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Innovations in financial intermediation
Innovation has been important in the financial markets of the 1980s. It promises
to be at least as important during the next decade. Innovation in financial
markets brings change to financial products, the institutions that produce or
deliver these products, and the markets where they are traded. Old products
and ways of doing business are being replaced with new and more efficient
ones. During the 1980s we have seen the development of options and financial
futures, the deregulation of many depository financial institutions, the
introduction of a wide variety of new financial instruments, and the globalization
of many financial markets.
Two of the most important innovations during the 1980s have been thesecuritization of a wide variety of financial products and the evolution of
financial intermediaries as the providers of risk-management products. But
before we take up these specific examples of innovation in financial
intermediation, we need to focus on the process of innovation itself to
understand why so much of it has taken place in the last decade and whether it
will continue.
The Process of Innovation
Innovation is generally a response to a change in the environment. We can
make this idea more specific by formulating a list of the most important
environmental factors. The major changes in financial markets in the last
decade and those we can foresee in the next decade appear to be responses to
changes in one or more of these four environmental factors:
* The level and volatility of inflation and interest rates;
* Technological progress in computers and communications;
* Regulation; or
* Tax law.
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Probably the largest single cause of innovation in financial markets and
institutions in the last decade has been rising inflation and the resulting increase
in the level and volatility of interest rates in the 1970s and early 1980s. Many
types of financial products and many financial institutions were originally
designed with an environment of relatively low and stable interest rates in mind.
When interest rates increased, many institutions incurred substantial losses.
Investors shifted away from products, particularly regulated accounts at
commercial banks and savings and loans, that could not effectively compete in
the new environment. The innovations in the last decade can be divided into
three useful categories:
product,
process,
organizational innovations.
Two of the most important innovations in the last decade deal with the
securitization of some key financial markets and the growth of risk-management
services provided by intermediaries through the interest rate swaps market.
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SECURITIZATION OF FINANCIAL ASSETS
One of the most important innovations in the operation of financial
intermediaries is the securitization of many financial assets. Securitization
refers to the transformation of an asset that once had no secondary market into
a tradeable security with active secondary markets; it is the transformation of a
market where financial intermediaries hold loans on their books and fund them
by issuing distinct liabilities, an intermediated market, into an over-the-counter
and ultimately an auction market where the assets themselves are traded. A
number of assets once funded largely through financial intermediaries are now
becoming securitized. The market where securitization has gone the farthest is
the residential mortgage market. But auto loans and leases, consumer credit
cards, recreational vehicle and boat loans, and commercial loans from banks
are also becoming securitized to varying degrees.
Securitization began in the 1980s with mortgage payments, auto loans, and
credit card debt being pooled and used as collateral for securities offerings.
More recently, healthcare providers have securitized accounts receivables to
obtain low-cost, off-balance-sheet financing. As the need of both raise capital
and contain costs grows in health care, providers likely will make increased use
of this financing method.
Securitization involves pooling and structuring predictable cash flows, derived
from the transfer and sale of assets, to an entity that is "bankruptcy remote."
Among other benefits, securitization is an efficient source of off-balance-sheet
financing.
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History of securitization
Securitization was introduced to capital markets in the early 1980s, as
mortgage payments were pooled and used as collateral for securities issues.
The United States government played an active role by creating agencies that
guaranteed the securities' principal and interest. Securitization became a cost-
effective financing alternative to traditional bank sources for a large number of
thrifts and other mortgage originators. In 1985,securitization was extended to
include automobile loans and, shortly thereafter, other consumer assets, such
as credit-card receivables, second mortgages, and home-equity loans.
By the late 1980s, companies such as Citibank, General Motors Acceptance
Corporation, Marine Midland Bank, Chrysler Corporation, and Ford Motor
Company accessed the securitization market to raise billions of dollars of off-
balance-sheet financing. Over the next several years, new issuance of
consumer asset-backed securities averaged about $50 billion annually.
Following the initial focus on consumer assets, securitization of commercial
receivables was the next frontier to be developed, asset by asset. Investment
bankers positioned lease-rental payments as analogous to the cash flow from a
pool of automobile loans, while trade receivables were likened to credit-card
debt. By the end of the 1980s, securitization of trade receivables had become
an accepted financing option for companies in a variety of industries. Securities
backed by trade receivables used newly issued credit-card securities as a
pricing benchmark.
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Introduction to securitization
The key to securitization is transfer of a pool of assets - in this case, receivables
- to a bankruptcy-remote structure. The bankruptcy-remote structure insulates
the investor from any "corporate" risk of the entity selling the cash flow stream.
Once the cash-flow or asset is transferred, under no circumstances can it
become the property of the transferrer, not even if the transferrer files for
bankruptcy.
Certain conditions need to be satisfied to achieve a bankruptcy-remote sale of
assets, also called a "true" sale. A critical condition is the transference of the
assets to a special-purpose corporation created for the sole purpose of buying
assets and issuing debt. The receivables must be sold, not financed. The seller
records the transfer of assets as a Financial Accounting Standards (FAS) 77
sale for generally accepted accounting principals accounting purposes. The
seller is permitted limited recourse for purposes of providing a credit
enhancement for the receivables.
The security also must be structured in a manner that provides ample protection
for anticipated losses. The tenet "past is prologue" is implicit in rating and
structuring the security. Therefore, extensive historical analysis of the bad-debt
experience for the asset is performed. Based on this analysis, the rating
agencies size the protection at two to three times expected losses for a high
investment-grade rating of the securities. Because direct recourse to the seller
for losses only can be very limited (to ensure a bankruptcy-remote transfer), the
protection for losses usually takes the form of credit support from a highly ratedentity, such as a bank, an insurer, or a subordinated security held by the seller.
The subordinated security represents the residual cash flow of the transferred
assets after the debt service of the senior securities, taking into account any
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losses. The subordinated securities are accounted for by the seller as a capital
investment in the special-purpose corporation.
Securities backed by healthcare receivables usually take the form of medium-
term notes, with the term ranging from three to ten years. The life of the
receivable and the corresponding cash-flow and debt-service profile is similar to
the more familiar securities that are backed by credit-card debt. In consideration
of the short-term nature of the asset relative to the term of the debt, the notes
pay interest only for a stated term, then retire the principal at the end of the
"interest-only" (or "revolving") period. During the interest-only period, collections
from purchased receivables are used to purchase new receivables weekly.
Therefore, from the borrower's perspective, the securities are analogous to a
term working-capital line of credit.
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Why securitize?
Securitization provides a means for many to borrow at a better rate than they
can obtain on their own. In general, this observation is true for borrowers with
senior unsecured corporate-debt ratings of A or lower. While the cost of debt
may be a key motivating factor for securitization, other benefits, both tangible
and intangible, also apply. The limited-recourse nature of this financing method
is preferable to recourse debt, which can involve personal guaranty of a
borrower's principals. Securitization represents off-balance-sheet financing,
which improves leverage and certain other balance-sheet ratios. In addition, it
helps diversify financing sources. More available cash enables the borrower to
take advantage of prompt-pay-vendor discounts. The ability to plan ahead for
projects and investments also is enhanced.
Finally, receivables sellers are required to track payments, and abnormally high
delinquency rates trigger a wind-down of the financing. This requirement
encourages borrowers to effectively monitor their receivables, to monitor
reimbursement by individual payers, and to ensure that the collection process is
efficiently designed and executed. Receivables days outstanding, a measure of
efficiency, is invariably improved after securitization.
