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
Introduction to Securitisation by
Vinod Kothari
2
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Lecture 1
Introduction to Securitisation
Introduction to Securitisation by
Vinod Kothari
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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
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Vinod Kothari
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Securitisation and corporate finance
Nature General claim against the
assets of an entity
Claim against specific
assets of an entity, on
mutually exclusive basis
Objective To harness the strengths of
the corporate's balance
sheet to raise funding
To strip the excess spread
inherent in assets and
service them on off-balance
sheet basis
Investor risks Subject to entity-wide risks Isolated from entity risks
Structured funding Less amenable to
structured funding
More amenable to
structured funding, since
assets are hived off into a
separate entity
Leverage Leverage limited to entity-
wide prudential/regulatory
limits
Leverage based on
portfolio risks - usually
quite high
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Basic process of securitisation
Originator
Obligors

SPV
special
purpose
entity

2.Assigns
Cash flow
Investors
1. Cash flow before
securitisation
4. Proceeds of
issue of securities
3. Issues
securities/ notes
5.Collection and servicing
6.Passes over to SPV,
less fees
Reinvestment
contract
7. Reinvestment/liquidity
buffer
8. Reinvestment
proceeds/liquidity
facility
9. Payments to investors
10. Originators
residuary
profit
4. Proceeds
of sale of
receivables
Security
trustee
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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


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Concept of SPVs
Transferor
Special
purpose
vehicles as
trustee
Investors as
beneficial
owners
Transferor
Special
purpose
vehicles as
owner
Investors
as debt
investors
Security
trustee
holding
charge for
investors
Pass-through form Pay-through/ CDO/ CLO form
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Use of SPVs
Generic use of SPVs - to isolate identifiable assets/risks into a stand alone, self-
sustained 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
Operating companies and SPVs:
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
Nature of interest in SPV:
beneficial or proportional, equity-type interest in assets
debt-type interest, collateralized by specific assets
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Vinod Kothari
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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
Common structuring devices:
tranching
subordination
support classes:
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
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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
Repackaging by components:
Structured finance resecuritisations
Repackaging by tenure:
Revolving type structure
Refinancing type structures
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ABS types based on collateral
Securitisation
Existing asset
Future asset
Risk
Mortgage
backed
Asset
backed
Credit risk
Insurance
risk
Operating
revenues
RMBS
CMBS
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ABS types based on other parameters
Securitisation
Purpose
Nature of
asset transfer Term of
paper
Balance
sheet
Arbitrage
Synthetic
structures
Commercial
paper
Cash
structures
Term
paper
True
sale
structure
Secured
loan structure
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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
Early-stage securitisation
Advanced-stage securitisation
Synthetics stage
Operating Risk transfers/
Index risk transfers
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
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
? (possibly, reinvention stage)
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Vinod Kothari
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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
Physical assets
using transformation devices
using secured loan structures
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
Transfer of an asset/ several
assets of the originator
Normal monetary obligation
o f the originator
Parties to the transaction To allow the pool of
receivables to be aggregated
and kept intact, a collective
investment medium, the SPV
is formed.
Hence, there are 3 parties to
the transaction - the
Originator, SPV (issuer) and
the investors
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.
Relation with the debtors of
the originator
Transfers claims against
debtors/ customers of the
originator
No connection with the
debtors of the originator
Nature of instrument
acquired by investors
Either a fractional interest in
the pool of receivables held
by the SPV, or a debt
obligation of the SPV
Debt obligation of the
originator
Legal rights of the investors Exercisable against the SPV,
or through the SPV against
the debtors of the originator
Exercisable against the
originator
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Securitisation and borrowing
Treatment for regulatory
purposes
Not treated as borrowing
from public
Treated as borrowing from
public
Effect on regulatory capital
requirement
Normally frees up regulatory
capital
Does not free regulatory
capital
Bankruptcy of the originator Investors beneficially own
the pool of assets transferred
to the SPV
Investors have a claim against
the originator; usual
bankruptcy/ distressed
company protection available
to the originator
Failure of the debtors of the
originator
Depends upon recourse
features; normally investors
will suffer a loss
Investors will not be affected;
they have a claim against the
originator
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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 funding-
Off-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)
Lecture 2/3
Distinctive Features of Securitisation
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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
Introduction to Securitisation by
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Cash flow structure
Pooling of assets:
One-time/ continuing transfers
Pay-outs to investors:
Pass-through or pay through
Paydown to investors:
Sequential, proportional or a combination
Structural protection:
Diversion of proportional payments to
sequential payments
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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
Cash inflow and outflows:
pass- throughs and bond structures
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
To see the impact on:
Residual returns
Weighted average maturity

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

Is Actual Principal <
Scheduled Principal?

Debit Deliqnent
Principal Ledger
Pay Senior
Coupon
Excess
Spread
Principal
Waterfall
Transfer to
Deliqnent
Principal
Is excess spread
>delinquent
Principal ?
Pay Principal
Pay Junior
Coupon
No
Yes
No
Yes
Cash Flow Scheme of Securitisation
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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
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1
3
0
5
9
8
8
1
1
7
1
4
6
1
7
5
2
0
4
2
3
3
2
6
2
2
9
1
3
2
0
3
4
9
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
0
50
100
150
200
250
300
350
400
450
19
1
7
2
5
3
3
4
1
4
9
5
7
6
5
7
3
8
1
8
9
Default amount under
SDA