BBBL3053 Corporate Banking Practice & Law Tutorials for TAR UC Students Only.

Tutorial 13 BKL1

SECURITISATION

Tutorial Questions

1. Briefly explain the nature of ‘securitization’ or What is ‘securitisation’?

1. Securitization (S) is the process of pooling & repackaging loans into securities, which are then sold to investors.

2. In effect what a bank is doing in securitizing its loan is raising money on the security of some of its assets, i.e. its loans.

3. Often the securities issued to investors giving them an interest in the pool, are said to be ‘ASSET-BACKED’, because payment on them is based on the FLOW OF

PAYMENTS by borrowers on the underlying loans.

4. It is easier to securitize where the loans are standard. They are more easily valued. & it is probably also easier to estimate default rates.

5. The higher the gross spreads on loans, the more easily it can be securitized, because even with wide fluctuations in default levels the INCOME STREAM is strong

enough to pay the investors holding the securities.

6. Securitization has involved home mortgages (the largest category), credit card receivables & personal loans. The amounts involved are enormous. What has been

the driving force behind Securitization?

7. For banks an important motivation has been BALANCE SHEET MANAGEMENT for example the bank removes loans from its balance sheet, thus improving the

return on capital, while still profiting from having entered them in the first place.

8. ‘S’ also helps the bank to RAISE FUNDS. There might be a tidy profit, notwithstanding bad debts, given the disparity between interest rates on the securities & on

the underlying loans.

9. Moreover, as bank regulators have tightened capital adequacy requirements, banks have had to get loans off their books. Once this is done, it also means they have

greater freedom to engage in NEW LENDING.

10. By selling loans, banks are also INCREASING THEIR LIQUIDITY.

11. Selling loans is thus a means of reconciling the conflicting demands of continuing to make loans, satisfying return on assets requirements & generating profits. Of

course there are also profits from the fees involved in running a scheme & selling the securities.

12. Another motivation is to DIVERSIFY sources of funding, some governments have promoted mortgage- backed securities in the hope of generating more long term

funding for residential mortgages. As with other innovations, in financial markets sometimes ‘S’ is driven by tax advantages.

2. Briefly explain the various forms of securitisation.

FORMS OF SECURITIZATION

1. In theory there are various possibilities in English law as regards the legal structure of a ‘S’ issue. In broad outline, the first is that the INVESTORS’

CERTIFICATES represent the BANK'S UNDERTAKING to pay a proportionate share of the principal & interest. A declaration of this nature would be legally enforceable by

investors if:-

a. it were done by way of deed poll (i.e. a legal deed signed by one person only) or

b. by way of a trust.

2. In the first case, the investors would have a contractual right to payment; in the second they would have a right as beneficiaries under a trust. As far as a bank is

concerned this first possibility is a non-starter, since it does not remove the loans from its books.

3. The second possibility is that the investor holds a ‘PASS-THROUGH’ security, which represents the beneficial ownership of part of a portfolio of loans. The bank

establishes a SPECIAL TRUST, settles a portfolio of loans on the trust, & beneficial interests in the trust are sold to investors. The bank continues to service the loans i.e.

collects the principal & interest. & passes this onto the trust, less a SERVICING FEE. The beneficial interests in the trust, represented by the securities, entitle investors to

receive a proportionate share of that principal & interest as property of the trust. In other words, the amounts repaid by borrower’s on their loans are ‘passed through’ to

investors as beneficial owners. This trust structure has been widely used in ‘S’ in the USA but not in UK.

4. The third possibility is that loans are transferred to a SPECIAL PURPOSE COMPANY/VEHICLE (SPV). & the investor holds a security instrument issued by it.

Typically, the security will be a bond, note or other debt instrument (shares could also be issued, for example cumulative preference shares with a dividend calculated to reflect

the amount of interest & principal received). The securities entitle the investor to certain payment during their lifetime.

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5. The securities may be .of varying types (for example maturity, ranking). Unlike the earlier possibilities, the cash flows are NOT 'passed through' to investors as a

matter of law, although in effect this is the result. The term ‘PAY-THROUGH’ securities are sometimes used for this arrangement. Since this is the method most used, it is the

focus of the following discussion. Diagrammatically this type of ‘S’ can be shown as follows:-

Issuer Investors Trustee

Borrowers, Home Loans Banks Sale of
6. (SPV) for Investors
The actualCredit
owners, issuer card
of the securities which investors hold will be a specially establishedloan
vehicle
to (special purpose vehicle or 'SPY'), sometimes incorporated in a tax
External Credit
haven, with NOowners, etc.
creditworthiness Issuer ENHANCEMENT. Credit Enhancement involves providing a cushion
in itself. Therefore the securities issued by the "SPY" will need CREDIT
Enhancement
to investors to reflect potential losses & uncertainty. Credit Enhancement can be provided for EXTERNALLY, through a DEMAND GUARANTEE or INSURANCE, issued by

an independent third party for a fee.

