Securitization

• Securitization is a process which allows institutions such as banks and corporations to convert assets that are not readily marketable – such as residential mortgages or car loans – into rated securities that are tradable in the secondary market. It is a well-established practice in the global debt capital markets.
• The main incentive for the use of securitization, from the point of view of investors, is to provided the investors with exposures to certain types of original assets that they would not otherwise have an exposure to. The technique is well established and was first introduced by mortgage banks in the United States during the 1970s. The synthetic securitization market was established much more recently, dating from 1997.
• Securitization process includes the sale of assets by institutions that own the assets, to another company that has been specifically set up for the purpose of acquiring the assets, with the later issuing notes that are purchased by investors. These notes are supported by the cash flows from the original assets.
• The technique of securitization was introduced initially as a means of funding for the United States mortgage banks. Subsequently, the technique was applied to other assets such as credit card payments and equipment leasing receivables.
• Securitization has also been employed as part of asset/liability management, as a means of managing balance sheet risk.

Securitization Process

• Securitization process involves-
  1. Undertaking ‘due diligence’ on the quality and future prospects of the assets.
  2. Setting up the SPV and then effecting the transfer of assets to it.
  3. Underwriting of loans for credit quality and servicing.
  4. Determining the structure of the notes, including how many tranches are to be issued, in accordance with originator and investor requirements.
  5. The rating of notes by one or more credit rating agencies.
  6. Placing of the notes in the capital markets.
• The most common securitization process involves an issuer acquiring the assets from the originator. The issuer is usually a company that has been specially set up for the purpose of the securitization. It is a Special Purpose Vehicle (SPV) and is usually domiciled offshore.
• The creation of an SPV ensures that the underlying asset pool is held separate from the other assets of the originator. This is done so that in the event that the originator is declared bankrupt or insolvent, the assets that have been transferred to the SPV will not be affected. This is known as being bankruptcy-remote.
• Conversely, if the underlying assets begin to deteriorate in quality and are subject to a ratings downgrade, investors have no recourse to the originator. By holding the assets within an SPV framework, defined in formal legal terms, the financial status and credit rating of the originator becomes almost irrelevant to the bondholders.
• The process of securitization often involves credit enhancements (in which a third-party guarantee of credit quality is obtained) so that notes issued under the securitization are often rated at investment grade and up to 𝐴𝐴𝐴-grade.
• The process of structuring a securitization deal ensures that the liability side of the SPV – the issued notes – carries a lower cost than the asset side of the SPV. This enables the originator to secure lower cost funding that it would not otherwise be able to obtain in the unsecured market. This is a tremendous benefit for institutions with lower credit ratings.

Key Participants in the Securitization Process

The key participants in the securitization process are –
1) The Originator
2) The Issuer
3) The Rating Agency
4) The Trustee
5) Financial Guarantors
The Originator
The Originator is the entity that writes the various loans that would eventually be securitized. These loans can be wide ranging and may include home loans, credit card debt, auto loans, etc. The Originator plays an important role in the securitization process as it does the bulk of the due diligence on the borrowers and the quality of its judgement, regarding the borrower’s capacity and willingness to repay the loans advanced, would directly impact the quality of the securities. The Originator gives out the various loans to customers and then sell these loans as an asset to the issuer who, in turn, would convert these assets into securities. This business model makes sense for the Originator in many cases as by selling these loans, it would receive cash upfront and won’t have to wait for the loans to mature over a long period of time.

The Issuer
The issuer is the entity that buys loans from the originator (usually in bulk), and then converts these loans into tradeable securities. The issuers conduct their own due diligence regarding the quality of the mortgages that are to be securitized. They also play an important role in establishing a structure (using special purpose vehicles and servicers) through which the securities can be further sold off to the investors. The issuers also lend their name to the
special purpose vehicles – which though do not have legal backing from the issuer in most cases, do benefit from the reputation of the issuer. Often big investment banks play the role of the issuer and they would go out of their way to ensure that the SPVs created by them do not fail due to the potential reputational damage such a failure could bring.
The Rating Agency
It is common for securitization deals to be rated by one or more of the formal credit ratings agencies – Moody’s, Fitch or Standard & Poor’s. A formal credit rating makes it easier for the issuer to place the notes with the investors. The methodology employed by the rating agencies, takes into account both qualitative and quantitative factors, and differs according to the asset class being securitized.

