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Citation: 9 Com. Lending Rev. 4 1993-1994

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 Internal and external pressuresare
pushing banks to find a way to securitize
commercial loans. In this article,Don
Wilson describes some ways that banks can
preparefor a future that includes the
securitizationof commercial loans.

Asset Securitization:
Strategic Questions Your
Bank Should Ask Now
DON WILSON

THE COMPETITIVE VALUE of a banking charter

continues to shrink. The process of disintermediation continues today
and affects both sides of the balance sheet. Large corporations access the
capital markets directly by issuing commercial paper, relegating banks
to the secondary role of providing backup letters of credit. The captive
finance subsidiaries of the automakers have significantly eroded banks'
auto loan business. Many consumers view mutual funds as attractive
alternatives to bank CDs. Nonbank players originate many mortgages.
To a large degree, banks are responding to the competitive squeeze at
both ends of their business (large and small loans) by focusing increas-
ingly on the middle-market customer base. It seems that every bank in
the country is targeting the small- to medium-sized business as the pri-
mary strategic thrust of its lending business. Indeed, most bankers view
this turf as the rightful and protected domain of commercial banking.
Here, building customer relationships, understanding the specific credit
conditions of the business, and cross-selling a variety of services are
Don Wilson is a vice president in the treasury department of LaSalle National Bank,
Chicago, a subsidiary of the Dutch banking company ABN AMRO.
Asset Securitization: Strategic Questions

viewed as the competitive advantage of banks.

Is the middle market really the safe domain of commercial banks?
This article will argue that the process of disintermediation will contin-
ue apace, eating away at banks' profitability, including the profits from
middle-market C&I loans. I will focus on asset securitization, which I
believe is in the process of significantly altering the competitive land-
scape for banks. Bankers must not look at securitization simply as
another product line in which they may or may not choose to compete.
Rather, securitization is a strategic weapon that will change the profit
dynamics of all aspects of their business and that they must use to sur-
vive. Despite cultural and psychological barriers against securitization,
the business of originating and then warehousing loans on the balance
sheet will increasingly become untenable. The balance sheet will have to
become more of a way station for loans as they are repackaged and por-
tions are sold off to the most effective holder.

Bankers must not look at securitization

simply as anotherproduct line in which
they may or may not choose to compete.
Rather,securitizationis a strategic weapon.

What Is Securitization?
Securitization involves the selling of securities backed by the cash flows
generated by a specific pool of assets. Theoretically, any pool of assets
providing a reasonably predictable stream of cash flows could be securi-
tized. The assets are held in a legal entity separate from the corporation
sponsoring the securitization and held for the beneficial interest of the
securities holders. Probably the key distinguishing characteristic of
securitization, as opposed to other forms of structured financing, is the
separation of the credit risk of the pool of assets from the credit risk of
the sponsoring organization. In fact, in a well-structured securitization,
even the bankruptcy of the sponsoring firm does not affect the credit
standing of the securitized assets.
This bankruptcy-remoteness is achieved through the use of a legally
distinct special-purpose vehicle (SPV), which may be in the form of a
trust or special-purpose corporation (the merits of the different legal
structures is beyond the scope of this article). This SPV is a separate
legal entity that is able to issue debt (or debtlike) securities entirely on
its own merits.
On a conceptual level, securitization looks similar to a loan partici-
pation. However, it has several important distinctions:

