Securitization


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 their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations.
Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing.
Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities.
The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized 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 beginnings in the late 18th century to 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 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.

Structure

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 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. 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", 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.
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 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 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 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" 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. 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 created in a securitization are "credit enhanced", 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 the cash flows to which they are entitled, and thus enables the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees.
The issued securities are often split into tranches, or categorized into varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure: there is generally a senior class of securities and one or more junior subordinated 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 been repaid. Because of the cascading effect between classes, this arrangement is often referred to as a cash flow waterfall. If the underlying asset pool becomes insufficient to make payments on the securities, 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 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, but only the residual cash flow 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 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 insurance, 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 credit or corporate guarantee.
  • A back-up servicer for the loans.
  • Discounted receivables for the pool.