7. INTERNAL CREDIT ENHANCEMENT is typically by a subordinated loan to the issuer, or by the issuer issuing a class of subordinated securities.

8. The flow of funds from the borrowers is used first to pay the investors. & only if they are fully paid is payment made on the subordinated loan or subordinated

securities.

9. Credit Enhancement (CE) is therefore provided through CAPITALIZING THE ISSUER. Either way CE can result in the issuer having a credit rating higher than

the bank.

10. The rating of the securities will be entrusted to one of the rating agencies. It will concentrate on the underlying assets & any CE. The underlying assets must be

capable of generating cash flows for the investors. The rating agency will focus on potential risks to these flows, including legal risks. Indeed, the issuer's lawyer will need to

give the rating agency a lengthy legal opinion about risks. One dimension to legal risks concerns the transfer of the loans, receivables or mortgages to the issuer.

3. In securitisation explain how loan assets can be transferred without any obstacle?

TRANSFER OF LOAN ASSETS

1. Generally there is no obstacle to transferring a loan from one lender to another. Novation & assignment are the methods of doing this.

2. Because the borrower must consent to novation, it is NOT a practical method of transferring numerous asset: like home loans, credit card receivables & personal

loans. The same applies to assignment, if in the original loan agreement, the borrower's consent must be obtained to any transfer. Even giving notice of an assignment is a

problem because a bank would not want to contact all the relevant borrowers, both because of COST & also because it might affect their REPUTATION if it were known that

they were selling their customers’ loan.

3. Typically therefore in a ‘S’ the loans are assigned to the issuer by the technique of EQUITABLE ASSIGNMENT. Because no notice is given, a borrower's claims

against the bank are NOT cut off & may be raised against the issuer if it exercises its remedies on default.

4. In English law. it is possible only to assign the BENEFITS of a contract & NOT its BURDENS. Therefore a bank can assign the benefit of receiving the principal

& interest payable under the loan but it CANNOT assign the burden of making further advances.

5. This is relevant with credit-card loans, which are revolving in nature. Therefore it is the RECEIVABLES & not the loans which are assigned.

6. In leasing contracts, if the banks obtain tax advantages as owner (lessor) it will transfer the receivables, NOT the contracts as a whole.

7. In theory, any security or insurance, coupled with a loan, can also be transferred on the same principles as the assignment of the loan itself. In practice there are a

number of problems.

8. The transaction costs of making changes in the register for a pool of charges are so great that what typically happens is that where the issuer (or trustee for-the

investors) being given a POWER OF ATTORNEY to effect a complete transfer if necessary.

9. Since there is only an agreement to transfer, the issuer (or trustee) may need the help of the court Specific performance will generally be granted for the transfer of

a charge but it is a DISCRETIONARY remedy.

4. What are the risk factors that the bank and the issuer may encounter during securitisation? Briefly discuss.

RISK

1. The extent & location of risk is crucial in a ‘S’.

2. On the one hand, a bank will seek to minimize its risks once the loans have been transferred. On the other hand unless the risks of investors are minimized, the

securities are unlikely to be widely marketable. There IS a TENSION between these goals.

3. As far as the bank is concerned, novation means the bank has no further obligations or liabilities under the loan.

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4. Assignment however cannot absolve the bank from its obligations, for example to make further advances. The bank remains subject to claims that accrued before

borrowers were notified of the assignment. Therefore the transfer of loans, receivables & charges by means of assignment means that the bank remains subject to risk.

Moreover, the bank will often continue to service the loans, i.e. collects the principal & interest & pass this onto the issuer & is therefore exposed to OPERATIONAL RISK.

Legally, it might be in breach of its duties as agent of the issuer, or it might be liable for misrepresentations made to the borrowers.

5. What risks face the issuer? Once the loan is transferred to the issuer, it must bear the credit risks attached to the underlying transactions. The most basic credit risk

is non-payment.

6. Another risk is the possibility that borrowers will bring cross-claims or raise defenses when payment is sought from them.

7. Yet another risk, if the interest rates have fallen, is that borrowers may seek to repay loans early, but any new loans transferred will be at less profitable rates.

8. Apart from CE, these risks can be minimized in a number of ways. For example, the transfer of the loans maybe at a discount, taking potential risks into the

calculation of price.

9. Another possibility is to OVERCOLLATERALIZE the issuer, i.e. to transfer more loans to the issuer then required to fund payment on the securities, but taking

into account that a certain proportion will cause problems.

10. These are mainly commercial solutions what about legal approaches? For example, the bank will give certain representations & warranties to the issuer in the

documentation concerning the quality of loans being transferred, for example on the inquiries it conducted prior to granting them & the satisfaction by the borrowers of its

lending criteria. In the event of a breach of these representations & warranties, the issuer will have recourse against the bank.