In a loan participation, the buyer holds an interest

directly in the loan itself. In a securitization, the buyer
holds a proportionate share in the cash stream generated
 Commercial Lending Review
by the pool of assets held by the SPV. The buyer holds no
direct interest in the loans themselves.
" In a securitization, the buyer generally does not have the
ability, capacity, or interest in doing due-diligence work
on the underlying assets that a buyer of a loan participa-
tion would do. Therefore, the buyer must rely on some
other means of assuring that the credit quality of the
assets meets its criteria. Generally, one of several forms
of credit enhancement provides this assurance. Losses up
to a level in excess of several times the historical loss rate
will be borne by someone other than the security holder.
* In a participation, the lead bank usually is responsible
for assuring that the servicing of the customer relation-
ship and the maintenance of the cash accounts is done
well. In a securitization, the sponsoring bank usually
does not hold a direct ongoing financial interest in the
performance of the underlying assets and, therefore, can-
not be presumed to act in the best interests of the securi-
ties holders. To remedy this problem, a trustee is
appointed to act in a fiduciary capacity to protect the best
interests of the securities holders. The trustee is respon-
sible for maintaining the cash accounts and contracting
for the loan servicing (which may or may not stay with
the entity that sponsors the transaction).
* Loan participations are private transactions between a
few counterparties; securitizations can be structured as
public deals, with all the legal protections and potential
liquidity such transactions offer. In addition, many secu-
ritizations have public ratings from one or more of the
large rating agencies.

Several devices, or combinations thereof, provide credit protection to

the securities holders. In some cases, the value of the securities sold by
the SPV is less than the current value of the assets placed in the pool.
This process, called overcollateralization, provides an implicit credit
protection since even if some of the underlying assets default, there
probably will be enough remaining assets to pay the securities holders
in full. Or, the SPV may pay an outside party to provide either a stand-
by letter of credit (from a highly rated bank) or private insurance (from
a mono-line financial insurance company) to reinforce the credit stand-
ing of the pool of assets. Or, the SPV can issue two (or more) classes of
securities with different seniority for receiving payments. When some
assets do default, the junior securities don't get paid, thereby providing
protection to the senior securities. These credit enhancements allow
the purchaser of the securities to treat them more like a typical corpo-
rate bond and obviates the purchaser's need for a rigorous due-dili-
gence process.
Asset Securitization: Strategic Questions
Securitizations may be public transactions or private deals. The pub-
lic transactions usually are larger and entail more documentation. Pri-
vate deals offer greater flexibility and may have more specialized terms
and conditions. While the private market is hard to track, market par-
ticipants usually estimate that the private market is between 5 and 10
times the size of the public market.
Strategic Advantages of Securitization
For banks, an important advantage of securitization is the ability to
remove the securitized assets from the balance sheet, thereby freeing up
scarce capital and funding resources. Even though the assets are off the
bank's balance sheet, however, the process of securitization often does
nothing to change the relationship of the originating bank with the bor-
rowing customer. In most cases, the trustee retains the originating bank
as the servicer, primarily because that bank is assumed to be in the best
position to work the credit and to avoid disrupting the bank/client rela-
tionship. (If the originating bank does not want or is unable to service
the loans, the trustee will contract with other servicers.) Therefore,
when a bank securitizes a pool of loans, usually neither the lending offi-
cer nor the borrowing client needs to know that the bank no longer owns
the loan. This can assist to overcome lenders' bias against securitization.

