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Introduction to Securitisation by Vinod Kothari
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
Securitisation and corporate finance Nature General claim against the assets of an entity To harness the strengths of the corporate's balance sheet to raise funding Subject to entity-wide risks 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.usually quite high Objective Investor risks Structured funding Less amenable to structured funding Leverage Leverage limited to entitywide prudential/regulatory limits Introduction to Securitisation by Vinod Kothari 5 . since assets are hived off into a separate entity Leverage based on portfolio risks .
Reinvestment proceeds/liquidity facility 5. Proceeds of issue of securities 9. less fees 2. Originator’s residuary profit Originator 4. Issues securities/ notes 8.Assigns Cash flow Security trustee SPV special purpose entity 3. Cash flow before securitisation Obligors 6. Payments to investors Investors Introduction to Securitisation by Vinod Kothari 6 . Proceeds of sale of receivables 1. Reinvestment/liquidity buffer Reinvestment contract 4.Passes over to SPV.Collection and servicing 7.Basic process of securitisation 10.
prepayment risk? Securitised instruments reorganise investors‟ rights to suit their needs Introduction to Securitisation by Vinod Kothari 7 .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.
Concept of SPVs Transferor Transferor Special purpose vehicles as trustee Special purpose vehicles as owner Investors as beneficial owners Pass-through form Investors as debt investors Introduction to Securitisation by Vinod Kothari Security trustee holding charge for investors Pay-through/ CDO/ CLO form 8 .
no other claims to affect the investors‟ rights over assets SPVs are not companies in substantive operations.no other assets or general recourse against the SPV no less than isolated assets . This feature is necessary to ensure “asset-backed” securities beneficial or proportional. collateralized by specific assets Operating companies and SPVs: Nature of interest in SPV: Introduction to Securitisation by Vinod Kothari 9 . equity-type interest in assets debt-type interest.Use of SPVs Generic use of SPVs . selfsustained entity which is no more than such assets/ risks. they do not have any business except acting as a legal instrumentality. An SPV is no more and no less than incorporated name for specific assets no more than isolated assets . SPVs are used in securitisation transactions as devices of hiving off assets and converting assets into securities.to isolate identifiable assets/risks into a stand alone.
Use of structured finance devices Structured finance devices mean re-distribution of risks/rewards or components of assets into different segments. Uses of structured finance: aligning securities to investor needs . to churn out securities with different risk/reward profiles. credit risk.term. prepayment risk. etc credit enhancement arbitrage tranching subordination support classes: Common structuring devices: 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 . interest rate risk.
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 Structured finance resecuritisations Revolving type structure Refinancing type structures Introduction to Securitisation by Vinod Kothari Repackaging by components: Repackaging by tenure: 11 .
ABS types based on collateral Securitisation Existing asset Future asset Risk Mortgage backed Asset backed RMBS CMBS Operating revenues Introduction to Securitisation by Vinod Kothari Credit risk Insurance risk 12 .
ABS types based on other parameters Securitisation Purpose Nature of asset transfer Synthetic structures Term of paper Balance sheet Arbitrage Cash structures True sale structure Term paper Secured loan structure Introduction to Securitisation by Vinod Kothari Commercial paper 13 .
Life cycle of asset-backed securitisation Quasi-financial deals •Unrated. Bilateral transfers •Full originator backing •Purpose: off-balance sheet. transaction models are built around securitisation mechanics. reinvention stage) Introduction to Securitisation by Vinod Kothari 14 . exploiting excess spread. lower classes take risk •Synthetics. origination/ servicing split •More stress on risk transfers •risks of operating businesses: retail credits. better capital/ risk management •Separation of funding and risk transfers Synthetics answer regulatory concerns more easily •In traditional cash structures. better ratings •Credit enhancements dwindle. banking and insurance becomes less clear Early-stage securitisation Advanced-stage securitisation Synthetics stage Operating Risk transfers/ Index risk transfers ? (possibly. etc •Transfers through SPV route •High degree of credit enhancement/ cash participation by originators •Purpose: off balance sheet. performance-oriented businesses are transferred •Distinction bet. arbitrage activity enter the stage •Purpose: economic capital.
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 .
rentiers Public utilities Intellectual property holders insurance companies aviation companies exporters of unprocessed materials plantations governments Introduction to Securitisation by Vinod Kothari 16 . Typical users of securitisation are: Mortgage financiers Bank loans Finance companies Credit card companies Hoteliers.Typical originators Application of securitisation techniques has greatly expanded recently.
Introduction to Securitisation by Vinod Kothari 17 . private equity funds.Typical assets securitised Financial assets long-term assets short term assets revolving assets using transformation devices using secured loan structures Physical assets Whole business transactions Future flow transactions Structured investment vehicles: CDOs of investment products such as hedge funds. etc.
comingling. particularly payments. decisive action Ability and willingness to act as backup servicer or organise succession Introduction to Securitisation by Vinod Kothari 18 .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.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. compliance with respective agreements monitoring covenant compliance and reporting .
Securitisation investors Professional investors Institutional investors Fixed income investors Investors driven by concerns of risk diversification Introduction to Securitisation by Vinod Kothari 19 .
