'Securitization' is a financing process in which a corporate entity moves assets, to an ostensibly bankruptcy-remote / low risk vehicle, in order to obtain lower interest rates from potential lenders. This is obtained because the assets cannot be seized in a bankruptcy proceeding, the risk is less for lenders and they are willing to offer a lower rate. The technique comes under the umbrella of
structured finance as it applies to assets that typically are illiquid
contracts (i.e. assets that cannot easily be sold). It has evolved from tentative beginnings in the late 1970s to a vital funding source with an estimated total aggregate outstanding of $8.06 trillion (as of the end of 2005, by the Bond Market Association) and new issuance of $3.07 trillion in 2005 in the U.S. markets alone.
Alternate but similar definitions are:
''Securitization is the process of homogenizing and packaging financial instruments into a new
fungible one. Acquisition, classification, collateralization, composition, pooling and distribution are functions within this process''
[1]
''Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors. Investors buy the repackaged assets in the form of securities or loans which are collateralized (secured) on the underlying pool and its associated income stream. Securitization thereby converts illiquid assets into liquid assets.''
[2]
History of Securitization
"Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets). But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the
credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well."
[3]
In February 1970, the U.S.
Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or
Ginnie Mae) sold securities backed by a portfolio of mortgage loans.
[4]
To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.
[3]
This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).
[6]
The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.
[3]
As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995-2004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion.
[8]
At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.
[8]
What is Securitization?
In the article "Asset Securitization Controller's Handbook", there is a very concise and straightforward definition of securitization. "Asset securitization is the structured process whereby interests in loans and other receivables are packaged, underwritten, and sold in the form of “asset-backed” securities."
[3]
Another handbook states that "In essence, securitization is the open market
selling of
financial instruments backed by asset cash flow or asset value. It is characterized by
★ The pooling of assets or asset cash flow, and division of the benefits among investors on a pro rata basis, by systematic risk assessment, and
★ its offering form as a security (rather than, for example, as a loan or a group of receivables)."
[11]
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. However, it cannot demand early repayment on the leases and so cannot get its money back early if required. If, however, 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 (in effect, receiving today the present value of a future cash flow). Where the company originating the debts (the leasing company in our example) is a bank or other organisation that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts.
In vanilla structures, the credit derivative is used to change the credit quality of the underlying portfolio of leases so that it will be acceptable to the final investors. The diagram below describes a typical transaction with this separate company (usually referred to as a Special Purpose Vehicle [SPV] or as a
Special Purpose Entity [SPE]).
The diagram describes a typical transaction with this separate company (usually referred to as a Special Purpose Vehicle 'SPV' or in the USA as a Special Purpose Entity 'SPE'
'Explanations':
★ Originator: Assets such as loans are created by a company, and appear on that company's balance sheet — eg., Abbey International makes a number of residential mortgages and these appear in their account.
★ SPV: Once a suitably large portfolio of assets have been built up, they are packaged as a portfolio, and then sold to a third party which is normally a Special Purpose Vehicle company (an "'SPV'") formed for the specific purpose of funding the assets. The SPV must not be owned by Abbey International (the originator) because if it did, the mortgages will still remain in the balance sheet. The company must be structured in such a way that if Abbey International went into bankruptcy, the assets of the SPV would not be distributed to Abbey International's creditors.
★ Investors: The SPV has no money of its own. To be able to buy the loans from the originator (Abbey International), it issues tradable "
securities" to fund the purchase. The performance of these "
securities" is directly linked to the performance of the assets and there is normally no recourse back to the originator.
True Sale Concept
Integral to the process of Securitization is the concept of "True Sale". It is essential to recognize that the whole process of Securitization aims to have the originator of some asset sell off the asset without having an continuing interest post-sale. Securitization is an institutionalization of this aim.
Why Securitize?
Issuer's View of Securitization
Advantages
★ Reduces funding costs
::Through Securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB
debt and AAA debt can be multiple hundreds of
basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but a senior automobile backed securities issued by Ford Motor Credit in January 2002 and April 2002 continue to be rated AAA, because of the strength of the underlying collateral, and other credit enhancements.
[12]
★ Reduces
asset-liability mismatch
::"Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both
duration and pricing basis"
Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.
★ Lower
capital requirements
::Some firms, due to legal,
regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to lessen the
equity on their balance sheets while maintaining the "earning power" of the asset.
★ Locking in profits
::For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
★ Transfer risks:
credit,
liquidity,
prepayment, reinvestment, asset concentration
::Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good example of this are
Catastrophe Bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.
★ Off-Balance Sheet
::Derivatives of many types have in the past been referred to as off balance sheet. This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.
★
Earnings
::This is the one benefit that is never talked about in the Asset-Backed and Structured Finance worlds. Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the
Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.
★
Admissibility
::Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.
★
Liquidity
::Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.
Disadvantages
★ May reduce portfolio quality
::If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.
★ Costs: management and systems,
legal fees,
underwriting fees, rating fees, ongoing administration
::Securitizations are expensive, and the more complicated or unusual the transaction is, the more expensive it is going to be. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.
★ Size limitations - since securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.
★ Risks - it is important to realize that since securitization is a structured transaction it may well include par structures as well as credit enhancements that are subject to risks of impairment such as prepayment as well as credit loss; especially for structures where there are some retained strips.
Investors' View of Securitization
Advantages
★ Opportunity to potentially earn a higher
rate of return (on a risk-adjusted basis);
★ Opportunity to invest in a specific pool of high quality credit-enhanced assets;
::Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of .
