Securitization

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 (but also includes businesses established specifically to generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under traditional corporate finance 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. Many issuers are typically "orphaned". In the case of certain assets, such as credit card debt, where the portfolio is made up of a constantly changing pool of receivables, a trust in favor of the SPV may be declared in place of traditional transfer by assignment (see the outline of the master trust structure below). Accounting standards govern when such a transfer is a true sale, a financing, a partial sale, or a part-sale and part-financing. In a true 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 investors) 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-amortizing 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. If 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 might be AAA or AA 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 whenever the properties are sold. Since any early repayments are 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 one cannot categorise the revenue so easily between income and principal repayment. In this case all the revenue 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 for 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 make the securities more attractive. In addition to subordination, credit may be enhanced through: A controlled amortization structure can give investors a more predictable repayment schedule, even though the underlying assets may be nonamortising. 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 to be paid on the scheduled 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 scheduled 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 Some originators (e.g. of mortgages) have prioritised loan volume over credit quality, disregarding the long-term risk of the assets they have created in their enthusiasm to profit from the fees associated with origination and securitization. Other originators, aware of the reputational harm and added expense if risky loans are subject to repurchase requests or improperly originated loans lead to litigation, have paid more attention to credit quality. ==Special types of securitization==

Master trust A master trust is a type of SPV particularly suited to handle revolving credit card 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. 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 reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes. ==Motives for securitization==

Advantages to Originator 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 debt and AAA debt can be multiple hundreds of basis points. 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. 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. 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. 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. ==History==

Among the early examples of mortgage-backed securities in the United States were the farm railroad mortgage bonds of the mid-19th century which contributed to the panic of 1857. In February 1970, the U.S. Department of Housing and Urban Development created the first modern residential 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 $60 million (~$ in ) 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 $50 million (~$ in ) 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. As estimated by the Bond Market Association, in the United States, the total amount outstanding at the end of 2004 was $1.8 (~$ in ) trillion. This amount was 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 previous ten years (1995–2004) ABS amount outstanding had 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 was strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion. Green securitization in the EU In recent years there has been a growing debate in the European Union on the merits of developing securitization for green lending assets, such as renovation loans, mortgages or loans for electric vehicles. Recent lawsuits Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. In July, 2009, the US's largest public pension fund has filed suit in California state court in connection with $1 billion (~$ in ) in losses that it says were caused by "wildly inaccurate" credit ratings from the three leading ratings agencies. ==See also==