Introduction to Asset Securitisation

Vinod Kothari 1012 Krishna 224 AJC Bose Road Calcutta 700 017. India
Phone 91-33-22811276/22817715/22813742/23233863/23233864 E-mail: vinod@vinodkothari.com; vinodk@vsnl.com Fax 91-33-23233863/22811276

All rights reserved with Vinod Kothari.

The presentation is to be used only for the purpose of the training course/meeting/ session for which it is intended and any use of any part of it, other than for distribution at such training course/meeting is unauthorized. No rights of any kind have been transferred in soft copy of the presentation, meant only for the purpose of printing. The soft copy should be purged immediately after printing.

Introduction to Securitisation by Vinod Kothari

Lecture 1

Introduction to Securitisation

What is securitisation

In traditional methods of corporate finance, a corporation raises equity/obligations to own assets. In securitisation, a corporation creates and securitises assets - that is, transfers assets. In form of securities. The claim is on assets, and not on the entity Hence, asset-based funding Securitisation and traditional funding: is the difference skin-deep or surfacial?

All claims are, eventually, claims on assets: question is one of stacking order: securitisation puts investors on the top of the stacking order by isolation Broader the periphery of assets backing up the claims, more the volatility, risks Asset-backed funding narrows down asset definition and hence reduces volatility Hence, reduces credit enhancement Crux of asset backed funding lies in reducing the equity, and increasing the leverage
Introduction to Securitisation by Vinod Kothari

Securitisation and corporate finance

N a tu re G e n e ra l c la im a g a in s t th e a s s e ts o f a n e n tity T o h a rn e s s th e s tre n g th s o f th e c o rp o ra te 's b a la n c e s h e e t to ra is e fu n d in g S u b je c t to e n tity -w id e ris k s L e s s a m e n a b le to s tru c tu re d fu n d in g C la im a g a in s t s p e c ific a s s e ts o f a n e n tity , o n m u tu a lly e x c lu s iv e b a s is T o s trip th e e x c e s s s p re a d in h e re n t in a s s e ts a n d s e rv ic e th e m o n o ff-b a la n c e s h e e t b a s is Is o la te d fro m e n tity ris k s M o re a m e n a b le to s tru c tu re d fu n d in g , s in c e a s s e ts a re h iv e d o ff in to a s e p a ra te e n tity L e v e ra g e b a s e d o n p o rtfo lio ris k s - u s u a lly q u ite h ig h

O b je c tiv e

In v e s to r ris k s S tru c tu re d fu n d in g

L e v e ra g e

L e v e ra g e lim ite d to e n tity w id e p ru d e n tia l/re g u la to ry lim its

Introduction to Securitisation by Vinod Kothari

Basic process of securitisation

10. Originators residuary profit

Originator
4. Proceeds of sale of receivables

1. Cash flow before securitisation

Obligors
6.Passes over to SPV, less fees

2.Assigns Cash flow

Security trustee

SPV special purpose entity

3. Issues securities/ notes

8. Reinvestment proceeds/liquidity facility

5.Collection and servicing

7. Reinvestment/liquidity buffer

Reinvestment contract
4. Proceeds of issue of securities

9. Payments to investors

Investors
Introduction to Securitisation by Vinod Kothari

Key features of securitisation

Capital market funding Use of special purpose vehicles as a transformation device Structured finance

Meaning of structured financial products: product structured or made-to-needs of the investor Key structuring principles:
What are investors rating needs What are investors payback needs/ paydown needs What is investors appetite for interest rate risk, prepayment risk?