The Trustee
Since most investors whom the securities are sold do not have a lot of financial knowledge, a trustee is appointed to protect the interest of the investors. The SPV pledges its right to the receivables to the trustee and the trustee in turns ensures the payment regarding the interest and principal repayment are made to the investors on time. Trustees are usually the Agency
services department of banks such as Deutsche Bank or Citibank or are specialist Trust companies such as Wilmington Trust.
The Financial Guarantor
The process of securitization often involves credit enhancements, like a third-party guarantee of credit quality is obtained. This helps the notes issued under the securitization to be rated at investment grade and up to𝐴𝐴𝐴-grade. The investment bank decides whether or not an insurance company, known as a mono-line insurer, should be approached to ‘wrap’ the deal by
providing a guarantee of backing for the SPV in the event of default. This insurance is provided in return for a fee.

Reasons For Securitization (From Bank’s Perspective)

• The issuer’s role is very important from the point of view of bringing liquidity into the otherwise illiquid market and also from the risk dispersion perspective. This can be understood by the following example-
• If retail banks had about$100Million to give out as mortgage loans and securitization is not an option, it would lead to the following scenario-
  • The issuer would only be able to give out loans up to the maximum amount of $100 Million.
  • Since these are mortgage loans, most of the loans would remain on the books of the bank
  • for a very long period of time.
  • The risk management in the mortgage loan business of the bank can not be done appropriately due to the lack of instruments to hedge borrower defaults. This is primarily because the$100million worth of mortgage loans would include hundreds, if not thousands, of mortgage loans with borrowers across many geographic locations.
  • The loans can not be sold by the bank on individual basis to the various investors. This can be due to the fact that there are many loans and the loss given default for individual loans is extremely high.
  • Individual investors can not usually buy whole mortgage loans due to the huge notional

• Thus, securitization allows-
  • The retail banks to free up part of their capital (part of the$100Million in the above example).
  • The impact of individual defaults of loans to be greatly reduced through the diversification process during securitization. This happens because thousands of mortgages are bundled into the security which is ideal when the probability of default is extremely low, but the loss given default is extremely high.

• Investor interest in the ABS market has been considerable from the market’s inception. This is because investors perceive ABSs as possessing a number of benefits. Investors can:
  • Diversify sectors of interest.
  • Access different (and sometimes superior) risk-reward profiles.
  • Access sectors that are otherwise not open to them.
• A key benefit of securitization is the ability to tailor risk-return profiles. This can be understood by the fact that if there is a lack of assets of any specific credit rating, they can be created via securitization.
• Securitized notes frequently offer better risk-reward performance than corporate bonds of the same rating and maturity. This is due to the fact that the originator holds the first-loss piece in the securitization structure.
• A holding in an ABS also diversifies the risk exposure. For example, rather than investing $100 million in an𝐴𝐴-rated corporate bond and being exposed to ‘event risk’ associated with the issuer, investors can gain exposure to, say, 100 pooled assets. These pooled assets will have lower concentration risk.

Over-Collateralization

• Over-collateralization is a tool of credit enhancement which helps in improving the quality of the securities. Over-collateralization happens when the principal value of notes issued is lower than the principal value of assets, and a liquidity facility provided by a bank.
• The lower rated notes usually have a greater element of over-collateralization and are thus, capable of absorbing greater losses. The rationale here is quite simple- if the quality of mortgages is low – as is the case in the lower rated notes, there is a greater probability of default of mortgages. Thus, to ensure that the tranches begin to taken on losses only after a good number of mortgages have defaulted, a cushion in the form of additional principal value of assets over and above the principal value of notes is created.

First Loss Piece / Equity Piece

• The most junior note is the lowest rated or non-rated. It is often referred to as the first-loss piece, because it is impacted by losses in the underlying asset pool first.
• The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually owned by the originator.