In the healthcare industry, Jersey City Medical Center - which is part of a
relatively cash-rich system - disproved the myth that receivables are sold only
by the cash-starved. The A-rated security had London Interbank offered rates
(LIBOR) +90 basis-points pricing, with a 79 percent advance rate against the
receivables. This rate was an incentive for the medical center to gain additional
liquidity at a lower rate than available sources could offer. The medical centerwas able to invest the proceeds of the issuance and earn a positive carry, to
benefit from prompt-pay-vendor discounts, and to increase its flexibility with
respect to project planning. As expected, the receivables-days-outstanding rate
improved after the securitization.
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From a corporate-finance perspective, securitization can be both a means and
an end to the consolidation process. For many providers, securitizing their
receivables, or securitizing those of an organization to be acquired, cangenerate part of the proceeds needed to finance an acquisition. In other
instances, when a merger is effected through a stock swap, issuing additional
stock often creates underleverage. When considering post-merger financing, if
a consolidated entity is rated less than A, securitization may be the most cost-
efficient means to raise capital (including equity financing) for the entity to move
forward.
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Demands of securitization
Schechner mentions that the composition of a mortgage pool and structure of
the transaction can be tailored to meet specific needs. Mortgages can be
selected and combined to reduce concentration in property types, geographies
or borrowers. The portfolio can also be selected to shorten or lengthen
maturities to better match assets and liabilities.
Securitization is widely seen as the best way to sell pools of commercial
mortgages because of the structuring flexibility, certainty of execution and the
capacity for very large transactions, according to Schechner.
The process has also been used increasingly as a source of mortgageorigination for high-quality single properties and property portfolios. Property
owners are foregoing the traditional mortgage lending market to access the
better pricing, increased certainty and greater depth of the securities market.
Shopping centers have been especially popular, according to Mark Ettenger,
head of the Retail Focus Group at Goldman Sachs.
Schechner also noted that securitization is "quite exciting" for insurance
companies, offering them opportunities to reduce their real estate exposureand shift a portion of the economic risk, leaving the insurance company with a
manageable first loss position. By acting as a conduit, insurance companies
can switch over their existing and now under-utilized underwriting capability to
write new mortgages. "It keeps the capability busy and makes it a profit center
without increasing their exposure," Schechner said.
"Given that a securitization can be equal in pricing with a traditional loan,
securitization has many benefits for larger deals, whether they are property-
specific or pools," Schechner said. "The framework of the transaction can be
more flexible as can the pricing. However, there are more upfront costs with
securitization in terms of rating agencies, trustees, additional documentation
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and sometimes the disclosure necessary for an SEC registration for public
offerings. "Sometimes it's worth it, sometimes it's not."
Orem of Morgan Stanley points out that the RTC is currently the major issuer,
that life insurance company portfolios and non-performing bank assets can also
benefit, and that Morgan Stanley is discussing equity issues with a number of
companies as well. "The focus is on finding ways to free up liquidity, both in
debt and equity," Orem said.
Equity securitization is also a very important emphasis at Kidder Peabody,
according to Baum. "We are actively pursuing the best Real Estate Investment
Trust (REIT) possibilities. We're evaluating what executions are available. The
focus is how to most effectively raise money in today's market," Baum said.
The direct access to capital markets, the custom-designed transactions and the
potentially lower cost of funds make it clear why securitization will continue to
attract the attention of a new broad pool of investors, help ease the credit
crunch and make real estate a more liquid investment
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Asset securitisation:
However, in the sense in which the term is used in present day capital market
activity, securitisation has acquired a typical meaning of its own, which is at
times, for the sake of distinction, called asset securitisation. It is taken to mean
a device of structured financing where an entity seeks to pool together its interest
in identifiable cash flows over time, transfer the same to investors either with or
without the support of further collaterals, and thereby achieve the purpose of
financing. Though the end-result of securitisation is financing, but it is not
"financing" as such, since the entity securitising its assets it not borrowing
money, but selling a stream of cash flows that was otherwise to accrue to it.
Blend of financial engineering and capital markets:
Thus, the present-day meaning of securitisation is a blend of two forces that are
critical in today's world of finance: structured finance and capital markets.
Securitisation leads to structured finance as the resulting security is not a generic
risk in entity that securities its assets but in specific assets or cashflows of such
entity. Two, the idea of securitisation is to create a capital market product - that
is, it results into creation of a "security" which is a marketable product.
This meaning of securitisation can be expressed in various dramatic words:
Securitisation is the process of commoditisation. The basic idea is to
take the outcome of this process into the market, the capital market. Thus,
the result of every securitisation process, whatever might be the area to
which it is applied, is to create certain instruments which can be placed in
the market.
Securitisation is the process of integration and differentiation . The
entity that securities its assets first pools them together into a common
hotchpot (assuming it is not one asset but several assets, as is normally
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the case). This is the process of integration. Then, the pool itself is broken
into instruments of fixed denomination. This is the process of
differentiation.
Securitisation is the process of de-construction of an entity. If one
envisages an entity's assets as being composed of claims to various cash
flows, the process of securitisation would split apart these cash flows into
different buckets, classify them, and sell these classified parts to different
investors as per their needs. Thus, securitisation breaks the entity into
various sub-sets.
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The Securitization Process and Rationale:
Securitisation is a multi-stage process starting from selection of financial assets
and ending with the final payment been made to investors. The originator having
a pool of such assets selects a homogeneous set from this pool and sells /
assigns them to SPV in return for cash.
The SPV in turn converts these homogeneous assets into divisible securities to
enable it to sell them to investors through private placement or stock market in
return for cash. Prior to selling the securities through private placement / stock
market, the SPV may take credit rating for the securitized assets. Investors
receive income and return of capital from the assets over the life-time of the
securities. Normally, the originator acts as the receiving and paying agent for
collection of the interest and the principal from obligors and passing on the same
to investors. The difference between the rate of interest payable by obligor and
the return promised to investors is servicing fee for the originator and SPV.
The originator by securitizing the financial assets transfers the risk associated
with economic downturn on cash flows or credit deterioration in a loan /receivable portfolio. The investors buy this risk in exchange for high fixed income
return. Investors buy this risk if they see the risk as a diversifying asset, the risk
premium demanded by them for underwriting such a risk is lower than the
internal funding costs of the originator who has a concentration of such a risk.
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The Financial Structure:
The financial structure of the securitized product is a function of the type of the
instrument to be issued i.e. Pass Through Certificates (PTC) or Pay Through
Certificates (Bonds /Debentures). In both the cases, assets are sold to SPV for
further sale to investors in the form of a new instrument. However, the similarity
ends here. In case of PTC, investors get a direct undivided interest in the assets
of SPV. The cash flows which include principal, interest and pre-payments
received from the financial asset are passed on to investors on a pro rata basis
after deducting the servicing fee etc. as and when occurred without any
reconfiguration. Therefore, the investor takes the reinvestment risk on the
payments received. The frequency of the payment is dependent on the frequency
of the payment from the financial assets. The PTC structure has a long life and
unpredictable cash flows that inhibit participation by some of the fixed income
investors. The pay through structure reduces the term to maturity and provides
some certainty regarding timing of cash flows. It is issued as a debt security
(bonds / debentures) and designed for variable maturities and yield so as to suit
the needs of different investors. The debt instrument is issued in the form of a
tranche and each tranche is redeemed one at a time. In this case, cash flows are
to be reconfigured since they have to match the maturity profile of the debt
security. The payment to investors is at different time intervals than the flows
from the underlying assets. Therefore, the reinvestment risk on the cash flows till
they are passed on the investors is carried by the SPV.
