Securitization
Encyclopedia
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation
(CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities(ABS).
Critics have suggested that the complexity inherent in securitization can limit investors ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.
In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts.
The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitised debt is non-stationary
due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.
Securitization has evolved from its tentative beginnings in the late 1970s to a vital funding source with an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom
in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to control the company.
To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralised pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.
This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).
The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.
Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance
and insurance
markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina
and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer
include catastrophe bond
s, Life Insurance Securitization and Reinsurance Sidecar
s.
The first public Securitization of Community Reinvestment Act
(CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods.
As estimated by the Bond Market Association
, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995–2004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion.
At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligation
s (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.
Securitization only reached Europe in the late 80's, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 90's or early 2000's, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards), Insurance-backed transaction (such as the ones implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables for the Greek government, executed by Philippe Tapernoux).
As the result of the credit crunch
precipitated by the subprime mortgage crisis
the market for bonds backed by securitised loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. As a result interest rates are rising for loans that were previously securitised such as home mortgage
s, student loan
s, auto loans and commercial mortgage
s
concepts, such a company would have three options to raise new capital: a loan
, bond issue, or issuance of stock
. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating
of the company and the associated rise in interest
rates.
The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.
A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or "SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy
remote," meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.
Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing. In a sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator. Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE".
Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.
s) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies
rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision.
In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors.
Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.
The securities can be issued with either a fixed interest
rate or a floating rate under currency pegging system. Fixed rate ABS set the “coupon
” (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-amortising assets in the floating market. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate
(LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.
," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bond
s and parental guarantees (although this may introduce a conflict of interest).
Individual securities are often split into tranche
s, or categorized into varying degrees of subordination
. Each tranche has a different level of credit protection or risk exposure than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascading effect between classes, this arrangement is often referred to as a cash flow waterfall. In the event that the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk.
The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.
There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.
If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.
Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.
In addition to subordination, credit may be enhanced through:
The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.
When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors.
, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralised by fully amortizing assets such as home equity loan
s, auto loans, and student loan
s. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The PSA prepayment model
is a well-known example.
A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be nonamortissing. After a predetermined “revolving” period, during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.
On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.
Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth. Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.
balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards.
There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.
A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors and potential receivables.
A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur.
introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations, that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities.
and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.
and AAA debt can be multiple hundreds of basis point
s. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.
Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration
and pricing basis." Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.
Lower capital
requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets.
Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
Transfer risks (credit
, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bond
s and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.
Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet
." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association
(ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.
Earnings
: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.
Admissibility
: Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.
Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.
Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting
fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.
Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.
Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.
(on a risk-adjusted basis)
Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.
Portfolio
diversification
: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated
to their other bonds and securities.
Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).
Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.
However, the credit crisis of 2007–2008 has exposed a potential flaw in the securitization process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards.
Event risk
Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.
Contractual agreements
Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.
Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.
Collateralized mortgage obligation
A collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
(CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities(ABS).
Critics have suggested that the complexity inherent in securitization can limit investors ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.
In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts.
The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitised debt is non-stationary
Stationary
Stationary can mean:* In statistics and probability: a stationary process.* In mathematics: a stationary point.* In mathematics: a stationary set.* In physics: a time-invariant quantity, such as a constant position or temperature....
due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.
Securitization has evolved from its tentative beginnings in the late 1970s to a vital funding source with an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
in the 1990s, and became common in various Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to control the company.
History
In February 1970, the U.S. Department of Housing and Urban Development created the first transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralised pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.
This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).
The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.
Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance
Reinsurance
Reinsurance is insurance that is purchased by an insurance company from another insurance company as a means of risk management...
and insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina
Hurricane Katrina
Hurricane Katrina of the 2005 Atlantic hurricane season was a powerful Atlantic hurricane. It is the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall...
and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer
Alternative Risk Transfer
Alternative Risk Transfer is the use of techniques other than traditional insurance and reinsurance to provide risk bearing entities with coverage or protection...
include catastrophe bond
Catastrophe bond
Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors...
s, Life Insurance Securitization and Reinsurance Sidecar
Reinsurance Sidecar
Reinsurance sidecars, conventionally referred to as "Sidecars," are financial structures that are created to allow investors to take on the risk and return of a group of insurance policies written by an insurer or reinsurer and earn the risk and return that arises from that business...
s.