Cash Waterfall Structure

All securitization structures incorporate a cash waterfall process, whereby all the cash that is generated by the asset pool is paid in order of payment priority. Only when senior obligations have been met can more junior obligations be paid. An independent third-party agent is usually employed to run ‘tests’ on the vehicle to confirm that there is sufficient cash available to pay all obligations. If a test is failed, then the vehicle will start to pay off the notes, starting from the senior notes.

Types Of Special Purpose Vehicle Structures

1. Amortizing Structures
   • Amortizing structures pay principal and interest to investors on a coupon-by-coupon basis throughout the life of the security. In this type of structure, the amount of principal outstanding keeps reducing with passage of time.
   • These SPVs issue securities that are priced and traded based on expected maturity and weighted-average life (WAL), which is the time-weighted period during which principal is outstanding.
   • A WAL approach incorporates various pre-payment assumptions, and any change in pre-payment speed will increase or decrease the rate at which principal is repaid to investors.
   • Passthrough structures are commonly used in residential and commercial mortgage-backed deals (MBS), and consumer loan Asset Backed Securities (ABS).
2. Revolving Structures
   • Revolving structures revolve the principal of the assets; i.e., during the revolving period, principal collections are used to purchase new receivables that fulfil the necessary criteria.
   • The structure is used for short-dated assets with a relatively high pre-payment speed, such as credit card debt and auto-loans.
   • During the amortization period, principal payments are paid to investors either in a series of equal instalments (controlled amortization) or the principal is “trapped’ in a separate account until the expected maturity date and then paid in a single lump sum to investors (soft bullet)
3. Master Trust
   • Frequent issuers under US and UK law use master trust structures, which allow multiple securitizations to be issued from the same SPV.
   • Under such schemes, the originator transfers assets to the master trust SPV. Notes are then issued out of the asset pool based on investor demand.
   • Master trusts are used by MBS and credit card ABS originators.

Credit Enhancement and its Types

• Credit enhancement refers to the group of measures that can be instituted as part of the securitization process for ABS and MBS issues so that the credit rating of the issued notes meets investor requirements.
• The lower the quality of the assets being securitized, the greater is the need for credit enhancement. This is usually done by using some or all of the following methods-
  • Over-collateralization – In Over-collateralization, the nominal value of the assets in the pool are in excess of the nominal value of issued securities.
  • Pool Insurance – An insurance policy is provided by a composite insurance company to cover the risk of principal loss in the collateral pool. The claims paying rating of the insurance company is important in determining the overall rating of the issue.
  • Senior/Junior note classes – In this mechanism, the credit enhancement is provided by subordinating a class of notes (‘class B’ notes) to the senior class notes (‘class A’ notes). The class B note’s right to its proportional share of cash flows is subordinated to the rights of the senior note holders. Class B notes do not receive payments of principal until certain rating agency requirements have been met, specifically satisfactory performance of the collateral pool over a predetermined period, or in many cases until all of the senior note classes have been redeemed in full.
  • Margin step-up – In Margin step-up, a number of ABS issues incorporate a step-up feature in the coupon structure, which typically coincides with a call date. Although the issuer is usually under no obligation to redeem the notes at this point, the step-up feature was introduced as an added incentive for investors, to convince them from the outset that the economic cost of paying a higher coupon is unacceptable and that the issuer would seek to refinance by exercising its call option.
  • Excess spread – Excess spread is the difference between the return on the underlying assets and the interest rate payable on the issued notes (liabilities). The monthly excess spread is used to cover expenses and any losses. If any surplus is left over, it is held in a reserve account to cover against future losses or (if not required for that), as a benefit to the originator. In the meantime, the reserve account is a credit enhancement for investors.

Performance Analysis Tools – Auto Loan

• Auto loan pools were some of the earliest to be securitized in the ABS market. Investors had been attracted to the high asset quality involved and the fact that the vehicle offers an easily sellable, tangible asset in the case of obligor default.
• In addition, no real pre-payment culture exists. Prepayment speed is extremely stable and losses are relatively low, particularly in the prime sector. This is an attractive feature for investors.