No connection with the debtors of the originator Debt obligation of the originator Relation with the debtors of the originator Nature of instrument acquired by investors Legal rights of the investors Exercisable against the originator Introduction to Securitisation by Vinod Kothari 20 . 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. there might be an indenture trustee acting as a trustee for the investors. the SPV is formed. In case of participation of several persons in the loan.the borrower and the lender. or through the SPV against the debtors of the originator Normal monetary obligation o f the originator There are two parties to the transaction . a collective investment medium.Securitisation and borrowing Legal nature of the transaction Parties to the transaction Transfer of an asset/ several assets of the originator To allow the pool of receivables to be aggregated and kept intact.the Originator. Hence. there are 3 parties to the transaction . or a debt obligation of the SPV Exercisable against the SPV.
usual bankruptcy/ distressed company protection available to the originator Investors will not be affected. normally investors will suffer a loss Introduction to Securitisation by Vinod Kothari 21 . they have a claim against the originator Failure of the debtors of the originator Depends upon recourse features.Securitisation and borrowing Treatment for regulatory purposes Effect on regulatory capital requirement Bankruptcy 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 Treated as borrowing from public Does not free regulatory capital Investors have a claim against the originator.
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 Lower cost . may allow higher fundingOff-balance sheet financing .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.
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 .
Mexican company‟s default. Turkey cos. Philippine Airlines.transition studies confirm ABS ratings are more stable than other fixed incomes.Securitisation from Investors‟ viewpoint Better security as direct claims over assets Tested in several bankruptcies: Japan Leasing. 47% of the par value lost -Moody‟s study Better yields in emerging markets Moral responsibility of investment bankers/ rating agencies: case of Ahmsa. 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. Rating resilience . several Thai companies. Introduction to Securitisation by Vinod Kothari 25 . no default to date. Even when underlying obligations default. losses are much lesser: In case of corporate bonds.
CMBS average recovery 66%. there are substantial recoveries for ABS investors. 81% in prime AA. Introduction to Securitisation by Vinod Kothari 26 . there might be a prolonged credit deterioration of a rated tranche before it can be termed a “default”. ABS 19 (out of 5193 classes) RMBS recovery rate average 61% . etc. Of the 19 defaults -12 belonged to a single issuer of credit card transactions which was a fraud.only 0.65% in prime and 49% in subprime. 96% in prime AAA. Rating agency Moody‟s cautions: due to the unique terms of structured finance transactions.86% This shows that even after D rating. (AA 89%) ABS recovery rate uneven averaging 29%.Defaults and recoveries in ABS transactions S&P released a defaulted class recovery study on 4th Sept.RMBS 83 (out of 6361). Credit cards and franchise loans took 17 of the defaults. CMBS 14 (out of 1984) . 2001 Total defaults only 116 out of 13538 classes . 116 defaults till June 2001 .
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 Pass-through or pay through Sequential. proportional or a combination Pay-outs to investors: Paydown to investors: 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 .
in case of triggers Introduction to Securitisation by Vinod Kothari 33 .Basic elements of securitisation structures Transfer of assets to bankruptcy-remote entities: Cash versus synthetic structures secured loan structures Two-tier transactions pass.throughs and bond structures Cash inflow and outflows: 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 .
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 Residual returns Weighted average maturity Introduction to Securitisation by Vinod Kothari To see the impact on: 34 .
Cash Flow Scheme of Securitisation Collect Interest (plus other revenue) Collect Actual Principal (Scheduled) Collect all Prepayment Deduct all Senior Expenses No Is Actual Principal < Scheduled Principal? Yes Debit Deliqnent Principal Ledger Pay Senior Coupon Excess Spread Is excess spread >delinquent Principal ? Yes Pay Junior Coupon Pay Principal No Transfer to Deliqnent Principal Principal Waterfall 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 .
the hazard rate ascends as the portfolio seasons.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 tends to flatten as the impact of ascending hazard rate is reduced by reducing pool size Introduction to Securitisation by Vinod Kothari 37 . that is. a 6-monthly moving average may be used For a typical portfolio. the rate of charge off relative to the then-outstanding portfolio balance To smoothen the impact of periodic ups and downs. the cumulative loss rate slows down In such cases. it is important to examine the hazard rate. however.
useful in predicting cashflows. 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.Prepayment models Prepayment models try to project the prepayment behavior of mortgage loans over time. 200 PDA would mean twice as much Impact of seasoning Introduction to Securitisation by Vinod Kothari 38 . then stay constant Prepayment behavior of specific mortgage pools is based on PSA – 100 PSA meaning equal to the above rate.2% (annualised) in Month 1 and linearly go upto 6% in Month 30. expected maturity.
PSA and CPR models 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 1 30 59 88 117 146 175 204 233 262 291 320 349 PSA prepayment CPR prepayment Introduction to Securitisation by Vinod Kothari 39 .
6% in Month 30.03% 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 .Standard default assumption Default models try to project the movement of the default rate in relation to time. grows linearly upto 0. and then declines to 0. US Bond Market Association‟s SDA: Starts with 0. Standard default assumptions in different countries project default movement over the seasoning of the pool.02% annualised default rate in Month 1. then stays constant for the next 30 months.
Defaults under SDA Default amount under SDA 450 400 350 300 250 200 150 100 50 0 Default amount under SDA 1 9 17 25 33 41 49 57 65 73 81 Introduction to Securitisation by Vinod Kothari 89 41 .