Securitised instruments reorganise investors rights to suit their needs

Introduction to Securitisation by Vinod Kothari

Concept of SPVs
Transferor Transferor

Special purpose vehicles as trustee

Special purpose vehicles as owner

Investors as beneficial owners

Pass-through form

Investors as debt investors

Introduction to Securitisation by Vinod Kothari

Security trustee holding charge for investors

Pay-through/ CDO/ CLO form

Use of SPVs

Generic use of SPVs - to isolate identifiable assets/risks into a stand alone, selfsustained entity which is no more than such assets/ risks. SPVs are used in securitisation transactions as devices of hiving off assets and converting assets into securities. An SPV is no more and no less than incorporated name for specific assets

no more than isolated assets - no other assets or general recourse against the SPV no less than isolated assets - no other claims to affect the investors rights over assets SPVs are not companies in substantive operations; they do not have any business except acting as a legal instrumentality. This feature is necessary to ensure asset-backed securities beneficial or proportional, equity-type interest in assets debt-type interest, collateralized by specific assets

Operating companies and SPVs:

Nature of interest in SPV:

Introduction to Securitisation by Vinod Kothari

Use of structured finance devices

Structured finance devices mean re-distribution of risks/rewards or components of assets into different segments, to churn out securities with different risk/reward profiles. Uses of structured finance:

aligning securities to investor needs - term, credit risk, prepayment risk, interest rate risk, etc credit enhancement arbitrage tranching subordination support classes:

Common structuring devices:

planned amortisation class and support class floating rate class and inverse floating class fixed income class and leveraged floating class debt class and equity class Introduction to Securitisation by Vinod Kothari

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Use of repackaging devices

Repackaging implies:

Repackaging various loans or structured products into a new product Repackaging loans into loans of smaller or longer tenure Structured finance resecuritisations Revolving type structure Refinancing type structures
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Repackaging by components:

Repackaging by tenure:

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ABS types based on collateral

Securitisation Existing asset Future asset Risk

Mortgage backed Asset backed RMBS CMBS Operating revenues

Introduction to Securitisation by Vinod Kothari

Credit risk

Insurance risk

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ABS types based on other parameters

Securitisation

Purpose

Nature of asset transfer

Synthetic structures

Term of paper

Balance sheet

Arbitrage

Cash structures

True sale structure

Term paper Secured loan structure

Introduction to Securitisation by Vinod Kothari

Commercial paper

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Life cycle of asset-backed securitisation

Quasi-financial deals
Unrated, Bilateral transfers Full originator backing Purpose: off-balance sheet; exploiting excess spread, etc Transfers through SPV route High degree of credit enhancement/ cash participation by originators Purpose: off balance sheet; better ratings
Credit enhancements dwindle; lower classes take risk Synthetics; arbitrage activity enter the stage Purpose: economic capital; better capital/ risk management

Early-stage securitisation Advanced-stage securitisation Synthetics stage Operating Risk transfers/ Index risk transfers ? (possibly, reinvention stage)

Separation of funding and risk transfers Synthetics answer regulatory concerns more easily In traditional cash structures, transaction models are built around securitisation mechanics; origination/ servicing split More stress on risk transfers risks of operating businesses: retail credits, performance-oriented businesses are transferred Distinction bet. banking and insurance becomes less clear

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Parties to securitisation transaction

Originator Obligors Special purpose vehicle: single/ multiple Trustees Investors Swap counterparties Liquidity provider Credit enhancement provider
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Typical originators

Application of securitisation techniques has greatly expanded recently. Typical users of securitisation are:

Mortgage financiers Bank loans Finance companies Credit card companies Hoteliers, rentiers Public utilities Intellectual property holders insurance companies aviation companies exporters of unprocessed materials plantations governments
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Typical assets securitised

Financial assets

long-term assets short term assets revolving assets using transformation devices using secured loan structures

Physical assets

Whole business transactions Future flow transactions Structured investment vehicles:

CDOs of investment products such as hedge funds, private equity funds, etc.
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Trustee

A logistic requirement, later made a statutory obligation in public offerings of debt instruments Fiduciary for the investors Holder and administrator of security interests and safeguarding collateral documents Traditional functions:

Acting as registrar and transfer agent for the securities Distribution of principal and interest payments oversight of the conduct of the transaction, particularly payments, comingling, compliance with respective agreements monitoring covenant compliance and reporting - regular loan level and bond level reports monitoring principal and interest payments Enforcement of seller representations and warranties monitoring of triggers and withholding distributions

Timely, decisive action Ability and willingness to act as backup servicer or organise succession

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Securitisation investors

Professional investors Institutional investors Fixed income investors Investors driven by concerns of risk diversification