Performance Analysis of Auto Loans–

• The main indicators are Loss Curves, which show expected cumulative loss through the life of a pool and so, when compared to actual losses, give a good measure of performance. In addition, the resulting loss forecasts can be useful to investors buying subordinated note classes.
• Prime obligors will have losses more evenly distributed, while non-prime and sub-prime lenders will have losses recognized earlier and so show a steeper curve. In both instances, losses typically decline in the latter years of the loan.
• The absolute prepayment speed is a standard measure for prepayments. It provides an indication of the expected maturity of the issued ABS and essentially, the value of the implicit call option on the issued ABS at any time.

Performance Analysis Tools – Credit Card Debt

• Credit card pools are differentiated from other types of ABS in that loans have no predetermined term.
• A single obligor’s credit card debt is often no more than six months and so the structure has to differ from other ABS in that repayment speed needs to be controlled, either through scheduled amortization or the inclusion of a revolving period (where principal collections are used to purchase additional receivables).
• Since 1991, the Stand-alone Trust has been replaced with a Master Trust as the preferred structuring vehicle for credit card ABS. The Master Trust structure allows an issuer to sell multiple issues from a single trust and from a single, although changing, pool of receivables. Each series can draw on the cash flows from the entire pool of securitized assets with income allocated to each, pro-rata, based on the invested amount in the Master Trust.
• An important feature of this is excess spread, reflecting the high yield on credit card debt compared to the card issuer’s funding costs. In addition, a financial guaranty is included as a form of credit enhancement given the low rate of recoveries and the absence of security on the collateral.
• Excess spread released from the trust can be shared with other series suffering interest shortfalls.

Performance Analysis of Credit Card Debts –

• The delinquency ratio is measured as the value of credit card receivables overdue for more than 90 days as a percentage of total credit card receivables. The ratio provides an early indication of the quality of the credit card portfolio.
• The default ratio refers to the total amount of credit card receivables written off during a period as a percentage of the total credit card receivables at the end of that period. Together, these two ratios provide an assessment of the credit loss on the pool and are normally tied to triggers for early amortization and so require reporting through the life of the transaction.
• The monthly payment rate (𝑀𝑃𝑅) reflects the proportion of the principal and interest on the pool that is repaid in a particular period. The ratings agencies require every non-amortizing ABS to establish a minimum as an early amortization trigger.

Performance Analysis Tools – Mortgages

• The MBS sector is notable for the diversity of mortgage pools that are offered to investors. Portfolios can offer varying duration as well as both fixed rate and floating rate debt.
• The most common structure for agency-MBS is pass-through, where investors are simply purchasing a share in the cash flow of the underlying loans. Conversely, non-agency MBS (including CMBS), have both senior and subordinated classes with principal losses being absorbed in reverse order. The other notable difference between RMBS and CMBS is that the CMBS is a non-recourse loan to the issuer as it is fully secured by the underlying property asset.

Performance Analysis of Mortgages–

• The Debt service coverage ratio (DSCR), indicates a borrower’s ability to repay a loan. A DSCR of less than1.0means that there is insufficient cash flow generated by the property to cover required debt payments.
• The weighted average coupon (WAC) is the weighted coupon of the pool that is obtained by multiplying the mortgage rate on each loan by its balance. The WAC will, therefore, change as loans are repaid, but at any point in time when compared to the net coupon payable to investors, gives us an indication of the pool’s ability to pay.
• The weighted average maturity (WAM) is the average weighted (weighted by loan balance) of the remaining terms to maturity (expressed in months) of the underlying pool of mortgage loans in the MBS. Longer securities are by nature more volatile and so a WAM calculated on the stated maturity date avoids the subjective call of whether the MBS will mature and recognizes the potential liquidity risk for each security in the portfolio. Conversely, a WAM calculated using the reset date will show the shortening effect of prepayments on the term of the loan.
• The weighted average life (WAL) of the notes gives the dollar amount that remains outstanding on a mortgage.

Delinquency Ratio

• The delinquency ratio is measured as the value of credit card receivables overdue for more than 90 days as a percentage of total credit card receivables.
• The ratio provides an early indication of the quality of the credit card portfolio.

Delinquency Ratio = (\frac{\text{Delinquents}}{\text{Outstanding Pool Balance}})

• The Delinquency Ratio is most commonly used in the Credit Card Portfolios.