11. If the bank fails (for example becomes insolvent) there is little credit risk to the issuer if the loans have been transferred to it, either by novation or assignment. The

ONLY credit risk would be if the transfer of assets to the issuer is a voidable disposition under the insolvency law for example, a PREFERENCE within the specified period of

the insolvency.

12. Even if the bank collects the principal & interest as agent of the issuer, this will go DIRECTL Y into a bank accounts in the name of the issuer. & NOT to the bank

itself. If held on trust, it is not subject to claims by the bank's creditors.

13. To ISOLATE the issuer as much as possible from the risk of the bank failing & claims by bank creditors, it is made ‘INSOLVENCY REMOTE’. Its shares will be

held NOT by the bank, but by a NEUTRAL ENTITY, distinct from the bank or on trust. Then there is NO chance of it being treated as a subsidiary of the bank.

14. However if the bank fails, borrowers may be more inclined to delay or default on their obligations because they no longer have a continuing relationship with the

bank. Borrowers may also be more likely to raise any possible defenses to their payment obligations. The law can do little in this regard.

15. If the issuer fails - the ultimate risk for INVESTORS- their position depends on the structure of ‘S’. If the securities they hold are DEBT INSTRUMENTS, they

rank equally with other creditors.

16. In fact the issuer will be PREVENTED from incurring debts, other than strictly in association with the ‘S’.

17. It will have no employees who could have preference claims in its insolvency.

18. The liquidator might argue that the transfer of the assets were at an undervalue - not a fanciful threat if the bank has set the price on the high side, as a method of

extracting more profit from the ‘S’. Credit enhancement obviously becomes relevant of the issuer’s failure.

19. There is also a liquidity (or income) risk. There might be a MISMATCHING of the flow of funds from borrowers to bank to issuer, and what is required to be paid

to investors. One method of addressing this is to oblige the banks in administering the loans to increase the interest rate to borrowers, to cover any shortfall. This technique is a

serious matter for borrowers. Other methods are preferable, such as building a CUSHION by subordinated capital.

5. Briefly explain FOUR (4) ways in which an Issuer can minimise risk in securitisation.

REGULATION

1. There is a tension in ‘S’ between accommodating the risk to banks and the risk to investors. Bank regulators are concerned with the former, they have NOT been

primarily interested in the latter.

Moreover, there is another group affected by ‘S’ - the borrowers.

2. BORROWERS - Borrowers must be protected in a ‘S’. This is especially because most of the loans which have been securitized so far are consumer loans - home

charges, credit card receivables, personal loans &-so on.

3. One aspect is interest rate policy.

What if the issuer sets interest rates at a higher level than the bank would have fixed it?

What if the issuer adopts a less indulgent attitude to default than the bank?

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What if the issuer discourages early repayment - which disrupt the matching of income flows from borrowers to bank to issuer, & from issuer to investors - by imposing stiff

penalties?

4. To make the securities marketable, the issuer must retain a certain control over these matters, even if the bank will normally continue to administer the loans as its

agent. Thus in the documentation the bank may undertake to RESET interest rates to cover any shortfalls in the funds available to the issuer, which cannot be met elsewhere.

In this event the issuer or any trustee for investors will usually be given a power of attorney to reset the rate if the bank fails to do so. Although the documentation may confine

the issuer (or trustee) in the extent to which either can require the bank to enforce default, the bank will in turn be obliged to comply with any reasonable directions.

5. Any protection for borrowers in the documentation, however, depends simply on the degree to which a bank thinks its reputation may be affected if they suffer.

This is not good enough when the commercial pressures for ‘S’ is pulling in the opposite direction.

6. BANK REGULATORS - If bank regulators are to be persuaded that securitized assets have been completely removed from the balance sheet of a bank, the)' will

want to know what has been done to isolate the risks attached to them.

7. One concern will be whether the loans have been transferred to the vehicle in accordance with the general standards set for sale of loan assets.

8. Another will be the operational & moral risks which a bank may have in relation to securitized assets if it continues to administer them, even though investors do

not have any legal recourse to it.

The CONTINUED IDENTIFICATION of a bank with a securitized pool means that its commercial reputation is committed & a completely clean break is not achieved. Banks

may come under pressure to support losses incurred by investors (or to smooth cash flows) and may be inclined to do so in order to protect their name.

9. Another dimension to the impact which bank regulators have on ‘S’ is the RISK WEIGHTING they have attached to a bank’s holding of the securities of an issuer.

A bank will want to hold a diversified portfolio of the debt instruments on the market, for its own accounts & in the funds it manages.

10. SECURITIES REGULATION - The securities issued will be subject to the ordinary securities laws. Depending on the structure of the issue, they will be treated in

different ways under the law, e.g. debt instruments maybe regarded as ‘investments’ and subject to the ordinary issue and marketing controls. The debt instruments held by the

investors could represent direct ownership of the loan assets or interests under a trust that is ‘PASS-THROUGH’ securities.