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Asset-Backed Securities

The Securitization Process

Prof. Ian Giddy


Stern School of Business
New York University
Asset-Backed Securities

q The basic idea


q What’s needed?
q The technique
q Applications
q Typical sequence

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Securitization of Assets

q Securitization is the transformation of an


illiquid asset into a security.
q For example, a group of consumer loans can
be transformed into a publically-issued debt
security.
q A security is tradable, and therefore more
liquid than the underlying loan or receivables.
Securitization of assets can lower risk, add
liquidity, and improve economic efficiency.
q Sometimes,assets are worth more off the
balance sheet than on it.

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What is the Technique for Creating
Asset-Backed Securities?
q A lender originates loans, such as to a
homeowner or corporation.
q The securitization structure is added. The bank or
firm sells or assigns certain assets, such as
consumer receivables, to a special purpose
vehicle.
q The structure is legally insulated from
management
q Credit enhancement and rating agency reviews
q The SPV issues debt, dividing up the benefits
(and risks) among investors on a pro-rata basis
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Securitization: The Basic Structure
SPONSORING
COMPANY

ACCOUNTS
RECEIVABLE

SALE OR
ASSIGNMENT SPECIAL
PURPOSE
VEHICLE

ISSUES
ACCOUNTS
ASSET-BACKED
RECEIVABLE
CERTIFICATES

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The Process

IsIsthe
thecompany
company
ready?
ready?

Are
Arethe
theassets
assets
suitable?
suitable?

What
Whatpool?
pool?

What
Whatlegal
legal
structure?
structure?
What
Whatcredit
credit
enhancement?
enhancement?

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Is the Company Ready for ABS?

q Does the originator currently face a high cost of


funding assets that would be recognized as sound,
cash-generating assets if taken in isolation?
q Does it have a regulatory or capital constraint that
makes freeing up the balance sheet important?
q Does it have data about the assets (required by rating
agencies and financial guarantors)?
q Does it have the servicing process and systems that
can meet the more demanding standards of the asset-
backed market?
q Is the originator willing to undertake a complex, time-
consuming transaction to obtain a broader, potentially
cheaper, ongoing source of funding?

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Are the Assets Suitable?

The Pool of Assets Should Have:


n Volume which is sufficiently large and homogenous to facilitate
statistical analysis
n A stable history of rates, defaults, delinquencies, prepayments and so
forth
n Sufficient diversification--for example, geographic and socio- economic--
to reduce vulnerability to economic stresses
n Basic lender’s credit quality standards that are capable of being evaluated
and approved by rating agencies and specialized financial guaranty
companies
n Assets must be transferable and unencumbered
In short, the assets themselves must be sufficiently strong to support
a high credit rating without the backing of the originating lender.

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What is the Technique for Creating
Asset-Backed Securities?
q A lender originates loans, such as to a
homeowner or corporation.
q The securitization structure is added. The bank or IO N
firm sells or assigns certain assets, such as A T
consumer receivables, to a special purpose N T
vehicle. M E
PL E
q The structure is legally insulated from
management
IM
q Credit enhancement and rating agency reviews
q The SPV issues debt, dividing up the benefits
(and risks) among investors on a pro-rata basis
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Finance
Finance Company
Company Limited
Limited
Case Study: The Company
(Finance Company Limited)
q Finance company whose growth is
constrained
q Has pool of automobile receivables
q Has track record
q Plans to use this as an ongoing source of
financing

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Key Decisions

Securitize the assets

Decisions

Form of
Form of transfer Form of special Form of credit Form of cash flow
transformation of
of asset purpose vehicle enhancement allocation
cash flows

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Case Study: Initial Exchanges

Finance Co.’s
Customers

Hire-Purchase
Agreement

Finance Co. Ltd


(Seller)

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Case Study: Initial Exchanges

Finance Co.’s
Customers

Hire-Purchase
Agreement

Proceeds Proceeds
Finance Co. Ltd FCL 1997-A
Investors
(Seller) (Special Purpose Co.)

