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± Securitisation is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security ± Process by which an asset (or asset pool) is divested via the sale of securities which are collateralized by the cash flow on the original asset (pool)
Securi¶n: The process
computer leases. liquidity management and interest rate risk management Characteristics of assets that can be securitised - . etc) Mortgage-backed securities(MBS) and Asset-backed Securities (ABS) This is done for capital management. motor vehicles etc) ± Receivables (credit card receivables.Sec¶n in Australia > Assets commonly securitised include ± Loans (mortgages. home equity. aircraft/watercraft/equipment leases.
MBS issuers .
g. home loan) .They must have insurance Following types of assets can be securitised Asset having high-quality cash flows and low probability of debt . Home loans .The must have same risk ( e.Types of assets to sec¶ed The assets must have high quality cash flows ( that is. low probability of default) E.g.
Stable Pool: There is owner of the lending assets There is special-purpose vehicle (SPV) through which assets are sold completely A trustee/manager that manages the assets and their cash flows . Pass Through Structures : 1.Types Two types of securitisation structures: pass through structures and pay through structures These depends on the purpose of securitising lending assets A.
Contd The manager receives cash inflows from the lending assets Example: principal and interest payments would be received via the lending institution and be passed them onto the investor The trustee/manager invests surplus cash flow to maintain value of the assets .
Pay Through Structure .Not much different from pass through structure except asset ownership.Contd 2.Lending institutions do not sell the assets . the trustee/manager invests them to maintain the value of the pool. B. .They package the cash-flows into SPV such as credit card receivables . Dynamic pools They have assets with maturities shorter than the actual securitisation structure As cash flows come from the lending assets.
That is. To manage such credit risk.Securitisation and credit risk management It is important that there is no legal recourse ( claim back) to the lending institution if the securitised loan default. the lending institution is in risk If assets are sold at deep discounts then there is risk of liquidity. lending institution may suffer from liquidity problem. fair value for the credit should be received . If such provision is not included.
Credit derivatives can serve as an alternative . it may affect the relationship between the lender and the clients ( specially corporate one) This problem is overcome by assigning the assets to SPV which means that title remains with the lending institution.Contd If the borrowers are informed that their loans are sold to SPV.
Other risks Liquidity risk ± shortfalls or timing differences in cash flow from assets in pool may prevent security payments from being serviced on schedule Interest rate risk ± Risk of losses arising from mismatched assets (pool) and liabilities (securities Sponsor/structuring agent ± Initiator of securitisation Originators ± Companies selling assets to SPV .
. This pool of payments is separated into rated tranches. Each tranche also has a perceived (or stated) debt rating to it.Collaterised Debt Obligations (CDOs) It is ABS Initially. all the cash flows from a CDO's collection of assets are pooled together.
Each specific rating determines how much principal and interest each tranche receives . The middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings and the lowest junk or unrated tranches are called the equity tranches.Various Tranches( Slices) The highest end of the credit spectrum is usually the 'AAA' rated senior tranche.
Furthermore they are also first in line to absorb defaults and late payments. it has the most predictable cash flow and is usually deemed to carry the lowest risk. the lowest rated tranches usually only receive principal and interest payments after all other tranches are paid.Structure of Tranches The 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments. On the other hand. . As such.
so CDO investors can't presume a steady cookie-cutter breakdown. Most CDOs will involve mortgages. CDOs can literally be structured in almost any manner. .Contd This is the most basic model of how CDOs are structured. although there are many other cash flows from corporate debt or auto receivables that can be included in a CDO structure.
These institutions look to outperform Treasury yields.Who Buy CDOs ? Why ? Insurance companies. banks. Higher returns when the payment environment is normal and when the economy is normal or strong. investment managers. and will take what they hope is appropriate risk to outperform Treasury returns. the flip side is obvious and greater losses occur. pension funds. When things slow or when defaults rise. investment banks and hedge funds are the typical buyers. .
CDOs.Why? The existence of these debt obligations is to make the aggregate loaning process cheaper to the economy. . The other reason is that there is a willing market of investors who are willing to buy tranches or cash flows in what they believe will yield a higher return to their fixed income and credit portfolios than Treasury bills and notes with the same implied maturity schedule.
Risks of CDOs Unfortunately. there is very little recourse. If credit losses choke off borrowing. credit crunch begins . there can be a huge discrepancy between perceived risks and actual risks in investing. But when the credit blow-ups happen. Many buyers of this product are complacent after purchasing the structures enough times to believe they will always hold up and everything will perform as expected.
Importance of CDOs If loans cannot be carved up into tranches the end result will be tighter credit markets with higher borrowing rates. this will shrink the traditional group of buyers down to insurance companies and pension funds that have much longer-term outlooks than banks and other financial institutions that can only invest with a three. This boils down to the notion that firms are able to sell different cash flow streams to different types of investors.to five-year horizon. So. . then the pool of end product buyers will naturally be far smaller. if a cash flow stream cannot be customized to numerous types of investors. In effect.
Against a periodic fee. credit rating change.Credit derivatives (CD) Credit derivatives (CD) CD is a credit risk management technique There are 2 parties : protection buyer (bank) who transfer risks and protection seller (Insurance companies) who assumes risk Three CDs: credit default swap . protection seller pays an agreed amount in case a credit event such as bankruptcy. loan default borrower and changes in credit spreads . total return swaps and credit options Credit default swap acts like an insurance policy.
PS will receive the residual. If market value increases more than agreed value.Contd ± The protection seller (PS) pays residual value (difference between face value and market value of the assets) ± Total return credit swap (TRCS) deals with entire economic interests in particular credit or portfolios of loans. ± There is fee equivalent to LIBOR or BBSW (average bank bill rate) ± Credit option acts like normal options . PS pays the bank or protection buyer any loss in market value of the reference loan. Under TRCS.
CAT Bond Insurance companies would like to enter into capital market with new products such as catastrophe (CAT) Bond. Some investment banks such as Munich Re ( reinsurance ) are setting up reinsurers to develop alternative risk financing deals such as CAT Bond Cat bonds pay a higher interest or coupon rates than straight bond .
Contd The principal ( face value) owed at maturity may be reduced or lost if specific catastrophe such as flood occurs. There can be zero CAT Bond which is sold at a discount and no coupon is paid CAT Bond may attach specific loss rate and if losses exceed a certain threshold. face value will be returned. Investment banks can underwrite or trade CAT Bonds in the capital market. bondholder may not get anything. If there is no catastrophe. but classical risk (insurance) products cannot be sold in the capital market . CAT Bond can be structured in a number of ways.
Tutorial Questions 1. Explain the concept of securitisation 2. Distinguish pass through structures and pay through structures 3. Discuss the characteristics of securitised assets How does securitisation help credit risk management Discuss the importance of securitisation of insurance risk through CAT Bond .
Contd What is CDOs? Why is it required ? What is the difference between CDOs and Securitisation ? How are CDOs used for risk management ? How is credit crunch related to narrower secondary mortgage markets ? .
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