★
Portfolio diversification;
::Depending on the securitization,
hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be
uncorrelated to their other bonds and securities.
★ Isolation of credit risk from the parent entity;
::Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).
Risks
★ 'Liquidity Risk'
★ 'Credit/Default'
:Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.
[13]
★ 'Event risk'
:
★ 'Prepayment/reinvestment/Early Amortization'
:The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.
[14]
★ 'Currency interest rate fluctuations'
:Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.
[14]
★ 'Contractual agreements'
★ 'Moral Hazard'
:Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.
[16]
★ 'Servicer Risk'
:The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.
[14]
Tranching
Tranching is an important concept in Securitization because it is the system used to create different investment classes for the securities that are created in the Structured Finance world.
''Tranching allows the cash flow from the underlying asset to be diverted to the various investor groups.''
The Committee on the Global Financial System explained Tranching succinctly:
"A key goal of the tranching process is to create at least one class of securities whose rating is higher
than the average rating of the underlying collateral pool or to create rated securities from a pool of
unrated assets. This is accomplished through the use of credit support (enhancement), such as
prioritisation of payments to the different tranches."
Credit Enhancement and Credit Ratings
Rating agencies play an important part of this process by rating the securities created in the process. These agencies give an outside perspective on the liabilities being created and allow the Investor make a more informed decision.
Credit Enhancement
Credit Enhancement is key in creating a security that has a higher rating than the issuing company.
Common Securitization Structures
★ 'Subordination'
Individual securities are often split into “tranches” of varying degrees of subordination. One tranche will have less credit protection or risk exposure than another. A prevalent type of internal credit enhancement is the senior/subordinated structure. ABS with senior/subordinated structures are characterized by a senior (“A”) class of securities and one or more subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” tranche.
In the event that a loan in the underlying asset pool defaults, any resulting loss is absorbed first by the subordinated securities. The upper-level tranches remain unaffected unless losses exceed the entire amount of the subordinated tranches. The senior securities are typically AAA rated, while the lower-credit quality subordinated classes receive a correspondingly lower rating.
[13]
★ 'Amortizing'
Unlike corporate bonds, most ABS amortize. Amortization consists of scheduled and unscheduled principal payments.
Fixed Income Sectors: Asset-Backed Securities—7 Scheduled principal reflects the amortizing nature of most
consumer loans that back the majority of ABS. That is, the principal amount borrowed is paid back gradually over the
specifi ed term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing ABS are generally collateralized by fully amortizing assets such as HELs, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The
PSA prepayment model is a well-known example.
[19][13]
★ 'Controlling Amortization'
A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even
though the underlying assets may be nonamortizing. After a predetermined “revolving” period, during which only interest
payments are made, these ABS attempt to return principal to investors in a series of defi ned periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.
[13]
★ 'Bullet (Slug)'
Bullet structures return principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these ABS are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.
[14]
★ 'Coupon'
ABS can be issued with either fixed rate or floating rate coupons. Fixed rate ABS set the “coupon” at the time of issuance, in a fashion similar to corporate bonds. Floating rate securities may be backed by both amortizing and nonamortizing assets. In Fixed Income Sectors: Asset-Backed Securities—8 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 (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk
[13]
★ 'Sequential pay Bond'
ABS are often structured to pay off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth.
[13]
★ 'Pro Rata Bond'
Prorated pay structures pay each tranche a proportionate share of principal throughout the life of the security.
[13]
A Securitization Transaction
A typical securitization will start with a company that has a steady amount of
receivables (cash flow) coming from a consistent source. This could be any company with consistent cash flows from a particular source, a good example is an auto loan company. This company, autoloan company X, which is rated BB, wants to make a large purchase of $1 billion. Unfortunately auto loan company X does not know the best way to do this so they contact an
Investment Bank, call it Investment Bank Y. The Investment Banker assigned to auto loan company X analyzes the situation. The investment banker traditionally had few options for the autoloan company: Take a
loan, make a
bond issuance, or give up equity (
stock). Each of these options have downsides: as the company is BB rated, borrowing money through the bond market or a loan would cost the auto loan company a huge amount in
interest, and issuing stock would give up part of the control of the company.
The investment banker comes up with a new idea. The Banker determines that the auto loan company is rated BB because the company sometimes takes risky ventures in outside businesses, is not all that large, and is always at risk of a car market downturn, however, the underlying assets, the auto loans it originates, are very reliable. The investment banker figures out that if they could do a bond issuance where they promise the funds from a set of auto loans to pay down the bonds, they should be able to get an interest rate significantly better. He figures that the auto loans are AAA
assets, not BB like the company as a whole.
The investment banker then contacts a
rating agency to explain his idea and see if they agree and rate the bonds higher then the parent company. Unfortunately, as the investment banker finds out it is not that easy. If the parent company goes
bankrupt, which has a BB likelihood, in
U.S. bankruptcy law, the judge would order an
automatic stay provision thus halting payments on all
liabilities, and, very possibly, those funds promised to the AAA rated bonds would be
consolidated with all other funds and liabilities and those bonds would be lumped with all other debt obligations the now bankrupt company would have. Clearly more has to be done.
Important, Unique, or Interesting Securitizations
Insurance Securitization
Starting in the 1990's with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by
Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of
Alternative Risk Transfer include
Catastrophe bonds,
Life Insurance Securitization and
Reinsurance Sidecars.
العربية
中国
Français
Deutsch
Ελληνική
हिन्दी
Italiano
日本語
Português
Русский
Español