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Case Study: Initial Exchanges

Finance Co.’s
Customers

Hire-Purchase Servicing Agreement


Agreement

Proceeds Proceeds
Finance Co. Ltd FCL 1997-A
Investors
(Seller) (Special Purpose Co.)
Sale of Assets Asset-Backed
Securities

Trustee
Trust
Agreement

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Case Study: Initial Exchanges

Finance Co.’s Rating Agency


Customers

Hire-Purchase Top Rating


Servicing Agreement
Agreement

Proceeds Proceeds
Finance Co. Ltd FCL 1997-A
Investors
(Seller) (Special Purpose Co.)
Sale of Assets Asset-Backed
Securities

Trustee
Trust
Agreement

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Case Study: Ongoing Payments

Finance Co.’s
Customers

Hire-Purchase Servicing Fees


Payments

Monthly HP Monthly ABS


Finance Co. Ltd Payments FCL 1997-A Payments
Investors
(Seller) (Special Purpose Co.)

Financial Guarantee
Trustee
Trustee Guarantee Provider
Responsibilities Responsibilities

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Getting a Rating: The Risks

q Credit risks
q Liquidity risk
q Servicer performance risk
q Swap counterparty risk
q Guarantor risk
q Legal risks
q Sovereign risk
q Interest rate and currency risks
q Prepayment risks

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Risk-Management Techniques in ABS

SPONSORING CREDIT
CREDIT
COMPANY ENHANCEMENT
ENHANCEMENT
ACCOUNTS
RECEIVABLE

SOVEREIGN
SOVEREIGN
PROTECTIONS
PROTECTIONS
SALE OR SPECIAL
ASSIGNMENT
PURPOSE
VEHICLE
INTEREST
INTERESTRATE/
RATE/
ACCOUNTS
ISSUES CURRENCY
CURRENCY
ASSET-BACKED
RECEIVABLE CERTIFICATES HEDGES
HEDGES

CASH
CASHFLOW
FLOW
REALLOCATION
REALLOCATION

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Credit Enhancement: Guarantee Method

Finance Co.’s Rating Agency


Customers

Hire-Purchase Top Rating


Servicing Agreement
Agreement

Proceeds Proceeds
Finance Co. Ltd FCL 1997-A
Investors
(Seller) (Special Purpose Co.)
Sale of Assets Asset-Backed
Securities

Financial Guarantee
Trustee Provider
Trust Guarantee
(if required)
Agreement Agreement

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Credit Enhancement:
Rating Agency
An Alternative Approach
Top Rating

Senior

Lower Rating
Proceeds
Finance Co. Ltd FCL 1997-A
Subordinated
(Seller) (Special Purpose Co.)
Sale of Assets

No Rating

More Subordinated

Financial Guarantee
Provider
Guarantee
(if required)
Agreement

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Asset-Backed Securities

The Rating Process


and Credit Enhancement

Prof. Ian Giddy


Stern School of Business
New York University
Moodys
Rating Agencies nn Moodys
Standard
nn Standard&&Poors
Poors
nn Fitch
Fitch

Why bother with a rating?


q Compare equivalent credit risks across
different kinds of debt: corporate, sovereign,
ABS
q Compare alternatives across different ratings
levels
q Obtain a relative as well as an absolute
measure of credit risk
q Be reasonably sure of a market to sell the
security.
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Default Matrix

Source: Fitch, “Bank CLOs”

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Rating Reports: Who Pays for Them?

q General reports on a sector, like CLOs


q Pre-sale report on an individual CLO, once
risks have been evaluated but final terms and
credit enhancement have not yet been
finanized
q Final deal report
q Periodic updates

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ABS: Factors Agencies Examine

q Asset portfolio analysis


q Legal structure of the transaction
q Quality of the originator/servicer
q The trustee
q The cash flow structure
q The counterparties

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Rating Agencies: Business Analysis

q Organization and management structure


q Financial performance
q Business strategy and planning processes
q Controls and procedures
q Asset origination and credit assessment
procedures
q Quality of its loan documentation
q Credit administation and debt recovery
procedures

