing, securitization slices the credit risk into several slices; the juniormost slice may be retained by the borrower, but the other slices are transferred to the “lenders.” That is to say, investors buying the securities. At the option of the client firm, the factor may provide a cash advance against a portion of the accounts receivable.

Just three of the advantages of securitization compared to nonrecourse and modified recourse are that (1) there is typically lower funding cost when a securitization is used; (2) receivables that factors will not purchase may be acceptable for a securitization; and (3) proceeds from the sale in a securitization are received immediately while the firm may or may not obtain a cash advance from the factor.

As noted earlier, generally, securitization is a form of structured finance. Structured finance also encompasses project finance, the financing of some types of equipment, and some other kinds of secured financing. The common theme to all types of structured finance transactions is that the transaction is structured to modify or redistribute the risk of the collateral among different classes of investors by the use of a structure. The risks of the collateral are its credit risk, interest rate risk, prepayment risk, and liquidity risk. Securitization is primarily concerned with monetizing financial assets in such a way that the risk is tied primarily to their repayment rather than to the performance of a particular project or entity.

The assets that can be sold by an originator and then used as collateral in an asset securitization fall into two types: (1) existing assets/existing receivables and (2) assets/receivables to arise in the future. Some examples of assets that fall into the former category are residential mortgage loans, commercial mortgage loans, corporate loans, automobile car loans, and student loans. Transactions with this type of collateral are referred to as existing asset securitizations. Transactions of asset/receivables to arise in the future are referred to as future flow securitizations. Examples include airline ticket receivables, oil and gas royalties, and tax revenue receivables.

ILLUSTRATION OF A SECURITIZATION

We use a hypothetical securitization to illustrate the key elements of a securitization and the parties to a transaction. Our hypothetical firm is the Ace Corporation, a manufacturer of specialized equipment for the construction of commercial buildings. Some of its sales are for cash, but the bulk are from installment sales contracts. For simplicity, we assume that the installment period is typically seven years. The collateral for each installment sales contract (sometimes loosely referred to herein as a loan) is the construction equipment purchased by the borrower. The loan specifies the interest rate the customer pays.

The decision to extend a loan to a customer is made by the credit department of Ace Corporation based on criteria established by the firm, referred to as its underwriting standards. In this securitization, Ace Corporation is referred to as the originator because it has originated the loans to its customers. Moreover, Ace Corporation may have a department that is responsible for collecting payments from customers, notifying customers who may be delinquent, and, when necessary, recovering and disposing of the collateral (i.e., the construction equipment in our illustration) if the customer fails to make loan repayments by a specified time. These activities are referred to as servicing the loan. While the servicer of the loans need not be the originator of the loans, in our illustration we are assuming that Ace Corporation is the servicer.

Suppose that Ace Corporation currently has $400 million in installment sales contracts (i.e., its accounts receivable). The chief financial officer (CFO) of Ace Corporation wants to use its installment sales contracts to raise $320 million rather than issue a traditional corporate bond. To do so, the CFO will work with its legal staff to set up a legal entity referred to as a special purpose vehicle (SPV), also referred to as a special purpose entity (SPE). The SPV is critical in a securitization transaction because it is this entity that delinks the credit of the entity seeking funding (Ace Corporation) from the creditworthiness of the securities that are created in a securitization. Assume that the SPV set up by Ace Corporate is called Financial Ace Trust (FACET). Ace Corporation sells $320 million of the loans to FACET and receives from FACET $320 million in cash, the amount the CFO wanted to raise. Since Ace Corporation is the originator of the loans and has sold these loans to FACET, Ace Corporation is referred to as the originator/seller in this transaction.

It is critical that the sale of the loans transferred be a true sale by Ace Corporation to FACET. By a true sale it is meant that the sale of the assets closely substantively resembles a commercial sale of such assets by Ace Corporation. If it is subsequently determined in a bankruptcy proceeding that the so-called sale by Ace Corporation was merely a nomenclature or a camouflage, then a bankruptcy judge can rule that the assets were never sold and were merely pledged as collateral for a financing. In that case, in the event of a bankruptcy filing by Ace Corporation, the bankruptcy judge can have the assets of FACET treated as part of the assets of Ace Corporation. This would defeat the purpose of setting up the SPV. Typically, a true sale opinion letter by a law firm is sought to provide additional comfort to the parties in the transaction.