The Act has named the securitized instrument as Security Receipt which has
been added as a security in The Securities Contract (Regulation) Act, 1956 and
thereby makes it available for trading through stock exchange mechanism. Asper the definition of security receipt in the Act (section 2(zg)) transfer of only an
undivided interest in the financial asset is allowed and thus the Act recognizes
only pass-through certificates (PTC) as the possible instrument for securitization.
This has eliminated the possibility of issuing pay through certificates in Indian
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markets which are more investor friendly and are the norm in the international
markets outside USA.
Players and Their Role:
The number of players in the securitisation process is large. They can be
grouped in two categories the main players and the facilitators . The main
players and their role are as follows:
The Originator is an entity owning the financial asset that are the subject
matter of securitisation. Originator is normally making loans to borrowers or is
having receivables from customers. It is the originator who initiates the process
for securitisation and is the major beneficiary of it. As already stated, the Act
envisages only banks and financial institutions acting as originators.
The Obligor (borrower) takes the loan or uses some service of the originator
that he has to return. His debt and collateral constitutes the underlying financial
asset of securitisation.
The Investor is the entity buying the securitized instrument. Section 7 (1) of
the Act allows only Qualified Institutional Buyers (QIBs) to invest in Security
Receipt (securitized product). The Act has thereby restricted the players in the
market. The rational is that being a new product only informed, big players
capable of taking risk shall be allowed to invest in it.
Special Purpose Vehicle (SPV) is a legal entity in the form of a trust or
company created for the purpose of securitisation. It buys assets (loans /
receivables etc.) from originator and packages them into security for further sale
to investors. In securitisation, one of the primary concern of participants is toensure non-bankruptcy of the SPV.
The Act has recognized SPV as a vehicle to promote securitisation. Section 2 (v)
and 2 (za) restricts the legal structure of SPV to a company under the
Companies Act, 1956. In order to have effective supervision of such companies
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and to make them bankruptcy proof, Section 3 of the Act has prescribed
Registration, Net worth and Corporate Governance requirements for them. These
requirements are expected to help in orderly development of the market for
securitized product. However, nothing debars such a SPV from floating separate
trust(s) for each securitisation program.
Facilitators play a very crucial role in the securitisation chain. Their services are
instrumental in enhancing the credit worthiness of the product which is one of the
prime reasons apart from collateral for the run away success of securitized
products
Credit Rating Agency provides rating to the securitized instrument and thus
provide value addition to security. Insurance Company / Underwriters provide
cover against redemption risk to investor and /or under-subscription.
The Trustee acts on behalf of the investors and has priority interest in the
financial asset supporting the securitized product. Trustee oversee the
performance of other parties involved in securitization transaction, review
periodic information on the status of the pool, superintend the distribution of the
cash flow to the investors and if necessary declare the issue in default and take
legal action necessary to protect investors interest.
Receiving and Paying Agent is the entity responsible for collecting periodic
payment from obligors and paying it to investors. Normally, the originator
performs this activity.
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Benefits and Threats:
Securitization offers major benefits to originator and provides a low risk high yield
instrument to investors. The main benefits to the originator are two fold. One,
originator s funds get blocked after it extends loan or expects receivables.
Securitization converts these illiquid assets into marketable securities and thus
provides alternate source of funding for the originator. Second, the illiquid assets
are sold to SPV and are removed from the balance sheet of the originator. This
improves capital adequacy and lowers capital requirement for a given volume of
asset creation by the originator. By regularly securitizing its illiquid assets the
originator can continue to expand its business without increasing its capital /
equity.
There are other attractions as well like separation of the credit risk of the illiquid
assets from the credit risk of the originator since the originator markets claims on
other assets.
Securitized product is thus a distinct bundle whose credit risk is based on the
intrinsic quality of the financial assets having credit enhancement measures and
is independent of the credit risk of the originator. This lowers the cost of funds for
the originator as the new security is not clubbed with the rating of the Originator
and is used to raise funds at much lower cost.
Securitization can be used to reduce credit concentration either sectoral or
geographical by regularly transferring such concentration to investors of
securitized product. Thus it is possible to expand operations in a particular
portfolio of assets without increasing total exposure. Additionally, it transfers the
interest rate risk, default risk of loans and receivable from originator to investors.
However, securitization is a complicated process involving large number of
intermediaries and huge upfront legal and rating costs. Therefore it is viable only
in case of large sourcing. It also tends to disclose originator s customer
information to third parties and this may.prove to be harmful in a competitive
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environment. Sometimes securitization forces originator to strip off its good
quality assets leaving only junk assets on its books.
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Features of securitisation:
A securitised instrument, as compared to a direct claim on the issuer, will
generally have the following features:
Marketability:
The very purpose of securitisation is to ensure marketability to financial
claims. Hence, the instrument is structured so as to be marketable. This is
one of the most important feature of a securitised instrument, and the
others that follow are mostly imported only to ensure this one. The
concept of marketability involves two postulates: (a) the legal and
systemic possibility of marketing the instrument; (b) the existence of a
market for the instrument.
The second issue is one of having or creating a market for the instrument.
Securitisation is a fallacy unless the securitised product is marketable. The
very purpose of securitisation will be defeated if the instrument is loaded
on to a few professional investors without any possibility of having a liquid
market therein. Liquidity to a securitised instrument is afforded either by
introducing it into an organised market (such as securities exchanges) or
by one or more agencies acting as market makers in it, that is, agreeing to
buy and sell the instrument at either pre-determined or market-determined
prices.
Merchantable quality:
To be market-acceptable, a securitised product has to have a
merchantable quality. The concept of merchantable quality in case of
physical goods is something which is acceptable to merchants in normal
trade. When applied to financial products, it would mean the financial
commitments embodied in the instruments are secured to the investors'
satisfaction. "To the investors' satisfaction" is a relative term, and
therefore, the originator of the securitised instrument secures the
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instrument based on the needs of the investors. The general rule is: the
more broad the base of the investors, the less is the investors' ability to
absorb the risk, and hence, the more the need to securitise.
For widely distributed securitised instruments, evaluation of the quality,
and its certification by an independent expert, viz., rating, is common. The
rating serves for the benefit of the lay investor, who is otherwise not
expected to be in a position to appraise the degree of risk involved.
In case of securitisation of receivables, the concept of quality undergoes
drastic change making rating is a universal requirement for securitisations.
As already discussed, securitisation is a case where a claim on the
debtors of the originator is being bought by the investors. Hence, the
quality of the claim of the debtors assumes significance, which at times
enables to investors to rely purely on the credit-rating of debtors (or a
portfolio of debtors) and so, make the instrument totally independent of the
oringators' own rating.
Wide Distribution:
The basic purpose of securitisation is to distribute the product. The extent
of distribution which the originator would like to achieve is based on a
comparative analysis of the costs and the benefits achieved thereby.
Wider distribution leads to a cost-benefit in the sense that the issuer is
able to market the product with lower return, and hence, lower financial
cost to himself. But wide investor base involves costs of distribution and
servicing.
In practice, securitisation issues are still difficult for retail investors to
understand. Hence, most securitisations have been privately placed with
professional investors. However, it is likely that in to come, retail investors
could be attracted into securitised products.
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Homogeneity:
To serve as a marketable instrument, the instrument should be packaged
as into homogenous lots. Homogeneity, like the above features, is a
function of retail marketing. Most securitised instruments are broken into
lots affordable to the marginal investor, and hence, the minimum
denomination becomes relative to the needs of the smallest investor.
Shares in companies may be broken into slices as small as Rs. 10 each,
but debentures and bonds are sliced into Rs. 100 each to Rs. 1000 each.
Designed for larger investors, commercial paper may be in denominations
as high as Rs. 5 Lac. Other securitisation applications may also follow this
logic.