The first public Securitization of Community Reinvestment Act
Community Reinvestment Act
The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...
(CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods.
As estimated by the Bond Market Association
Bond Market Association
The Bond Market Association was the international trade association for the bond market industry. It had headquarters in London, New York City, and Washington D.C. Twenty per cent of the membership was located outside of the US, while 70 per cent was located outside New York City...
, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995–2004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion.
At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.
Securitization only reached Europe in the late 80's, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 90's or early 2000's, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards), Insurance-backed transaction (such as the ones implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables for the Greek government, executed by Philippe Tapernoux).
As the result of the credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
precipitated by the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
the market for bonds backed by securitised loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. As a result interest rates are rising for loans that were previously securitised such as home mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s, student loan
Student loan
A student loan is designed to help students pay for university tuition, books, and living expenses. It may differ from other types of loans in that the interest rate may be substantially lower and the repayment schedule may be deferred while the student is still in education...
s, auto loans and commercial mortgage
Commercial mortgage
A commercial mortgage is a mortgage loan made using commercial real estate as collateral to secure repayment.A commercial mortgage is similar to a residential mortgage, except the collateral is a commercial building or other business real estate, not residential property. In addition, commercial...
s
Pooling and transfer
The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances. Under traditional corporate financeCorporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
concepts, such a company would have three options to raise new capital: a loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
, bond issue, or issuance of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
of the company and the associated rise in interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
rates.
The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.
A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or "SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
remote," meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.
Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing. In a sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator. Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE".
Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.
Issuance
To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investorInstitutional investor
Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets...
s) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies
Credit rating agency
A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision.
In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors.
Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.
The securities can be issued with either a fixed interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
rate or a floating rate under currency pegging system. Fixed rate ABS set the “coupon
Coupon
In marketing, a coupon is a ticket or document that can be exchanged for a financial discount or rebate when purchasing a product. Customarily, coupons are issued by manufacturers of consumer packaged goods or by retailers, to be used in retail stores as a part of sales promotions...
” (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-amortising assets in the floating market. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate
London Interbank Offered Rate
The LIBOR rate is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate Banks borrow money for one day, one month, two months, six months, one year etc. and they pay interest to their lenders based on...
(LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.
Credit enhancement and tranching
Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are "credit enhancedCredit enhancement
Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization. The credit crisis of 2007-2008 has discredited the process of credit enhancement of structured securities as a financial practice as...
," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bond
Surety bond
A surety bond is a promise to pay one party a certain amount if a second party fails to meet some obligation, such as fulfilling the terms of a contract...
s and parental guarantees (although this may introduce a conflict of interest).
Individual securities are often split into tranche
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...
s, or categorized into varying degrees of subordination
Subordination (finance)
Subordination in banking and finance refers to the order of priorities in claims for ownership or interest in various assets.-Subordination of debt:...
. Each tranche has a different level of credit protection or risk exposure than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascading effect between classes, this arrangement is often referred to as a cash flow waterfall. In the event that the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk.
The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.
There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.
If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.
Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.
In addition to subordination, credit may be enhanced through:
- A reserve or spread account, in which funds remaining after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPE expenses are greater than its income.
- Third-party insuranceInsuranceIn law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
, or guarantees of principal and interest payments on the securities. - Over-collateralisation, usually by using finance income to pay off principal on some securities before principal on the corresponding share of collateral is collected.
- Cash funding or a cash collateral account, generally consisting of short-term, highly rated investments purchased either from the seller's own funds, or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows.
- A third-party letter of creditLetter of creditA standard, commercial letter of credit is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking....
or corporate guarantee. - A back-up servicer for the loans.
- Discounted receivables for the pool.
Servicing
A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle.The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.