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Credit Enhancement

q Senior/Sub or overcollateralization
q Reserve and liquidity accounts and lines
q Excess cash flow
q Third-party guarantees

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The Result: Bond Credit Ratings

Standard &
Moody’s Poor’s Interpretation
Aaa AAA High-quality debt instruments
Aa AA
A A Strong to adequate ability to
Baa BBB pay principal and interest
Ba BB Ability to pay interest and
B B principal speculative
Caa CCC
Ca CC
C C
D In default
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Typical Rating Analysis
Originator’s credit underwriting standards
Pre-securitization Screening of assets to be included in the portfolio
risk reduction
Diversification of the portfolio

Legal structure based Legal insulation from originator default


credit risk reduction Legal insulation from servicer default

Originator/Seller/Servicer
Credit quality of
deal participants Trustee, swap counterparties

Guarantors

Cash flow sufficiency and mismatches


Integrity of
cash flow structure Safeguards and agreements such as swaps or caps

Direct recourse
“Internal” Senior/subordination or overcollateralization
credit enhancement Reserve or spread accounts
Credit enhancement
“Third party” Cash collateralized accounts
credit enhancement Financial guarantees
Rating
Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process33
Credit Enhancement

q Overcollateralization
q Senior/Sub or
q Reserve and liquidity accounts and lines
q Excess cash flow
q Third-party guarantees

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Over-Collateralization Method

SPECIAL-PURPOSE VEHICLE

SENIOR
COLLATERAL POOL ASSET-BACKED
SECURITIES

“EQUITY” ABS
OVER-COLLATERAL
(owned by seller)

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Example of Senior/Sub Structure

Class Rating Subordination


A1,A2,A-x AAA 28%
B AA 22%
C A 16.5%
D BBB 12%
E BB 8.5%
F B 5.5%
Issuer balance NR 0%

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Possible Time Frame

1 • Determination of structure

• Information Memorandum

• Commencement of documentation
2
• Detailed cash flow analysis

• Preparation for rating process

3
• R e s u lt of cash flow analysis
months • Determination of eligible receivables

• Approach rating agencies and introduction of the structure envisaged


4
• Founding of the SPV

• Initiation of stock exchange approval process (in case of a Bond issuance)

5 • Draft of Offering Circular (in case of a Bond issuance)

• Comments of the Rating agencies (Rating confirmation)

• Determination of funding strategy


6
• Publication of Offering Circular (in case of a Bond issuance)

• Marketing (in case of a Bond issuance)

7 • Completion of documentation

This schedule serves as an indication only and may • Purchase of receivables and issuance of securities
vary from transaction to transaction.

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One Bank’s Assessment

q The implementation of a transaction


usually takes between two and six
months, provided all necessary data
and information is readily available.
q This time frame does not take into
account the rating process.

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The Securitization Process - 1
One Bank’s List
A private placement for a client who has done If new client, this
previous securitizations would follow
screening of
Ø Select securitization counsel and accountants corporation and loan
pool for suitability
Ø C o n sider tax, accounting and securitization objectives
Any info used in the PPM
Ø Discuss data fields required for loan data file or in the pool analysis must
be audited.
Ø D e fine data to be audited by accountants

Ø Begin drafting Private Placement Memorandum (PPM) If it’s a public


offering, need a
Ø Begin drafting legal documents public Prospectus or
Prospectus
Ø A s s e m ble preliminary pool and create initial data tape Supplement.
Ø C o n sider preliminary bond structure
A discussion with rating
Ø Select rating agencies agency be necessary for
selection of legal structure
Ø Perform integrity check on data tape (cracking the tape) and pool selection if it’s a
new type of ABS.