The need to break the whole lot to be securitised into several
homogenous lots makes securitisation an exercise of integration and
differentiation: integration of those several assets into one lump, and then
the latter's differentiation into uniform marketable lots.
Special purpose vehicle:
In case the securitisation involves any asset or claim which needs to be
integrated and differentiated, that is, unless it is a direct and unsecured
claim on the issuer, the issuer will need an intermediary agency to act as a
repository of the asset or claim which is being securitised. Let us take the
easiest example of a secured debenture, in essence, a secured loan from
several investors. Here, security charge over the issuer's several assets
needs to be integrated, and thereafter broken into marketable lots. For this
purpose, the issuer will bring in an intermediary agency whose basic
function is to hold the security charge on behalf of the investors, and then
issue certificates to the investors of beneficial interest in the charge held
by the intermediary. So, whereas the charge continues to be held by the
intermediary, beneficial interest therein becomes a marketable security.
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The same process is involved in securitisation of receivables, where the
special purpose intermediary holds the receivables with itself, and issues
beneficial interest certificates to the investors.
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Risk Profile:
The difference between yield on the assets and yield to investors is the spread
which is the gain to the originator. A portion of the amount earned out of this
spread is kept aside in a spread account to service investors. This amount is
taken back by the originator only after the payment of principal and interest to
investors.
Other third party credit enhancement measures such as insurance, guarantee
and letter of credit are also used by originator to get a better credit rating for the
instruments. With such multiple options for risk reduction and natural
diversification inherent in the product, can a securitized instrument be presumed
to be risk free? No. Primary risks associated with securitized product are pre-
payment risk and credit risk. The pre-payment means refinancing at lower rate of
interest or early repayment of the loan amount in part or in full. This risk is
associated with mortgaged backed products using the pass through structure
(PTC). Generally, loan agreements allow the borrower to make an early payment
of the principal amount. The risk originates from the possibility of obligor making
such early payment of principal amount and thereby disturbing the yield and the
investment horizon of the investors. For premium securities, accelerated pre-
payment reduces the average life and yield since the principal is received at par
which is less than the initial price. Opposite is the case of securities purchased at
a discount. Consequently, investors have to predict the average life of such
securities and may have to look for alternate investment opportunities in a
changed interest rate scenario. The Act provides for PTC as the securitized
instrument and so the pre-payment risk will exist in Indian market. Factors
affecting pre-payment and corresponding pre-payment models to evaluate thisrisk will have to be developed in order to make investment decisions. Credit risk
reflects the risk that the obligor may not be able to make timely payments on the
loans or may even default on the loans. In case of defaults, internal and external
riskenhancement measures will come into play.
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The inherent nature of the securitized instrument makes it less risky. The cash
flow from the securitized instrument is backed by tangible identified financial
assets earmarked exclusively for an instrument and is independent of the
originator. Dependability of these cash flows is further strengthened as signified
by the ageing of the portfolio. This means, an asset having a cash flow for three
years would be monitored for the first 8 to 10 months to determine its historic loss
profile. Earmarking a specific pool of aged assets is the core feature contributing
to lowering the risk associated with securitized product.
Further, the pool of borrowers creates a natural diversification in terms of
capacity to pay, geography, type of the loan etc and thereby lowers the variability
of cash flows in comparison to cash flows from a single loan. So, lower the
variability, lower is the risk associated with the resulting securitised instrument.
Understanding of risk enhancement measures, which at times are used in
combination, is also necessary to analyze the risk profile of securitized product.
Normally, these risk enhancement measures are provided to cover the historic
risk profile (first level risk) of the financial assets and some percentage of losses
which may be higher than the historic risk profile (second level risk). Internal risk
enhancement measures like over-collateralization, liquidity reserve, corporate
undertaking, senior / sub-ordinate structure, spread account etc. cover the first
level risk. External risk enhancement measures like insurance, guarantee, letter
of credit are used to cover the second level risk.
Finally, the mortgaged backed securitized product in the foreign markets are
backed by a guarantor who guarantee to the investors the timely payment of
interest and principal. As of now, such guarantees do not exist in Indian market.
However, National Housing Board (NHB) is working in this direction to guaranteesecuritization of housing loan mortgages.
The funny piece below seeks to capture the inherent risks of securitisation:
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10 reasons as to why the Titanic was actually a securitisation instrument:
1) The downside was not immediately apparent.
2) It went underwater rapidly despite assurances it was unsinkable.
3) Only a few wealthy people got out in time.
4) The structure appeared iron-clad.
5) Nobody really understood the risk.
6) The disaster happened overnight London time.
7) Nobody spent any time monitoring the risk.
8) People spent a lot trying to lift it out of the water.
9) People who actually made money were not in original deal.
10) Despite the disaster, people still went on other ships.
The above highlights the risks inherent in securitisation. One of the biggest
inherent threat in securitisation deals is that the market participants have
necessarily believed securitised instruments to be safe, while in reality, many of
them represent poor credit risks or doubtful receivables.
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The Legal Structure and Constraints:
The intermediaries involved in creating a securitized product have to comply with
multiple legal provisions to give shape to the product. The financial asset is
transferred from the originator to the SPV and thereby attracts the relevant
provisions of Stamp Act, The Transfer of Property Act, 1882, The Negotiable
Instruments Act and Registration Act. These provisions throw up the issues
related with
i. Stamp duty
ii. Registration charges in case of mortgage back securities
iii. Negotiability / transferability of new security
iv. Assignment of mortgage backed receivables,
v. Assignment of future receivables and
vi. Issue of part assignment.
These issues, on the one hand, make securitized product economically unviable
due to high stamp duty and registration charges. On the other hand, lack of clear
supporting legal provisions for the features which are integral part of the process
of securitization hinders wider acceptability of the product. The Act has
addressed above mentioned issues by providing appropriate definition of
financial assets and securitization and recognizing security receipt as a
security under the Securities Contract (Regulation) Act, 1956. However, the
problem arising due to stamp duty and registration have not been addressed to
the satisfaction of the participants and would therefore make it economically
unviable.
The securitization chain attracts the incidence of stamp duty at three stages.One, at the time of acquisition of financial assets by SPV from the originator. The
Act provides two modes.for acquisition of assets:
(i) by issuing a debenture which will attract stamp duty on the instrument of
transfer and on the issue of debentures, and
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(ii) by entering into an agreement which being a conveyance and would
attract stamp duty. The second incidence of stamp duty arises when the
Security Receipt is created. Finally, transfer of security receipt from one
investor to another in the secondary market would attract stamp duty
unless issued in demat form.
The incidence of stamp duty is one of the major concerns which make
securitization transactions financially unviable. Stamp duty is a state subject
and in most of the states the duty ranges from 4% to 12%. Four states viz.
Maharashatra, Tamil Nadu, Gujarat and West Bengal have recognized the
commercial benefits of securitization and have reduced stamp duty on such
transactions. The Act has not addressed the issue of stamp duty and the same
is left to respective state governments to decide.
Other area of concern is the registration requirements on transfer of mortgage
backed receivables from immovable property which again adds to the cost of
securitization transaction and needs to be addressed. Another impediment is the
taxation of income of various entities of securitization transaction since the
existing provisions are likely to result into double taxation.
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Listing and Trading:
Originators will be keen to get Security Receipt listed on stock exchanges to
enhance its liquidity and thereby its attractiveness for investors. This would
require framing of disclosure parameters for the securitized instrument. The aim
of such disclosures is to assist the market in assessing the creditworthiness and
the pricing of the instrument. Two features of the securitized instrument are the
determinants of the disclosure requirement for stock exchanges. One, the
periodic reduction in the face value of the instrument after each set of receivables
from obligors is passed on to investors. Secondly, this reduction in the face value
of the instrument might be higher or lower than the scheduled reduction in face
value since the cash flows is a function of the performance of the pool of assets
i.e. pre-payment and credit risk.