Default Ratio

• The default ratio refers to the total amount of credit card receivables written off during a period as a percentage of the total credit card receivables at the end of that period.
• Together, the default ratio, along with the delinquency ratio, provides an assessment of the credit loss on the pool and are normally tied to triggers for early amortization and so require reporting through the life of the transaction.

Default Ratio = \(\frac{\text{Defaults}}{\text{Outstanding pool balance}}\)

• The Default Ratio is most commonly used in the Credit Card Portfolios.

Monthly Payment Rate (MPR)

• The monthly payment rate (𝑀𝑃𝑅) reflects the proportion of the principal and interest on the pool that is repaid in a particular period.
• The ratings agencies require every non-amortizing ABS to establish a minimum 𝑀𝑃𝑅 as an early amortization trigger.

Monthly Payment Rate (MPR) = (\frac{\text{collection}}{\text{outstanding pool balance}})

• Monthly Payment Rate is very commonly used for all non-amortizing asset classes.

Debt Service Coverage Ratio (DSCR)

• Debt service coverage ratio (DSCR), which is Net operating income/Debt payments and so indicates a borrower’s ability to repay a loan.
• A DSCR of less than 1.0 means that there is insufficient cash flow generated by the property to cover required debt payments.

Debt Service Coverage Ratio (DSCR) = \(\frac{\text{Net Operating Income}}{\text{Debt Payments}}\)

• Debt service coverage ratio is generally used in the case of Commercial Mortgages.

Weighted Average Coupon (WAC)

• The weighted average coupon (WAC) is the weighted coupon of the pool that is obtained by multiplying the mortgage rate on each loan by its balance.
• The WAC will therefore change as loans are repaid, but at any point in time, when compared to the net coupon payable to investors, WAC would give us an indication of the pool’s ability to pay.
• The weighted average coupon is used intensively in the mortgage industry.

Weighted Average Maturity (WAM)

• The weighted average maturity (WAM) is the average weighted (weighted by loan balance) of the remaining terms to maturity (expressed in months) of the underlying pool of mortgage loans in the MBS.
• Longer securities are by nature more volatile and so a WAM calculated on the stated maturity date avoids the subjective call of whether the MBS will mature and recognizes the potential liquidity risk for each security in the portfolio.
• Conversely, a WAM calculated using the reset date will show the shortening effect of prepayments on the term of the loan.

Weighted Average Life (WAL)

• The Weighted Average Life (WAL) is the time-weighted period during which principal is outstanding.
• The weighted average life (WAL) of the notes at any point in time is given by-

Formula

where,
PF(s) is the pool factor at \(s = \sum t \cdot PF(s)\)
𝑡 is actual/365

• A WAL approach incorporates various pre-payment assumptions, and any change in this pre- payment speed will increase or decrease the rate at which principal is repaid to investors.

Prepayment Forecasting & CPR And PSA Calculation

• Forecasting prepayments is crucial to computing the cash flows of MBS products. Though, the underlying payment remains unchanged, prepayments, for a given price, reduce the yield on the MBS.
• There are a number of methods used to estimate prepayments, two commonly used ones are the constant prepayment rate (𝐶𝑃𝑅) and the Public Securities Association (PSA) method.
• The Constant Prepayment Rate (𝐶𝑃𝑅) is based on the characteristics of the pool and the current expected economic environment as it measures prepayment during a given month in relation to the outstanding pool balance. It is given by –
• The Single Monthly Mortality (SMM) is the single-month proportional prepayment. A SMM of 0.65% means that approximately 0.65% of the remaining mortgage balance at the beginning of the month, less the scheduled principal payment, will be prepaid in that month.
• The PSA (since merged and now part of the Securities Industry and Financial Markets Association or SIFMA), has a metric for projecting prepayment that incorporates the rise in prepayments as a pool seasons.
• A pool of mortgages is said to have 100% – PSA if its CPR starts at 0 and increases by 0.2 % each month until it reaches 6% in month 30. It is a constant 6% after that. Other prepayment scenarios can be specified as multiples of 100% PSA.
• This calculation helps derive an implied prepayment speed assuming mortgages prepay slower during their first 30 months of seasoning.

\(PSA = \frac{CPR}{0.2m} \times 100\)

• where, 𝑚 is the number of months since origination.