Data from companies come in


Copyright ©2001 Ian H. Giddy globalsecuritization.com
many different forms.
The Securitization Process39
The Securitization Process - 2 Most investment banks
active in ABS have
One Bank’s List developed modelling
software
Ø Model cash flow and bond structure
Invariably, with the amount of
Ø Prepare rating agency presentation information be supplied by
the issuer via the tape, there
Ø Select truste e/backup servicer
will be mistakes/discrepancies
to resolve, mostly with regard
Ø R e c o n cile discrepancies with accountants
to loan data that’s been
Ø Distribute rating agency presentations provided.

Ø M e et with rating agencies During this process, the


issuer is still originating
Ø Determine pending loan closings collateral going into the
deal. The bank has to
Ø Select rating agencies and sign engagement letters decide what else it
want to include, and
Ø Optimize loan pool and revise bond structure has to establish a “cut-
off date”.
Ø R a ting agency borrower visits (if necessary)

Ø R a ting agency due diligence (if necessary) Which asset should


not go into the pool?
Ø C o m plete loan closings and finalize loan pool Its not necessarily
bad collateral, but it
Ø Obtain preliminary subordination levels from rating agencies may still hurt the
overall profile of the
pool
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The Securitization Process - 3
Alternative would be
One Bank’s List for originator to keep
sub tranche
Ø Market transaction to sub-bond buyers (if necessary)
The collateral cash
Ø Tie out collateral cash flow with accountants
flows in aggregate are
Ø Final subordination levels from rating agencies structured to pay
bonds. The bonds are
Ø Finalize bond structure based on final loan pool and sub-levels then sold based on the
likelihood that the
Ø Tie out bond cash flows with accountants bonds will receive
those payments at a
Ø Finalize PPM and legal documents certain period in time.
Therefore, the cash
Ø Arrange distribution by other banks
flows that pay the
bonds are what the
Ø Finalize internal marketing material
investor is purchasing.
Ø Issuer presentation to salesforce The bond cash flow
characteristics are
Ø Print red herring PPM and distribute to investors presented in the
prospectus to investors
Ø Market transaction to investors and if they aren’t tied
out, there is a huge
Ø Price bonds and execute Bond Purchase Agreement legal liability for the
underwriter and issuer
Ø Print final PPM if they aren’t correct.
Ø CLOSE TRANSACTION
This is the agreement to purchase the bonds from
Copyright ©2001 Ian H. Giddy the SPV by the investor or investment
globalsecuritization.com banks Process41
The Securitization
Asset-Backed Securities

Asset-Backed Securities:
Legal and Regulatory Issues

Prof. Ian Giddy


Stern School of Business
New York University
Asset-Backed Securities:
Legal and Regulatory Aspects

q Legal
u The Transfer
u The Special-Purpose Vehicle

q Taxation
q AccountingTreatment
q Bank Regulatory Treatment

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AL
Legal Aspects EG
L

q Goal: Credit quality must be solely


based on the quality of the assets and
the credit enhancement backing the
obligation, without any regard to the
originator's own creditworthiness
q Otherwise, quality of the ABS issue
would be dependent on the originator's
credit, and the whole rationale of the
asset-backed security would be
undermined.
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Three conditions enable the separation AL
G
of the assets and the originator LE

q The transfer must be a true sale, or its legal


equivalent. If originator is only pledging the
assets to secure a debt, this would be
regarded as collaterized financing in which
the originator would stay directly indebted to
the investor.
q The assets must be owned by a special-
purpose corporation, whose ownership of the
sold assets is likely to survive bankruptcy of
the seller.
q The special-purpose vehicle that owns the
assets must be independent
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AL
The Form of Transfer: True Sale? EG
L

Form of transfer
of asset

True Sale
Alternative:
Assignment Credit swap
(Synthetic ABS)

Collateral

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AL
What Makes it a Sale? EG
L
q The form and treatment of the transaction
q The nature and extent of the benefits
transferred
q The irrevocability of the transfer
q The level and timing of the purchase price,
q Who possesses the documents
q Notification when the assets are sold

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Asset Securitization

CHASE (SPONSOR)