Disclosures can be divided into two:
initial disclosure and
continuing disclosure.
The initial disclosure shall concentrate on information having significant effect on
pre-payment and credit risk such as lender s credit policy, characteristics of the
loans, of the properties that collateralize the loans and of obligors, etc.:
1. Lender s credit policy shall disclosure loans selection policy, documentation,
filling, collection etc.
2. Loan related disclosure will be coupon, difference of weighted average coupon
for the pool and the current market benchmark rate, original weighted average
yield, original tenure, remaining tenure, weighted average remaining tenure to
maturity, age of the loans, size of the loans, start and end date etc.
3. Property / collateral information will require geographical distribution, type of
the property and other features of the pool of financial assets.
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4. Other collateral information like performance expectation based on the aging
analysis of the portfolio, current / cumulative principal defaults, pre-payment
assumptions, periodic rating will also required to be disclosed.
5. Instrument specific information like scheduled principal and interest payment
dates and the corresponding amount, allotment date, record date, total original
face value, scheduled principal and interest distribution amount are to be
informed upfront.
6. Obligor information will comprise loan purpose, their social and economic
profile etc.
7. Details of credit enhancement measures and how they are going to be
activated and work in case there is a short fall in the receivables from obligors.
The continuing disclosure requirements will keep investors updated on the
performance of the pool and as to the funds collected. Information like number of
delinquencies till date and the corresponding amount, new delinquencies for the
period and the corresponding amount, the scheduled outstanding face value and
actual outstanding face value of the instrument, current weighted average yield,
face value prior to and after each payment date, the current and cumulative
interest and principal shortfall / excess for the pool and for the instrument,
amount drawn from credit enhancement measures and the balance available etc.
are to be disclosed to enable the market to judge the creditworthiness and to
price the instrument. Stock exchanges would be required to set-up ex-dates for
each scheduled payment date.
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Pricing:
For taking the investment and pricing decisions for securitized securities,
investors need to find answers to the following question: the dynamics of the risk
transferred in securitization transaction, the expected value of loss being
transferred and the compensation for this expected loss, whether this will be a
diversifying asset in the investor s portfolio and the fair risk premium to be paid
for underwriting this exposure. Once, an understanding of the above issues is
gained, it is possible to develop pricing models incorporating the effect of
relevant risks.
Given an understanding of above issues, the initial pricing is based on the
creditworthiness, the presumed pre-payment rate and the financials of the
instrument. The creditworthiness is used to arrive at the required discount factor
and the presumed pre-payment rate is factored to determine the reduced
average life vis--vis the stated tenure of the instrument. The financials cover the
suitability of the instrument in the portfolio of the investor. The discount factor is a
function of the interest rate scenario, investor s risk profile and the
creditworthiness of the instrument and would comprise a benchmark rate and a
risk premium on it. The bench mark rate could be a GOI security having similar
average maturity / duration while the rate of risk premium would vary by
investors. The historical analysis of past data of pre-payment is done to get the
presumed pre-payment rate and the reduced tenure.
Using these parameters, the price of the securitized instrument is calculated like
a plain bond by applying the discounted net present value method. However, a
securitized instrument has an embedded option of pre-payment and the value ofthis option is reduced from the plain bond price to arrive at the expected price of
it.
The pricing for the secondary market after the cash flows have commenced
throw up another challenge, since, the actual performance of the pool is to be
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factored in the prices. Therefore, the effect of past delinquencies and accelerated
pre-payments are to be.considered for assessing the future cash flows.
Projecting delinquencies and accelerated pre-payments based on past
performance of a instrument for arriving at an appropriate risk premium is a
complex problem that depends on both economic variables (interest rate,
inflation, economic trend and credit deterioration) and demographic variables
(frequency of moves, nature of borrowers etc).
This implies, at times the actual outstanding face value may be higher or lower
than the scheduled face value. Determining the present price for such an
instrument will be a teaser. If the outstanding amount is more, it means the pool
is turning to be delinquent and may need to be priced even lower than the
scheduled face value. If the outstanding amount is less, it means the pool is pre-
paying thereby taking away the initial yield expected by investors for a given
tenure and need to be priced accordingly. Therefore, the market would have to
develop pre-payment and default analysis models in order to price securitized
instruments. Also, the instrument requires the investors to be vigilant while
pricing it since the scheduled face value of it will keep changing after each
payment date.
Overall, the Act has provided the much need legal sanctity to securitization by
recognizing the securitization instrument as a security under the SCR Act.
However, sponsors are restricted to banks and financial institutions and the
nature of the instrument to pass through certificates. This limits the scope of
financial assets that can be securitized and the coupon & tenure flexibility
associated with pay through instruments.
These restrictions, may limit the utility of securitization for Indian markets.
Additionally, the issue of stamp duty and registration has not been tackled and
will make securitization transactions financially unviable in some states. Taxation
is another matter which shall be clarified at the earliest. Finally, it is still not clear
whether securitization can be done outside the parameters of the Act or not. On
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the other hand, market participants namely sponsors, investors and stock
exchanges need to equip themselves to meet the challenges of this new product.
For making investment decisions, investors shall develop pre-payment and
pricing models. This would require them to understand the nature of the
new instrument and its risk profile. At the same time, stock exchanges need to
frame appropriate disclosure and monitoring requirements to meet the peculiar
nature of this product. However, these limitations shall not delay the introduction
of this product through Exchange mechanism and thereby restrict its wide spread
acceptability.
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TYPES OF SECURTIZATION:
Asset-Backed Securities (ABS)
Asset Backed Securities (ABS) are securities that are issued with a structure
that repayment is intended to be obtained from an identified pool of assets. Two
types:
Fully-supported: repayment is supported by a financial guarantee
(surety bond, letter of credit, third party guarantee or irrevocable liquidity
facility). This provides both liquidity and credit protection for investors: the
provider of the support has agreed to provide funds to the SPV (Special
Purpose Vehicle) to repay investors without regard to the value of assets
owned by the SPV.
Partially-supported: repayment primarily depends on the cash flow
expected to be realized on the pool of assets, as well as liquidity and
credit enhancement from third parties.
The credit enhancement / insurance providing companies are often referred to asMonoline insurers as this is their only business (they also insure other types of
debt such as municipal bonds) and this sector is dominated by four companies:
AMBAC (American Municipal Bond Assurance Corporation)
MBIA (Municipal Bond Insurance Association)
FGIC (Financial Guaranty Insurance Company)
FSA (Financial Security Assurance)
The ABS market is so well developed in the United States that assets (primarily
loan receivables) are originated right into an ABS program.
The assets are of all types and are primarily loans (either secured or unsecured):
Credit Card receivables
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Automobile loans
Bank loans
Boat loans
Highly-leveraged bank loans
Manufactured home loans
Railroad rolling stock
Aircraft
Single-family residential mortgages
Single-family home equity loans (HEL)
Commercial real estate mortgages
Student loans
Vacation time shares
The financing of the receivables held in the SPV is usually accomplished by
issuing short-term commercial paper to investors (through commercial paper
dealers). The amount of commercial paper issued usually matches the level of
assets held by the SPV. The short-term commercial paper needs to constantly be
rolled over and the pricing to and acceptance by investors reflects the
performance of the underlying receivables, the credit enhancement indicated
above and the availability, performance an yield of alternative investments.