Securitizationmakes it possible to
disaggregatethe banking business in a
manner that has not previously been
possible.
Most people see securitization primarily as a way to remove assets
from the balance sheet and to improve capital ratios. Even more impor-
tant from a strategic point of view, securitization makes it possible to
disaggregate the banking business in a manner that has not previously
been possible. If a bank determines that it is most proficient at credit
analysis of certain types of borrowers, then it can most profitably expand
its business by providing the credit enhancements to securitization
transactions of others. If a bank considers itself proficient at originating
loans of demonstrably higher quality than generally available in the
market, then securitization allows the bank to maximize its originating
capacity without stressing its funding, liquidity, concentration, or capital
ratios. If the bank determines that it has very efficient and profitable
back-office systems and technology, then it should emphasize the servic-
ing or trustee portion of the business.
Since securitization does nothing to eliminate the financial risks of
the underlying assets but merely redistributes those risks to parties
more willing or able to manage them, this strategic disaggregation of the
business is critical. For example, there is no reason to believe that any
given bank can be an efficient gatherer of deposits, efficient at new busi-
 Commercial Lending Review
ness development, a stellar credit analyst, an efficient servicer of lend-
ing relationships, and an effective cash manager, all at the same time. To
the extent a bank can identify its particular strength and strategic
advantage, securitization allows the bank to maximize those skills and
use the most efficient market participants to provide other services,
thereby maximizing not only its own profits but also those of the econo-
my as a whole.
To build on these strategic advantages, senior bank managers must
change their perspective on the business. Rather than view the bank as
an end user of the product they "manufacture," where the balance sheet
is a warehouse to hold the products (loans) until they expire (mature),
management must view the bank as an agent or broker who uses the
balance sheet as a way station for inventory awaiting purchase by oth-
ers. A bank's balance sheet need not be the indirect meeting point of
providers of funds (depositors) and users of funds (borrowers). Securiti-
zation makes possible a more direct connection between providers and
users of funds, while still allowing the bank to provide services (and col-
lect fees) where it offers a true competitive advantage.
Barriers to Securitization
In theory, any asset with a predictable cash flow can be securitized.
Nonetheless, while the securitization business has exploded in size in
the last few years, it accounts for a small proportion of banking assets.
Indeed, most bankers view securitization as the province of the largest
banks, who have large volumes of consumer loans or trade receivables
and a need to improve their capital ratios.
The assets to be pooled lack uniformity
The first problem with the development of a market for middle-mar-
ket commercial loan securitizations is a lack of uniformity in the assets
themselves. The loans are of higher average size than the standard con-
sumer or trade receivable credit; therefore, diversification is harder to
achieve. The variety of borrower types makes it hard to pool loans with
similar credit characteristics. For example, a loan to a tool and die shop
would be evaluated much differently than a loan to a retail merchant,
which in turn is different from a loan to an auto repair shop. Information
about the actuarial loss experience of each loan category does not exist.
(For more on obstacles to securitization, see "How Feasible Is the Securi-
tization of Loans to Small and Medium-sized Businesses?" Commercial
Lending Review, Fall 1993, 4.)
Those who want to see the market expand currently are wrestling
with this issue. Trade groups representing the insurance and pension
fund industries (both big purchasers of asset-backed securities) and sev-
eral large banks are trying to develop what amounts to a credit-scoring
model for middle-market loans (including commercial real estate loans)
that would standardize the risk measures for different types of middle-
market commercial loans. Having a closer consensus on the risks in a
Asset Securitization: Strategic Questions
given pool of loans would help the securitization business immeasurably,
because it would make it possible to identify more closely the amount of
credit enhancement necessary to protect investors to a specific degree
and it would bring together buyers' and sellers' perceptions of value.
The mortgage securities market (the granddaddy of the securitiza-
tion business) shows the importance of some agreement in perceptions of
risk. When a large player (FNMA) determined the criteria to meet its
credit standards, the market quickly adopted those standards. Previous-
ly, each mortgage lender had its own credit standards, much like middle-
market commercial lending today. But if a large participant can identify
an actuarial basis for determining probable credit losses in a pool of mid-
dle-market commercial loans, those factors probably would become the
de facto standards for making such loans. Many larger banks already
use a simplified version of this type of scoring system for their in-house
evaluation of loans. The strong desire of many potential investors to
expand the secondary market for loans is a powerful incentive for devel-
oping a consensus scoring model.
Up-front costs are daunting
Large up-front costs also impede the development of the market for
securitized middle-market commercial loans. To be economically feasi-
ble, pools must be relatively large-approximately $100 million for a
public deal. This large minimum size seems to lock out all but the largest
banks from the market. Some recent innovations attempt to solve this
problem. Several large banks have created multiseller vehicles, where
the SPV accepts assets from a variety of banks and the selling bank
arranges the credit enhancement separately or the SPV sponsor pro-
vides a blanket enhancement for all assets. This shares the fixed costs of
setting up the program among several banks and gives smaller banks
the opportunity to securitize loans without setting up a program from
scratch. As more banks get comfortable with the securitization process,
these programs are likely to proliferate.
Government facilitationseems unlikely
Some commentators believe a new government-sponsored entity
(GSE), or at least the legislative codification of a new special-purpose tax
vehicle (similar to the REMIC structure for mortgage loans), is a prereq-
uisite for securitization to succeed on a large scale. A new GSE for guar-
anteeing commercial loans seems unlikely. However, there is legislation
proposed to resolve some complicated tax issues involved in structuring
of SPVs for nonmortgage financial assets.