Where does FACET obtain the $320 million to buy the assets? It does so by issuing asset-backed securities, called bond classes or tranches. A simple transaction can involve the sale of just one bond class with a par value of $320 million. The payments to the bond classes are obtained from the payments made by the obligors (i.e., the buyers of the construction equipment). The payments from the obligors include principal repayment and interest. However, most securitization transactions involve a more complex structure than simply one bond class. For example, there can be rules for distribution of principal and interest other than on a pro rata basis to different bond classes. The creation of different bond classes allows the distribution of the collateral’s risk among different types of investors: investors with different appetite’s for interest rate risk (i.e., price sensitivity to changes in interest rates) and credit risk.

An example of a more complicated transaction is one in which two bond classes are created, bond class A1 and bond class A2. The par value for bond class A1 is $120 million and for bond class A2 is $200 million. The priority rule set forth in the structure can simply specify that bond class A1 receives all the principal generated from the collateral until all the entire $120 million of bond class A1 is paid off and then bond class A2 begins to receive principal. Bond class A1 is then a shorter-term bond than bond class A2. This type of tranching is used to create securities with different exposures to interest rate risk.

Also, as will be explained in later chapters, in most securitizations there is more than one bond class and the various bond classes differ as to how they share any losses resulting from the obligor defaults. For example, suppose FACET issued $290 million par value of bond class A, the senior bond class, and $30 million par value of bond class B, a subordinated bond class. As long as there are no defaults by obligors that exceed $30 million, then bond class A receives full repayment of its $290 million.

SECURITIES ISSUED IN A SECURITIZATION

The term used to describe the securities issued by the SPV in a securitization are referred to as asset-backed notes, asset-backed bonds, or asset-backed obligations. When the security is short-term commercial paper, it is referred to as asset-backed commercial paper (or ABCP). As will be explained when we discuss the different types of securitization structures in later chapters, asset-backed securities can have different credit exposure and based on the credit priority, securities are described as senior notes and junior notes (subordinated notes).

In the prospectus for a securitization, the securities are actually referred to as certificates: pass-through certificates or pay-through certificates. The distinction between these two types of certificates is the nature of the claim that the certificate holder has on the cash flow generated by the asset pool. If the investor has a direct claim on all of the cash flow and the certificate holder has a proportionate share of the collateral’s cash flow, the term pass-through certificate (or beneficial interest certificate) is used. When there are rules that are used to allocate the collateral’s cash flow among different bond classes, the asset-backed securities are referred to as pay-through certificates.

KEY POINTS OF THE CHAPTER

• Securitization is a form of structured finance.

• The common theme to all types of structured finance transactions is that the transaction is structured to modify or redistribute the risk of the collateral among different classes of investors by the use of a structure.

• Securitization involves the pooling of assets/receivables and the issuance of securities by a special purpose vehicle.

• The end result of a securitization transaction is that a corporation can obtain proceeds by selling assets and not borrowing funds.

• The asset securitization process transforms a pool of assets into one or more securities referred to as asset-backed securities.

• A securitization differs from traditional forms of financing in that the cash flow generated by the asset pool can be employed to support one or more securities that may be of higher credit quality than the company’s secured debt.

• Three advantages of securitization compared to nonrecourse and modified recourse factoring are that (1) there is a typically lower funding cost when a securitization is used; (2) receivables that factors will not purchase may be acceptable for a securitization; and (3) proceeds from the sale in a securitization are received immediately while the firm may or may not obtain a cash advance from the factor.

• Securitization is primarily concerned with monetizing financial assets in such a way that the risks of the collateral (credit risk, interest rate risk, prepayment risk, and liquidity risk) are tied primarily to their repayment rather than to the performance of a particular project or entity.

• The assets used in a securitization can be either existing assets/ existing receivables in which case the transaction is referred to as an existing asset securitization or assets/receivables to arise in the future in which case the transaction is referred to as a future flow transaction.

• The parties to a securitization are the originator, the servicer, and the investors in the asset-backed securities.

• The originator (also referred to as the originator/seller) makes the loans based on its underwriting standards and sells a pool of loans it originates to an SPV, the sale being required to be a true sale for legal purposes.

• The SPV purchases the pool of loans from the proceeds obtained from the sale of the asset-backed securities.

• The capital structure of the SPV can involve just one bond class or several bond classes with different priorities on the cash flow from the collateral.

• While the securities issued in a securitization are commonly referred to as asset-backed securities, in the prospectus they are referred to by various names.

CHAPTER 2

Issuer Motivation for Securitizing Assets and the Goals of Structuring