The credit enhancement of a securitization can also be achieved by dividing it
into tranches and allowing some tranches be exposed first to any loss from
defaulting / under-performing indivdual asset or group of assets first. In this
manner, these front-line tranches almost function like an equity piece such that
the investors in the other tranches (Mezzanine tranches) are stisfied first before
the lower tranches. These lower-rated (first loss) tranches usually receive ahigher yield (due to their higher risk position) when the security is first structured
in order to attract investors when first brought to market.
Asset-backed securitizations also usually have a backup liquidity facility in place
provided by a stand-by commitment from a syndicate (group) of banks. This
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facility protects the investors who purchase the commercial paper. If for some
reason the SPV cannot attract the same or new investors to roll over the
commercial paper or there is insufficient cash flow generated by the pool to pay
off maturing commercial paper then the SPV draws on the backup liquidity facility
to payoff the investors and the bank group then become the owners of the assets
held by the SPV (to either wait for the cash flow to improve or to liquidate the
portfolio).
Asset-backed securitizations usually have a hierarchy / priority of who receives a
payment first from the cash flow generated by the underlying assets and a
hierarchy / priority of who receives repayment first in the event of the liquidation
of the assets. This hierarchy of descending payments from senior to successive
subordinated investors is known as the "waterfall" such that those nearest to the
top in the hierarchy are compensated first when assets are "liquefied":
Pay fees first to the Trustee, Servicer / Asset manager
Pay interest due to the most senior notes. If over-collateralization and
interest coverage tests are not met, redeem notes until test is in
compliance
Pay interest due to the next subordinated tranche. If over-
collateralization and interest coverage tests are not met, redeem the most
senior notes first and then this subordinated tranche until test is in
compliance
Service all subordinate tranches in the hierarchy of investors in the
securitization
Satisfy as many tranches according to their priority as is necessary
and there are sufficient assets to continue to do so
Satisfy most subordinate equity investors if there are sufficient assetsto do so
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Mortgage-Backed Securities (MBS)
The most well-known asset backed security market is that of the Mortgage
Backed Securities (MBS) market. There are RMBS (Residential Mortgage
Backed Securities) and CMBS (Commercial Mortgage Backed Securities). In the
RMBS market, companies such as the Federal National Mortgage Association
(FNMA / Fannie Mae) purchase mortgages (individually or in groups) in the
primary market from banks (savings and commercial), credit unions, insurance
companies, etc., and packages the loans into MBS (which it guarantees for full
and timely payment of principal and interest). FNMA issues various types of debt
instruments in the global markets to fund its purchase of mortgages prior to
securitization.
MBS are sometimes also referred to as Mortgage Pass-Through Certificates as
the pro-rata share of the monthly interest, amortized principal payments (net of
fees paid to to the issuer, servicer and/or guarantor of the respective security
issue) and unscheduled principal pre-payments (many of the individual
underlying mortgages have no penalty prepayment features that allow the
mortgagee / borrower to make partial or full principal payments) generated by theunderlying pool of individual residential mortgages in the securitization are
"passed through" to the investors holding an undivided interest in the specific
security. Due to the principa pre-payment feature repayment of principal to the
holder of a pass-through security may accelerate during times of a declining
interest rate environment, thus shortening the life of the security.
Each securitized pool has a Weighted Average Coupon / WAC (all of the
mortgages within a specific security must be within 200 bps. of the WAC). The
pass-through rate is lower than the WAC / interest rates on the underlying
mortgages in the pool. FNMA provides a guarantee for its MBS for the timely
payment of principal and interest to the investor, whether or not there is sufficient
cash flow from the underlying group of mortgages. As some lenders continue to
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service the loan on the behalf of FNMA and the investor, part of the interest rate
differential is used to compensate the lender for the servicing function. In
addition, a portion of the interest rate ditterential is used to compensate FNMA
for providing a guarantee of the security. Each security also has a Weighted
Average Maturity (WAM), which indicates the average maturity in months of the
underlying mortgages in the pool.
Only GNMA is authorized to issue a guarantee with the full faith and credit of the
United States government for the timely payment of prinicipal and interest on
mortgage-backed securities issued by institutions approved by GNMA and
backed by pools of Federal Housing Administration-insured or Veterans
Administration-guaranteed mortgages.
FNMA issues both fixed-rate mortgage and adjustable rate mortgage (ARM)
securities.
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Commercial Mortgage-Backed Securities (CMBS)
Similar to residential mortgage backed securities in form and function, however
the mortgages in the pool are on multi-family or commercial real estate (industrial
and warehouse properties, office buildings, retail space, shopping malls,
cooperative apartments, hotels, motels, nursing homes, hospitals and senior
living centers). CMBS are issued in both public and private transactions and are
issued in a variety of structures, including multi-class structures featuring senior
and subordinated classes. The underlying mortgage loans of the securitization
tend to lack standardized terms with regard to rate (fixed and floating), term,
amortization and some properties also have comply with certain environmental
laws and regulations.
Collateralized Mortgage Obligation (CMO)
A Collateralized Mortgage Obligation (CMO) is a security that is collateralized
by a pool of individual mortgages. This pass-through security is divided into
various tranches of payment streams with varying maturities and payment priority
(seniority). Some of the lower-rated tranches must absorb any loss prior to the
higher rated tranches. Some tranches may payoff more rapidly than other
tranches. The division of the security in the various tranches increases the
differnt types of investor profiles than a single security could be marketed to. The
division can also eliminate prepayment risk from some investor classes. The
common CMO structures are: Interest Only, Principal Only, Floater, Inverse
Floater, Planned Amortization Class, Support, Scheduled, Sequential, Targeted
Amortization Class, and Z or Accrual Bond. Unfortunately, due to the uniqueness
of many of the multi-class (tranches) CMOs they are less liquid.
Stripped Mortgage-Backed Securities (SMBS)
In an SMBS the interest and principal payments from a standard FNMA MBS are
"stripped" out of the original security to create two new classes of security. One
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class of security receives the interest only (IO strip) and one class receives the
principal only (PO strip). While they are exclusive of each other they can still be
recombined if necessary at a later date. The pricing on either stripped security is
usually at a discount from the par value of the underlying MBS. In a declining
interest rate environment when the prepayment of residential mortgages
accelerates as home owners refinance to lower rates, the PO strips also
experience accelerated principal prepayment which increases the yield of the PO
strip discounted security. However, in a declining interest rate environment, the
IO strip receives less cash due to less outstanding principal balances on which to
calculate interest, thus the yield actually declines on the IO strip.
In a rising interest rate environment, with lower volumes of prepayment of
principal, the IO strip yield performs as expected or has an improved yield as
there is sufficient prinicipal and maturity of the underlying mortgages to sustain
the interest payments (however, the yield may not be as attractive as newly
issued MBS with WAC that reflect the recent increase in mortgage interest rates).
REMIC (Real Estate Mortgage Investment Conduit)
A REMIC is a multi-class, investment grade mortgage-backed security created byFannie Mae, Ginnie Mae, Freddie Mac and other entities. The monthly cashflow
from the underlying mortgages are allocated to various tranches, resulting in
each tranche having a separate and different maturity, coupon and payment
priority compared to the other tranches in the security. The REMIC is not subject
to income tax (except on net income from prohibited transactions, net income
from foreclosure property, and contributions made after the startup day). In
addition, REMICs also produce a residual of paper gains and losses in value
("phantom income" and "phantom loss"). Holders of the REMIC investment are
required to pay tax on the phantom income however they actually never receive
any actual cash. Phantom losses can by utilized to offset gains from other
investments. Thus, investors in REMICs must pay other qualified entities to
purchase the residual and the tax liability it generates (pension plans and non-
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U.S. individuals are barred from owning a residual). For other information about
REMICs, see sections 860A through 860G of the Internal Revenue Code (IRC).
