101. Securitization (s): creation of abSs, participants and functions, securitization’s impact and risks, regulators’ concerns.

A significant development in the bond markets in recent years has been the growth of securitisation, in which the cash flows from non-tradable assets are transformed into tradable securities. Any type of asset with a reasonably predictable stream of future cash flows can be securitized. In its most basic form, the process involves two steps.

In step one,

• A company with loans or other income-producing assets—the originator—identifies the assets it wants to remove from its balance sheet and pools them into what is called the reference portfolio.

• It then sells this asset pool to an issuer, such as a special purpose vehicle (SPV)—an entity set up, usually by a financial institution, specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes.

In step two,

• the issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases,

• the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee. In essence, securitization represents an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risk) from issuers to investors.

Participants:

• the originator,

• issuer agent (special purpose vehicle),

• investors.

General description:

True sale securitization are typically aimed at isolating assets from a transferor’s (originator) insolvency to enable a purchaser (investor) of tranched securities backed by assets (ABS) to rely solely on (the creditworthiness of) those assets.

Asset backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (“MBSs”), collateralised mortgage obligations (“CMOs”) and collateralised debt obligations (“CDOs”). ABS – financial security backed by a loan, lease or receivables against other than real estate and mortgage-backed security. For investors, assets-backed securities are an alternative to investing in corporate debt.

The aim of a typical S. is that the only source of “good” and “bad” for the note holders are the assets

“Good” = cash flow:

- source of payment generally is the cash flow from a pool of assets, rather than from the ongoing operations of a corporate entity;

- typically the notes are limited by their terms in resource to the asset portfolio (ABS);

- originator is generally not obligated to cover losses.

“Bad” = credit risk:

- risk of non-payment is intended to be limited to the credit risk of the asset pool;

- credit risk associated with the originator of the assets should not impact the payments under the notes.

Impact of S.: banks utilize regulatory loopholes to conserve capital through restricting assets or formally changing risks. Banks can lower capital requirements by simply changing the asset structure and risk disposal arrangements, and then reach the regulatory capital requirements without increasing the bank’s capital burden or risk adjusted total assets.

Why S.?

- refinancing; -diversify funding sources and liquidity options; - transfer of credit risk; - asset-liability management; -reduce funding costs, esp. for lower rated/unrated companies; -manage regulatory economic capital requirements.

Advantages to issuer:

-Reduces funding costs - through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates, the difference between BB debt and AAA debt can be multiple hundreds of basis points.

-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.

-Lower capital requirements.

-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

S. is achieved by legally isolating the assets so that their credit quality can be analyzed independently of the origination company’s risk.

Disadvantages to issuer

-May reduce portfolio quality

-Increase costs - Securitizations are expensive due to management and system costs

-Size limitations: Securitizations often require large scale structuring,

-Risks: risks of impairment, such as prepayment, as well as credit loss,

Risks for investors:

In a more recent refinement, the reference portfolio is divided into several slices, called tranches, each of which has a different level of risk associated with it and is sold separately. The conventional securitization structure assumes a three-tier security design—junior, mezzanine, and senior tranches. This structure concentrates expected portfolio losses in the junior, or first loss position, which is usually the smallest of the tranches but the one that bears most of the credit exposure and receives the highest return.

There are main risks for investors: 1) liquidity risk: 1.1) credit default risk: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. 2) event risk: 2.1) 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. 2.2) 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. 3) Contractual agreements. 3.1) 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. 3.2) Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent.

Regulator’s concerns:

• The market originated when the Federal National Mortgage Association (FNMA or Fannie Mae) was established to buy mortgages on the secondary market. These are then pooled and bonds are issued as "mortgage-backed securities" to investors.

• In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA). The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. It has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions. The ISDA Master Agreement is typically used between a derivatives dealer and their counterparty when discussions begin surrounding a derivatives trade. There are two basic forms of Master Agreement: single jurisdiction/currency and multiple jurisdiction/currency. One of these documents is generally combined with a Schedule to set out the basic trading terms between the parties; each subsequent trade is then recorded in a Confirmation which references the Master Agreement and Schedule. The terms of the Schedule are often negotiated, and many firms have preferred versions of the Schedule.