Strategic Questions for Banks that May Securitize Loans

The competitive incentives for banks to disaggregate their lending busi-
ness and remove assets from their balance sheets and the increasing
appetite of insurance company and pension fund investors for high-qual-
ity investment alternatives are likely to cause exponential increases in
 Commercial Lending Review
the market for asset-backed securities in the next five to seven years. If
this expansion of securitization does come to pass, your bank must be
prepared for change.
Given the lower overhead costs of capital markets transactions (ver-
sus bank on-balance-sheet transactions), spreads will continue to nar-
row. Banks that choose not to use securitization will find themselves
priced out of the market. This process is likely to mirror the maturation
of the mortgage market, where the economics strongly favor the large,
low-cost producers of mortgage products who specialize in one aspect of
the business over those who attempt to be portfolio lenders and retain all
aspects of the business.
Securitization will require some subtle managerial changes. The
shift from ROA to ROE as a measure of performance-already occur-
ring-will need to accelerate. Most banks will have to pay more atten-
tion to cost identification and allocation. Back-office technology will
become a more important source of competitive advantage and, there-
fore, will require significant investment. Banks will need to under-
stand the current values of all items on the balance sheet. While
managers may resist these changes at first, the industry is moving this
way anyway.

Whether or not a bank wants to securitize

loans now, it should preparefor changes
down the road.
Bank senior management should actively rethink strategic direc-
tion to consider the effect securitization will have on the business.
Whether or not a bank wants to securitize loans now, it should prepare
for changes down the road. Every bank should be taking the following
steps today:

" Identify the source of your bank's competitive advantage.

If you had to, in what portion of the lending business
would you choose to specialize?
* Begin to adjust accounting, operations, pricing, incen-
tive, and management reporting systems so they can pro-
vide information about smaller and smaller units of the
bank. For example, a potential purchaser may want
information about credit-related criteria (for example,
geographic distribution and cash flow characteristics) for
components of your portfolio. You may need to make sys-
tems changes to make such information accessible. Also,
you should be able to measure profitability for each loan
not only against the part of the funding curve where it
was originated but also against the part of the curve rel-
evant to its remaining life. Each loan record should have
Asset Securitization: Strategic Questions
a field to indicate whether or not the loan has been sold.
(To avoid distorting incentives, lending or servicing per-
sonnel should not be able to read this field.)
" Begin investigating specific multiseller vehicles offered
by correspondents or other large institutions. While you
may not be willing to participate for the foreseeable
future, you should learn about the mechanics and inves-
tigate the economics of your situation.
* Begin building internal expertise on securitization. Your
bank's CFO, treasurer, manager of funding, and a senior
lender should begin to identify the issues and financial
implications of securitization for your institution. Ideally,
this internal task force should target a time to consum-
mate a small private placement transaction in order to
gain practical experience in securitization.
* Incorporate some consideration of securitization into
decisions about strategy. For example, what markets
would you target more aggressively if you could increase
your funding capacity by 50% or more without ballooning
the balance sheet? Would you define your market differ-
ently? Would your pricing be different?
By starting now, the bank can respond effectively as the securitiza-
tion market develops and matures. If you need to make operational or
structural changes, you can change slowly now in concert with normal
business operations and with minimum cost and disruption.
The profit dynamics of the banking industry continue to deteriorate
as potential bank customers find more and more alternatives to tradi-
tional bank debt and deposits. While viewing the balance sheet as a way
station for loans awaiting funding off balance sheet will entail a difficult
transition for most banks, market forces will dictate that they make
such a change. The time to begin the transition is now.