Real Estate Synthetic Investment Securities (RESI)
A RESI is a security collateralized by a pool of mortgages like many mortgage-
backed securities. However, unlike other MBS, a RESI passes along any loss
incurred from an underlying mortgage to an investor. Thus, if a property ever
goes into foreclosure and there is insufficient value received from the sale of the
property to satisfy the outstanding mortgage principal and accrued interest, then
that loss is passed on to the investor. The security is divided into several
tranches with the lowest rated tranche incurring the first losses and then each
successively rated tranche incurring the next losses if the first tranche is
liquidated by accumulated losses. In exchange, the lowest rated tranche receives
a very high market interest rate in the form of a margin over LIBOR.
Collateralized Bond Obligation (CBO)
CBO (Collateralized Bond Obligations) are securitized pools of high-yielding
bonds and leveraged loans, whose purchase is financed by debt.
The issuer, normally a bankruptcy-remote special purpose vehicle
(SPV), buys a pool of assets (public bonds) which it then uses to
collateralize a series of securities.
By subordinating or ranking each series or tranche in terms of
seniority, the issuer effectively protects the most senior tranches against
potential losses by forcing the junior classes to accept the risk of first loss.
The bottom tranche rarely carries a coupon or attracts a rating thus it
function similar to equity. To obtain a Triple-A rating, the senior securities must typically be over
collateralized one-and-a-half times.
Thus, $500 million in assets assembled, no more than $330 million in
senior securities ($500 million divided by 1.5), and would have to place
$170 million in junior subordinated securities to close the transaction.
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Collateralized Loan Obligation (CLO)
CLO (Collateralized Loan Obligations) allows a bank/issuer to bundle low-
margin corporate loans into a new type of bond sold in the ABS market.
To the purchaser they offer higher yields than typical credit card and
auto loan ABS.
However, purchasers take on new types of downgrade and default
risks, combined with the novelty of the CLO may make it difficult to trade.
Sometimes it is not evident what corporate credits the CLO wrapper is
hiding: the pooled loans meet only certain criteria of the rating agencies. In
some issues the loans are not fully isolated from the bank such that if the
bank's debt rating were to be downgraded, so would the rating on the CLO
itself.
For the banks, selling a CLO frees up capital tied up in low margin
loans (the bank must set aside capital even for blue-chip issuers,
however, it cannot charge a higher interest rate due to the low default
profile for the blue-chip corporations. Banks that have securitized their
loan portfolios can lower their overall regulatory capital requirement.
The collateral in a CLO consists of investment grade and non-investment grade corporate loans, with several tranches of rated securities
issued based on the prioritization of cash flows, with the most subordinate
tranche (or an equity tranche retained by the bank) absorbing the first
launches from default. The most senior tranche holds the lowest credit risk
and receives the higher rating compared to the other tranches.
Credit enhancement is provided by the prioritization of cash flows,
cash reserve accounts, letters of credit or guarantees.
Ratings are also based on historical default and recovery information
for underlying assets, industry and obligor diversity, minimum interest
coverage ratios, minimum collateral ratings tests and hedging transactions
(to hedge against currency and/or interest rate related risk).
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The structure is that the bank assigns the loans to a
Seller/Servicer/Asset Manager; who in turn sells the loans to the Issuer
Trust (a bankruptcy remote special purpose vehicle that is limited to the
acquisition and managment of the collateral and the issuance of ABS); the
Trust issues ABS to invesotrs and uses the proceeds to purchase the
loans; a Trustee protects investor's security in the collateral; the bank may
act (or a third party) as a swap counter-party for currency/interest rate
hedging.
If the transfer of the loan is done by participation without the
knowledge of the Obligor, then the default of the originating bank could
result in the Trust being the unsecured creditor of the bank/seller without
recourse to the Obligor.
Assignments represent a more complete transfer.
CLN (Credit Linked Note) are debt instruments backed by the full credit
of the selling institution but whose performance is based on the reference
loan(s).
Synthetic CLO
In a synthetic CLO The assets remain on the balance sheet of the sponsor.Instead, the credit risk of the collateral pool of loans is transferred to the SPV by
means of a credit derivative (portfolio default swap).
Collateralized Debt Obligation (CDO)
Refers to multi-class CMOs, CBOs and CLOs held by an SPV. The SPV can
divide a portfolio of securities into various tranches with various maturities,
interest rates, seniority, credit enhancement and external credit rating in order tomarket the securitixation to several investor profiles.
FASIT (Financial Asset Securitization Investment Trust)
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A FASIT is a tax structure established by U.S. Legislation for the purpose of
attracting investment business to the United States and away from offshore tax
havens. As long as a FASIT has a particular capital structure and adheres to
certain investment regulations, then the FASIT can accumulate and distribute its
gross earnings without incurring U.S. taxation. CDOs may be issued in the form
of "regular interests" in a FASIT. For information on FASITs, see sections 860H
through 860L of the Internal Revenue Code (IRC).
Special Purpose Vehicle (SPV) Structure
SPV: Special Purpose vehicle; a bankruptcy remote corporation that
issues rated securities/commercial paper and uses the proceeds to
purchase assets (usually trade and term receivables) from a seller (in a
single seller program) or multiple sellers (in a multi-seller program). The
bankruptcy remote aspect is important as this way the SPV is not caught
up in any problems or failings of the parent organization and the
receivables in the securitization pool cannot be claimed by creditors of the
parent.
Multi-seller programs are typically established by a bank known as a
sponsor. The entities who sell assets to the SPV are often customers ofthe sponsoring bank. Because the SPV really does not have any active or
functional employees, the bank is usually engaged as "administrator" of
the SPV to perform all of its operational functions.
For a single seller program, the SPV purchases assets from one seller.
The seller often takes on the role of administrator/servicer for the SPV
(similar to the bank in the multi-seller). Although the SPV is established for
the benefit of the single seller, it is maintained as a separate entity.
The SPV issuer of notes backed by the receivables is usually known
as the Owner Trust.
The notes are issued subject to an indenture between the Owner Trust
and in many instances, the asset may be held by a third party, bankruptcy
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remote special purpose corporation solely for the purpose of managing,
leasing or servicing the assets.
The Owner Trust still maintains an interest in the underlying collateral
by exchanging the proceeds from the CP issuance to the third party and
receiving funding notes or certificates (with a specified beneficial interest
in certain specified collateral designated for the securitization) from the
third party entity.
The Owner Trust issues CP or medium term notes to investors backed
by its own assets which include the securitization entity's certificates or
notes of beneficial interest in the asset.
Issuance of the Commercial Paper will be backed up by a Liquidity
Facility made up of banks that are committed to paying off maturing
commercial paper, and perhaps, a credit derivative structure that protects
investors, and/or a Credit Facility such as a Letter of Credit Facility that
would provide additional over-collateralization of the assets.
Over-collateralization is based on the historical performance/default
rate, and/or the estimated residual value of the asset.
The scheduled payment stream from the asset is passed through to a
collateral account which is then used to pay-off maturing commercial
paper/medium term notes.
When a company pledges away its income to asset-backed investors, it
effectively places corporate bondholders in a second position claim on the assets
of the company / financial institution. If the company goes bankrupt, then the
corporate bond holders would not be allowed to go after the assets previously
promised to the asset-backed trust, at least not until the asset-backed investors
were paid off.