When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors.
Repayment structures
Unlike corporate bonds, most securitizations are amortizedAmortization
Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...
, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralised by fully amortizing assets such as home equity loan
Home equity loan
A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. These loans are useful to finance major expenses such as home repairs, medical bills or college education...
s, auto loans, and student loan
Student loan
A student loan is designed to help students pay for university tuition, books, and living expenses. It may differ from other types of loans in that the interest rate may be substantially lower and the repayment schedule may be deferred while the student is still in education...
s. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The PSA prepayment model
PSA prepayment model
PSA Prepayment Model is a prepayment model by the Bond Market Association formerly known as Public Securities Association or PSA that assumes increasing prepayment rates for the first 30 months of the lifetime and constant rates thereafter...
is a well-known example.
A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be nonamortissing. After a predetermined “revolving” period, during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.
On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.
Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth. Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.
Structural risks and misincentives
Originators (e.g. of mortgages) have less incentive towards credit quality and greater incentive towards loan volume since they do not bear the long-term risk of the assets they have created and may simply profit by the fees associated with origination and securitization.Master trust
A master trust is a type of SPV particularly suited to handle revolving credit cardCredit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards.
There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.
A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors and potential receivables.
A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur.
Issuance trust
In 2000, CitibankCitibank
Citibank, a major international bank, is the consumer banking arm of financial services giant Citigroup. Citibank was founded in 1812 as the City Bank of New York, later First National City Bank of New York...
introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations, that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities.
Grantor trust
Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.Owner trust
In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reservesExcess reserves
In banking, excess reserves are bank reserves in excess of the reserve requirement set by a central bank. They are reserves of cash more than the required amounts. Holding excess reserves is generally considered costly and uneconomical as no interest is earned on the excess amount...
and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.
Advantages to issuer
Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debtDebt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
and AAA debt can be multiple hundreds of basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
s. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.
Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration
Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
and pricing basis." Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.
Lower capital
Economic capital
-Finance and Economics:In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation....
requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets.
Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
Transfer risks (credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bond
Catastrophe bond
Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors...
s and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.
Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet
Off-balance-sheet
Off-balance sheet usually means an asset or debt or financing activity not on the company's balance sheet.Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients...
." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
(ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.
Earnings
Earnings
Earnings are the net benefits of a Corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before...
: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.
Admissibility
Admissibility
Admissibility may refer to:* Admissible evidence, evidence which may be introduced in a court of law.* Admissible decision rule, in statistical decision theory, a rule which is never dominated.* Admissible rule, in logic, a type of rule of inference....
: Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.
Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.
Disadvantages to issuer
May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.
Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.
Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.
Advantages to investors
Opportunity to potentially earn a higher rate of returnRate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
(on a risk-adjusted basis)
Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.
Portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
diversification
Diversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated
Uncorrelated
In probability theory and statistics, two real-valued random variables are said to be uncorrelated if their covariance is zero. Uncorrelatedness is by definition pairwise; i.e...
to their other bonds and securities.
Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).
Risks to investors
Liquidity riskLiquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.
However, the credit crisis of 2007–2008 has exposed a potential flaw in the securitization process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards.
Event risk
Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.
Contractual agreements
Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.
Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.
Recent lawsuits
Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. In July, 2009, the USA’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies.http://www.nytimes.com/2009/07/15/business/15calpers.html?_r=2&scp=1&sq=calpers&st=cseSee also
- Collateralized debt obligationCollateralized debt obligationCollateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
, securitization vehicle for corporate debt securities - Collateralized fund obligationCollateralized Fund ObligationA collateralized fund obligation is a form of securitization involving private equity fund or hedge fund assets, similar to collateralized debt obligations...
, securitization vehicle for private equity and hedge fund assets - Collateralized mortgage obligationCollateralized mortgage obligationA collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
, securitization vehicle for mortgage-backed securities - Collateralized loan obligationCollateralized loan obligationCollateralized loan obligations are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches...
, securitization vehicle for corporate loans
External links
- The Rocket Scientists of Finance BBC Programme: The City Uncovered