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
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Introduction to Securitisation by
Vinod Kothari 2
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 4
Securitisation and corporate finance
Nature General claim against the
assets of an entity
Objective To harness the strengths of
the corporate's balance
sheet to raise funding
Investor risks Subject to entity-wide risks
Structured funding Less amenable to
structured funding
Leverage Leverage limited to entity-
wide prudential/regulatory
limits
Introduction to Securitisation by
Vinod Kothari
Claim against specific
assets of an entity, on
mutually exclusive basis
To strip the excess spread
inherent in assets and
service them on off-balance
sheet basis
Isolated from entity risks
More amenable to
structured funding, since
assets are hived off into a
separate entity
Leverage based on
portfolio risks - usually
quite high
5
 Basic process of securitisation
10. Originator’s 1. Cash flow before
residuary
securitisation
profit
Originator
Obligors
2.Assigns 6.Passes over to SPV,
Cash flow 4. Proceeds less fees
of sale of
receivables 5.Collection and servicing
8. Reinvestment
proceeds/liquidity
Security SPV
facility
7. Reinvestment/liquidity
trustee special
buffer

purpose Reinvestment
entity contract

3. Issues 4. Proceeds of
securities/ notes issue of securities 9. Payments to investors

Investors
Introduction to Securitisation by
Vinod Kothari 6
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 7
Concept of SPVs
Transferor Transferor

Special Special
purpose purpose
vehicles as vehicles as
Security
trustee owner trustee
holding
charge for
investors
Investors as Investors
beneficial as debt
owners investors
Pass-through form Pay-through/ CDO/ CLO form

Introduction to Securitisation by
Vinod Kothari 8
 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

Introduction to Securitisation by
Vinod Kothari 9
 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

Introduction to Securitisation by
Vinod Kothari 10
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
Introduction to Securitisation by
Vinod Kothari 11
 ABS types based on collateral
Securitisation

Existing asset
Future asset Risk

Mortgage
backed
Insurance
Asset Credit risk risk
backed
RMBS
Operating
CMBS revenues

Introduction to Securitisation by
Vinod Kothari 12
ABS types based on other parameters
Securitisation

Purpose Nature of
asset transfer Term of
paper

Synthetic
Cash structures
Arbitrage
Balance structures
Commercial
sheet
Term paper
True paper
sale Secured
structure loan structure
Introduction to Securitisation by
Vinod Kothari 13
Life cycle of asset-backed securitisation
Quasi-financial deals
Early-stage securitisation
Advanced-stage securitisation
Synthetics stage
Operating Risk transfers/
Index risk transfers
? (possibly, reinvention stage)
Introduction to Securitisation by
•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
•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
Vinod Kothari 14
 Parties to securitisation transaction

 Originator
 Obligors
 Special purpose vehicle: single/ multiple
 Trustees
 Investors
 Swap counterparties
 Liquidity provider
 Credit enhancement provider
Introduction to Securitisation by
Vinod Kothari 15
 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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Vinod Kothari 16
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.

Introduction to Securitisation by
Vinod Kothari 17
 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

Introduction to Securitisation by
Vinod Kothari 18
Securitisation investors

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

Introduction to Securitisation by
Vinod Kothari 19
 Securitisation and borrowing
Legal nature of the
transaction
Parties to the transaction
Relation with the debtors of
the originator
Nature of instrument
acquired by investors
Legal rights of the investors
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.
Hence, there are 3 parties to
the transaction - the
Originator, 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
Introduction to Securitisation by
Vinod Kothari
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
Exercisable against the
originator
20
Securitisation and borrowing
Treatment for regulatory
purposes
Effect on regulatory capital
requirement
Bankruptcy of the originator
Failure of the debtors 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
Depends upon recourse
features; normally investors
will suffer a loss
Introduction to Securitisation by
Vinod Kothari
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
21
 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

Introduction to Securitisation by
Vinod Kothari 22
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
Introduction to Securitisation by
Vinod Kothari 23
 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

Introduction to Securitisation by
Vinod Kothari 24
 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 -Moody’s study
 Better yields in emerging markets
 Moral responsibility of investment bankers/ rating agencies: case of
Ahmsa, Mexican company’s default.

Introduction to Securitisation by
Vinod Kothari 25
 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 Moody’s 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”.
Introduction to Securitisation by
Vinod Kothari 26
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

Introduction to Securitisation by
Vinod Kothari 27
Recent default update (April 2004)

Introduction to Securitisation by
Vinod Kothari 28
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

Introduction to Securitisation by
Vinod Kothari 30
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

Introduction to Securitisation by
Vinod Kothari 31
Credit enhancement structure
 Excess spread
 Over-collateralisation
 Subordination

Introduction to Securitisation by
Vinod Kothari 32
 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
Introduction to Securitisation by
Vinod Kothari 33
 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

Introduction to Securitisation by
Vinod Kothari 34
Cash Flow Scheme of Securitisation
Collect
Interest Collect Collect all
(plus other revenue) Actual Principal Prepayment
(Scheduled)

No
Deduct all
Senior Expenses
Is Actual Principal <
Scheduled Principal?

Pay Senior Yes

Coupon

Debit Deliqnent
Principal Ledger
Excess
Spread

Is excess spread No Transfer to

Principal
>delinquent Deliqnent
Waterfall
Principal ? Principal
Yes
Pay Junior Graphics
Pay Principal
Coupon © Vinod Kothari

Introduction to Securitisation by
Vinod Kothari 35
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

Introduction to Securitisation by
Vinod Kothari 36
 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
Introduction to Securitisation by
Vinod Kothari 37
 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

Introduction to Securitisation by
Vinod Kothari 38
PSA and CPR models
5000
4500
4000
3500
3000
PSA prepayment
2500
CPR prepayment
2000
1500
1000
500
0
1

88
30
59

117
146

204
175

233
262
291
320
349

Introduction to Securitisation by
Vinod Kothari 39
 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 Association’s 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 ½ times the same

Introduction to Securitisation by
Vinod Kothari 40
Defaults under SDA
Default amount under SDA

450
400
350
300 Default amount under
250 SDA
200
150
100
50
0
41
49

73
1
9
17
25
33

57
65

81
89

Introduction to Securitisation by
Vinod Kothari 41