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Securitisation and borrowing

Legal nature of the transaction Parties to the transaction Transfer of an asset/ several assets of the originator To allow the pool of receivables to be aggregated and kept intact, a collective investment medium, the SPV is formed. H ence, there are 3 parties to the transaction - the O riginator, SPV (issuer) and the investors Transfers claims against debtors/ customers of the originator Either a fractional interest in the pool of receivables held by the SPV, or a debt obligation of the SPV Exercisable against the SPV , or through the SPV against the debtors of the originator Normal monetary obligation o f the originator There are two parties to the transaction - the borrower and the lender. In case of participation of several persons in the loan, there might be an indenture trustee acting as a trustee for the investors. No connection with the debtors of the originator Debt obligation of the originator

Relation with the debtors of the originator N ature of instrument acquired by investors

Legal rights of the investors

Exercisable against the originator

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Securitisation and borrowing

Treatment for regulatory purposes Effect on regulatory capital requirement Bankruptcy of the originator Not treated as borrowing from public Normally frees up regulatory capital Investors beneficially own the pool of assets transferred to the SPV Treated as borrowing from public Does not free regulatory capital Investors have a claim against the originator; usual bankruptcy/ distressed company protection available to the originator Investors will not be affected; they have a claim against the originator

Failure of the debtors of the originator

Depends upon recourse features; normally investors will suffer a loss

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Why securitisation

Lower cost - inherent cost and weighted average cost

The best example of economics of securitisation is an arbitrage CDO

Alternative investor base -institutional and retail Matching of assets and liabilities Issuer rating irrelevant Multiplies asset creation ability Non-conventional source; may allow higher fundingOff-balance sheet financing - removal of accounts Frees up regulatory capital Improves capital structure Higher trading on equity with no increased risk
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Why securitisation - 2

Extends credit pool Not regulated as loan Reduces credit concentration Risk management by risk transfers Arbitraging opportunities - repackaging transactions Avoids interest rate risk Improves accounting profits
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Lower cost due to securitisation

Increased leverage: lower use of equity: leverage arbitrage Capital market source reduces agency costs Better rated product: ratings arbitrage Aligns investment with investor objective: structural arbitrage Studies of whether securitisation has reduced funding costs:

Mortgage market is cited as an example Arbitraging profits in the securitisation market

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Securitisation from Investors viewpoint

Better security as direct claims over assets Tested in several bankruptcies: Japan Leasing, several Thai companies; Philippine Airlines, Turkey cos. Rating resilience - transition studies confirm ABS ratings are more stable than other fixed incomes. High rate of default recovery Structuring features: possibility for better risk-return alignment Rated investment Very few instances of default in 20 years history: In European securitisation, no default to date. Even when underlying obligations default, losses are much lesser: In case of corporate bonds, 47% of the par value lost -Moodys study Better yields in emerging markets Moral responsibility of investment bankers/ rating agencies: case of Ahmsa, Mexican companys default.
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Defaults and recoveries in ABS transactions

S&P released a defaulted class recovery study on 4th Sept. 2001 Total defaults only 116 out of 13538 classes - only 0.86% This shows that even after D rating, there are substantial recoveries for ABS investors. 116 defaults till June 2001 - RMBS 83 (out of 6361); CMBS 14 (out of 1984) , ABS 19 (out of 5193 classes) RMBS recovery rate average 61% - 65% in prime and 49% in subprime. 96% in prime AAA, 81% in prime AA, etc. CMBS average recovery 66%. (AA 89%) ABS recovery rate uneven averaging 29%. Of the 19 defaults -12 belonged to a single issuer of credit card transactions which was a fraud. Credit cards and franchise loans took 17 of the defaults. Rating agency Moodys cautions: due to the unique terms of structured finance transactions, there might be a prolonged credit deterioration of a rated tranche before it can be termed a default.
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ABS/ MBS default history S&P study of 12th Sept 2002

The first study period had some 15000 classes outstanding, and the second period had additional 3500 classes

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Recent default update (April 2004)

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Lecture 2/3

Distinctive Features of Securitisation

Legal structure

Most securitisation transactions are based on true sale structure:

True sale provides isolation:

Isolation makes originator performance irrelevant

True sale provides bankruptcy remoteness

Despite sale of the assets, originator retains significant role relative to the assets:

As servicer As first loss support provider

Therefore, characterising a securitisation transaction as a true sale can be challenging Other option:

Secured loan structure with appropriate security interest creation:

Will work in countries that allow security interest enforcement without bankruptcy court intervention

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Cash flow structure

Pooling of assets:

One-time/ continuing transfers Pass-through or pay through Sequential, proportional or a combination Diversion of proportional payments to sequential payments
Introduction to Securitisation by Vinod Kothari

Pay-outs to investors:

Paydown to investors:

Structural protection:

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Credit enhancement structure

Excess spread Over-collateralisation Subordination

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Basic elements of securitisation structures

Transfer of assets to bankruptcy-remote entities:

Cash versus synthetic structures secured loan structures Two-tier transactions pass- throughs and bond structures

Cash inflow and outflows:

Determination and form of credit enhancements Classes of securities and coupon of each Profit extraction devices Liquidity enhancements Structural protections: early payment or de-leverage triggers Pay down methods:

normal abnormal - in case of triggers

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Cashflow schematics of securitisation

We will model the cashflow structure of a dummy securitisation transaction And iterate it with respect to:

Simple pass through Reinvestment of principal into passive financial instruments Reinvestment of principal into the original asset Residual returns Weighted average maturity
Introduction to Securitisation by Vinod Kothari

To see the impact on:

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Cash Flow Scheme of Securitisation

Collect Interest (plus other revenue) Collect Actual Principal (Scheduled) Collect all Prepayment

Deduct all Senior Expenses

No Is Actual Principal < Scheduled Principal? Yes Debit Deliqnent Principal Ledger

Pay Senior Coupon

Excess Spread Is excess spread >delinquent Principal ? Yes Pay Junior Coupon Pay Principal No Transfer to Deliqnent Principal

Principal Waterfall

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Understanding the impact of prepayment

Prepones principal, reduces interest Reduces the weighted average maturity of the pool Impacts the quality of the pool? Introduces callability risk in asset backed securities

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Analysis of the cumulative loss curve

The cumulative loss curve plots the cumulative losses/charge offs to the initial outstanding balance of the pool Relation between prepayment and expected loss:

As obligors prepay, even though the charge off rate rises, the cumulative loss rate slows down In such cases, it is important to examine the hazard rate, that is, the rate of charge off relative to the then-outstanding portfolio balance To smoothen the impact of periodic ups and downs, a 6-monthly moving average may be used

For a typical portfolio, the hazard rate ascends as the portfolio seasons; however, the cumulative loss rate tends to flatten as the impact of ascending hazard rate is reduced by reducing pool size
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Prepayment models

Prepayment models try to project the prepayment behavior of mortgage loans over time; useful in predicting cashflows, expected maturity, and callability risk Mortgages in different countries behave differently One of the popularly used prepayment model is PSA model:

Mortgages begin with a prepayment rate of 0.2% (annualised) in Month 1 and linearly go upto 6% in Month 30; then stay constant Prepayment behavior of specific mortgage pools is based on PSA 100 PSA meaning equal to the above rate, 200 PDA would mean twice as much Impact of seasoning

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PSA and CPR models

5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0
1 30 59 88 117 146 175 204 233 262 291 320 349

PSA prepayment CPR prepayment

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Standard default assumption

Default models try to project the movement of the default rate in relation to time. Standard default assumptions in different countries project default movement over the seasoning of the pool. US Bond Market Associations SDA:

Starts with 0.02% annualised default rate in Month 1, grows linearly upto 0.6% in Month 30, then stays constant for the next 30 months, and then declines to 0.03% to the maturity of the mortgage 100 SDA would mean default rate equivalent to the standard rates; 150 SDA would mean 1 times the same

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Defaults under SDA

Default amount under SDA 450 400 350 300 250 200 150 100 50 0
1 9 17 25 33 41 49 57 65 73 81 89

Default amount under SDA

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