Lecture 5, Part 2

Securitisation

Securitisation is a structured finance product.

It is the process of taking an illiquid asset, or group of assets, and transforming them into a
security. This process can be referred to as financial engineering.
Securitisation involves converting future cash flows into tradable securities.

A mortgage backed security is one of a number of types of Asset Backed Security.

Asset pools can be made up of a range of asset classes. The following are pretty typical:

Auto/Car leases
Auto/Car loans
Commercial mortgages
Residential mortgages
Student loans
Credit card receivables
SME loans
Entertainment royalties

Key securitisation parties

The following parties are key players in securitisation:

Originator(s): institution(s) originating the pooled assets;

Issuer/Arranger: Sets up the structure and tranches the liabilities, sell the liabilities to investors and
buys the assets from the originator using the proceeds of the sale. The Issuer is a finite-lived,
standalone, bankruptcy remote entity referred to as a special purpose vehicle (SPV) or special
purpose entity (SPE);

Servicer: collects payments from the asset pool and distribute the available funds to the
liabilities. The servicer is also responsible for the monitoring of the pool performance: handling
delinquencies, defaults and recoveries. The servicer plays an important role in the structure. The
deal has an exposure to the servicers credit quality; any negative events that affect the servicer
could influence the performance and rating of the ABS. We note that the originator can be the
servicer, which in such case makes the structure exposed to the originators credit quality despite
the de-linking of the assets from the originator.

Investors: invests in the liabilities;

Trustee: supervises the distribution of available funds to the investors and monitors that the
contracting parties comply with the documentation;

Rating Agencies: Provide ratings on the issued securities. The rating agencies have a more or less
direct influence on the structuring process because the rating is based not only on the credit
quality of the asset pool but also on the structural features of the deal. Moreover, the securities
created through the tranching are typically created with specific rating levels in mind, making it

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important for the issuer to have an iterative dialogue with the rating agencies during the
structuring process. We point here to the potential danger caused by this interaction. Because of
the negotiation process a tranche rating, say AAA, will be just on the edge of AAA, i.e., it
satisfies the minimal requirements for the AAA rating without extra cushion.

Third-parties: A number of other counterparties can be involved in a structured finance deal, for
example, financial guarantors, interest and currency swap counterparties, and credit and liquidity
providers.

Asset Backed Security (ABS)

This is a long established form of structured finance with a very straightforward investment
objective:

The issuer of the ABS takes a load of assets that have predictable and similar cash flows
(e.g. lots of individuals home mortgages).
Pool them into one managed package that collects all of the individual payments.
Use this cash flow to pay a coupon to investors on the managed package.
This creates an asset backed security in which the underlying property assets (homes) act
as collateral.
Get the rating agencies e.g. Fitch, Moodys, S&P to give the ABS an approval rating,
preferably AAA or A+, which signals the ABSs relative safety as an investment (for investors
searching for yield).
The advantage to the investor is that s/he can buy a diversified portfolio of fixed income
assets that are delivered as one coupon payment.

What motivates corporate issuers? Reduced funding costs as follows:

Via securitisation, a company rated BB but with a AAA worthy cash flow would be able to
borrow at, possibly, AAA rates (i.e. gently to significantly less expensive borrowing costs).
This is the key reason for a company to securitise its cash flow.
The difference between BB debt and AAA debt can be multiple hundreds of basis points.
E.g. In January 2002, Moodys downgraded Ford Motor Credits rating, BUT senior
automobile backed securities, issued by Ford Motor Credit in Jan and April 2002, continued
to be rated AAA because of the strength of the underlying collateral.

Benefits to Investors

Could earn a higher rate of return than from other fixed income investments.
Opportunity to invest in a specific pool of high quality credit enhanced assets if you dont
have the resources to do it yourself.
Portfolio diversification.
The credit risk of the ABS is often different from the parent company and is isolated from the
parent.
E.g. a small bank may be considered more risky as an organisation than the mortgage
loans it makes to its customers. If these loans stay with the bank, the borrowers may have

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 to pay higher interest rates AND/OR the bank would be paying higher rates to its creditors
and would, therefore, be less profitable.

Risks to Investors

The credit crisis of 2007-2008 exposed a major flaw in the securitisation process: i.e.

Loan originators retain no residual risk for the loans they make, but still collect substantial
fees on loan issuance and securitisation. This does not encourage an improvement of
underwriting standards. The incentives are not right.

Originators have less incentive towards credit quality and more towards volume because
the originators do not bear the long term risk of the assets.

Credit risk: defaults in the collateral pool results in loss of principal and interest. These losses are
transferred to the investors and allocated to the notes, usually in reverse order of seniority.

Prepayment risk: this is the event that a borrower prepays the loan before the scheduled
repayment date. A borrower will do this if s/he can refinance the loan to a lower interest rate
from a different lender. A second consequence of prepayment is the effect of unscheduled
prepayment of principal that will e distributed among the securities according to the priority of
payments, reducing the outstanding principal amount and, thereby, affecting their weighted
average life.

Market risk: the market risks can be split into a) cross currency risk and b) interest rate risk.

a) The collateral pool may consist of assets denominated in one of several currencies
different from liabilities; therefore the cash flow from the pool has to be exchanged to
the liabilities currency; this means there is an exposure to FX rates. This risk can be
hedged using currency swaps.
b) The interest rate risk can be either basis risk or interest rate term structure risk. Basis risk
originates from the fact that the assets and liabilities may be indexed to different
benchmark indices. This could result in interest shortfall. Term structure risk arises from a
mismatch in fixed interest collections from the collateral pool and floating interest
payments on the liability side, or vice versa.

Reinvestment risk: the risk that the credit quality of the portfolio/pool deteriorates over time as
new assets are added that generate lower interest payments or have a shorter remaining term.

Liquidity risk: this refers to the timing mismatches between cash flows generated in the asset pool
and the cash flows paid to the liabilities. The cash flows can be: either interest, principal or both.

Counterparty risk: the servicer is a key party in the structure. If there is a negative event affecting
the servicers ability to get the cash collections form the asset pool, distribute the cash to the
investors and handle delinquencies/defaults, the whole structure is put under pressure.

Legal risks: These are associated with the transfer of the assets from the originator to the issuer and
the bankruptcy remoteness of the issuer. Very simply, the transfer of the assets from the originator
to the issuer MUST be such that an originator insolvency or bankruptcy does not impair the issuers

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rights to control the assets and the cash proceeds generated by the asset pool. This transfer of
the assets is usually done through a true sale.

Three conditions enable the separation of the assets and the originator:

1. The transfer must be a true sale. If the originator of the loans is only PLEDGING the assets to
secure a debt, this would be considered collateralised financing in which the originator
would stay directly indebted to the investor.
2. The assets must be owned by a special purpose corporation / vehicle, whose ownership of
the sold assets is likely to survive the bankruptcy of the seller, if the seller goes bankrupt.
3. The SPV (special purpose vehicle) that owns the assets must be independent.