CREDIT CARD
RECEIVABLES

SALE OR
ASSIGNMENT SPECIAL
PURPOSE
VEHICLE

ISSUES
CREDIT CARD ASSET-BACKED
RECEIVABLES CERTIFICATES

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AL
The Alternative: Synthetic ABS EG
L

HVB (Originator)

REFERENCE
POOL OF LOANS
(Stay on
balance sheet)

CREDIT SWAP
AGREEMENT SPECIAL
PURPOSE
VEHICLE

ISSUES
TOP QUALITY ASSET-BACKED
INVESTMENTS CERTIFICATES

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NG
Accounting Treatment TI
UN
CO
AC
q Saleversus financing
q Consolidation
q Accounting for loan servicing

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NG
FASB Sale Treatment TI
UN
CO
AC
q The transferor relinquishes control of
the future economic benefits embodied
in the assets being transferred
q The SPV cannot require the transferor
to repurchase the assets except
pusuant to certain recourse provisions
q The transferor's obligation under any
recourse provision are confined and can
be reasonably estimated
Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process52
Bank Regulation
and Capital Requirements

q Goal: Ensure that the substance and not the


form of the asset transfer is what governs
capital requirements.
The regulatory authorities may assess capital or
reserve requirements as if the financing was
a secured borrowing:
u Where the transfer leaves the bank open to
recourse deemed risky by the authorities,
u Or where there is potential for a "moral hazard"
whereby a bank may shore up potential or actual
losses in the sold assets to protect its name even
when not legally required to do so.

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Basel 2 and ABS

q Originatingbanks (“clean break”)


q Investing banks (use of ratings)
q Sponsor banks (for ABS conduits)
q Synthetic securitization (degree of risk
transference)

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Basel 2 for Investing Banks

AAA to AA- 20%


A+ to A- 50%
BBB+ to BBB- 100%
BB+ to BB- 150%
B+ and below Deducted from capital

Source: Basel Committee on Banking


Supervision, January 2001

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Example:
Ford Credit Owner Trust 1999-A

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Ford Structure

Ford Ford Motor Credit

Sale Class A-5 and A-6


Ford Credit Auto
Rec. Two LP
Sale
Ford Credit Auto
Owner Trust

Class A-1 to A6

Class B Class D
Receivables
Class C

Class D

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Ford Structure: Waterfall

Receivables Class A-1 to A6

Class B

Class C

Class D

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Ford Structure: Default or Loss?

Receivables
Class A-1 to A6

Class B

Class C

Class D

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Paydown: Soft Bullet Structure

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Example: DBS Singa Deal

DBS Bank Loan portfolio US$ FRN


Seller/Servicer Singa Investors

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Dah Sing/Hong Kong SAR

Mortgage Hong Kong


Dah Sing portfolio US$ FRN
SAR Investors
Seller/Servicer Res Mort. Ltd

Currency Financial
Swaps Guarantees

ASIA Ltd
General Re
CapMac

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Franchise Loan Securitization

Franchisees
(Borrowers)

Loan
Agreement
Loan
Payments Proceeds Proceeds
Atherton Capital Atherton FLF 1998-A
Investors
(Seller) (Special Purpose Co.)
Sale of Assets Asset-Backed
Servicing Advisor Securities

Class Rating Subordination


Mellon Mortgage A1,A2,A-x AAA 28%
(Servicer) Servicing Agreement B AA 22%
C A 16.5%
D BBB 12%
E BB 8.5%
F B 5.5%
Issuer balance NR 0%

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Films (Finance for an Italian
Library of Movies)

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Future-Flow Financing:
Offshore Purchase Agreement

Oil (under
YPF sales agreement) Oil Trading Co. Notes
(Argentinian Noteholders
(Cayman Is. SPV)
oil producer)
US$ US$
Oil
(under purchase Fixed
agreement) debt payments

Highly rated US$


Trust
U.S. oil buyer

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Asiansecuritization.com

Ian H. Giddy
Stern School of Business
New York University
44 West 4th Street, New York, NY 10012, USA

Tel 212-998-0426
ian.giddy@nyu.edu
http://giddy.org

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