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Gain on sale accounting:
Earnings are only as good as the company's assumptions on performance of
each securitization. If the pool of loans does not perform as well then the
company has overstated its earnings.
The triple-A rating that the ratings agencies confer upon these deals is based on
various types of credit enhancement built in that make loss of principal highly
unlikely. But the triple-A ratings do not address the risk that high losses within the
securitized trust will force the deal to pay off early leaving bondholder's with
reinvestment risk. Nor does the initial rating suggest how the bond may perform
in the secondary market.
Deposit Trust: conveys a participation interest to the owner trust, which then
issues notes and certificates to investors.
SIV (Structured Investment Vehicle) are credit arbitrage vehicles. They issue
debt in the U.S. and Euro medium-term note and commercial paper markets, and
with the proceeds, purchase assets of varying maturities. These assets consist of
traditional classes of debt and ABS. Derivatives transactions are used to
eliminate both i nterest-rate and foreign-exchange risk. Since the SIVs are
funding at the AAA levels but can purchase securities/assets at varying
investment-grade rating levels, they can pick up credit spread over the life of that
asset.
SNAP (Structured Note Asset Packaging) are repackaged notes, which
includes a trust structure that allows it to ring-fence a pool of underlying assetsinto separate new issues.
Student Loans
Student loans for higher education purposes at the 2-year college, 4-year
college, gradute degree programs and trade schools are securitized in the United
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States. The Student Loan Marketing Association (SLMA or Sallie Mae), is the
Government Sponsored Enterprise (GSE) that purchases these loans from
financial institutions and specialized lending programs, and then securitizes a
pool of student loans that are in turn sold to investors. SLMA also guarantees
individual issued securitizations (although many of the loans securitized already
have a FFELP / Federal Guaranteed Student Loan Program federal government
guarantee). However, the SLMA is in the process of terminating its GSE
designation and becoming a privatized concern by September 30, 2006. The
successor entity is SLM Corp., which will continue to use the Sallie Mae name.
All existing securitizations funded by debt incurred by SLMA (a AAA rated entity)
will have to be refinanced as part of the privatization completion, as the
successor entity, SLM Corp. is only a single-A+ rated issuer. Some of the largest
originators of student loans include: National Education Loan Network, Collegiate
Funding Services, Education Lending Group, Inc., and College Loan Corp.
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SECURTISATION LEADING CHANGE IN MARKETS
Securitisation and structured finance:
Securitisation is a "structured financial instrument". "Structuredfinance" has become a buzzword in today's financial market. What it
means is a financial instrument structured or tailored to the risk-return and
maturity needs of the investor, rather than a simple claim against an entity
or asset.
Does that mean any tailored financial product is a structured financial
product? In a broad sense, yes. But the popular use of the term structured
finance in today's financial world is to refer to such financing instrumentswhere the financier does not look at the entity as a risk: but tries to align
the financing to specific cash accruals of the borrower.
On the investors side, securitisation seeks to structure an investment
option to suit the needs of investors. It classifies the receivables/cash
flows not only into different maturities but also into senior, mezzanine and
junior notes. Therefore, it also aligns the returns to the risk requirements
of the investor.
Securitisation as a tool of risk management:
Securitization is more than just a financial tool. It is an important tool of
risk management for banks that primarily works through risk removal but
also permits banks to acquire securitized assets with potential
diversification benefits. When assets are removed from a bank's balance
sheet, without recourse, all the risks associated with the asset are
eliminated, save the risks retained by the bank. Credit risk and interest-
rate risk are the key uncertainties that concern domestic lenders. By
passing on these risks to investors, or to third parties when credit
enhancements are involved, financial firms are better able to manage their
risk exposures.
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Securitisation: changes the function of intermediation:
Hence, it is true to say that securitisation leads to a degree of disintermediation.
Disintermediation is one of the important aims of a present-day corporate
treasurer, since by leap-frogging the intermediary, the company intends to
reduce the cost of its finances. Hence, securitisation has been employed to
disintermediate.
It is, however, important to understand that securitisation does not eliminate the
need for the intermediary: it merely redefines the intermediary's loan. Let us
revert to the above example. If the company in the above case is issuing
debentures to the public to replace a bank loan, is it eliminating the intermediary
altogether? It would possibly be avoiding the bank as an intermediary in the
financial flow, but would still need the services of an investment banker to
successfully conclude the issue of debentures.
Hence, securitisation changes the basic role of financial intermediaries.
Traditionally, financial intermediaries have emerged to make a transaction
possible by performing a pooling function, and have contributed to reduce the
investors' perceived risk by substituting their own security for that of the end user.
Securitisation puts these services of the intermediary in a background by making
it possible for the end-user to offer these features in form of the security, in which
case, the focus shifts to the more essential function of a financial intermediary:
that of distributing a financial product. For example, in the above case, where the
bank being the earlier intermediary was eliminated and instead the services of an
investment banker were sought to distribute a debenture issue, the focus shiftedfrom the pooling utility provided by the banker to the distribution utility provided
by the investment banker.
This has happened to physical products as well. With standardisation, packaging
and branding of physical products, the role of intermediary traders, particularly
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retailers, shifted from those who packaged smaller qualities or provided to the
customer assurance as to quality, to the ones who basically performed the
distribution function.
Securitisation seeks to eliminate funds-based financial intermediaries by fee-
based distributors. In the above example, the bank was a fund-based
intermediary, a reservoir of funds, whereas the investment banker was a fee-
based intermediary, a catalyst, a pipeline of funds. Hence, with increasing trend
towards securitisation, the role of fee-based financial services has been brought
into the focus.
In case of a direct loan, the lending bank was performing several intermediation
functions noted above: it was distributor in the sense that it raised its own
finances from a large number of small investors; it was appraising and assessing
the credit risks in extending the corporate loan, and having extended it, it was
managing the same. Securitisation splits each of these intermediary functions
apart, each to be performed by separate specialised agencies. The distribution
function will be performed by the investment bank, appraisal function by a credit-
rating agency, and management function possibly by a mutual fund who
manages the portfolio of security investments by the investors. Hence,
securitisation replaces fund-based services by several fee-based services.
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Securitisation: changing the face of banking:
Securitisation is slowly but definitely changing the face of modern banking and by
the turn of the new millennium, securitisation would have transformed banking
into a new-look function.
Banks are increasingly facing the threat of disintermediation. When asked why
he robbed banks, the infamous American criminal Willie Sutton replied "that's
where the money is." No more so, a bank would say ! In a world of securitized
assets, banks have diminished roles. The distinction between traditional bank
lending and securitized lending clarifies this situation.
Traditional bank lending has four functions:
1. originating,
2. funding,
3. servicing, and
4. monitoring.
Originating means making the loan, funding implies that the loan is held on the
balance sheet, servicing means collecting the payments of interest and principal,
and monitoring refers to conducting periodic surveillance to ensure that the
borrower has maintained the financial ability to service the loan. Securitized
lending introduces the possibility of selling assets on a bigger scale and
eliminating the need for funding and monitoring.
The securitized lending function has only three steps:
1.originate,2.sell, and
3.service.
This change from a four-step process to a three-step function has been
described as the fragmentation or separation of traditional lending.
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Capital markets fuelled securitisation:
The fuel for the disintermediation market has been provided by the capital
markets:
Professional and publicly available rating of borrowers has eliminated the
informational advantage of financial intermediaries. Imagine a market
without rating agencies: any one who has to take an exposure in any
product or entity has to appraise the entity. Obviously enough, only those
who are able to employ high-degree analytical skills will be able to survive.
However, the availability of professionally and systematically conducted
ratings has enabled lay investors to rely on the rating company'sprofessional judgement and invest directly in t