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Securitization Colloquium
Spring, 2003
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What’s asset
securitization?
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• What is securitization?
• What is the history of
securitization?
• Why do entities securitize?
• What is the profile of an
ordinary securitization?
• Why are law and accounting
so important for
securitization?
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What is Securitization?
• Process:
 The pooling of assets and the issuance of securities
to finance those assets
• Substance:
 The use of superior data on a pool of assets in
order to finance the assets, or distribute risk, more
efficiently, usually by means of the use of
“structure”
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Example: General Motors
What goes into predicting whether GM
will repay its unsecured debt:
• Automobile industry in general
• North American, European, Asian, and Latin
American automobile industries
• GM v. domestic & international competitors
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Example: General Motors
•
•
•
•
•
Politics and international trends
Management
Unions
Balance sheet and income statement
Luck!
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Example: General Motors
How about GMAC, where financial
assets reside?
• Fewer variables
• More dependent on interest rates, quality of
receivables as opposed to quality of autos
• Multiple businesses + residential and
commercial mortgage businesses
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Example: General Motors
How about the senior debt of GMAC?
• Focus on specific financial assets
• Law prevents exclusive focus on those assets
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Securitization
Securitization involves:
• Isolation of pool of assets from financial fortunes of originator
• Focus on historical data with similarly situated assets
• Predicting the future behavior of the pool at hand
Originator
transfer of
transfer of
pool
pool or
Special Purpose interest in pool
Entity
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Purchaser
Issuer
issuance of
securities
Securitization
• Efficiency #1:
 Isolation in order to enable investor to predict
behavior
• Efficiency #2:
 Unbundling and allocation of risks/rewards to
different populations
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Credit Risk
AAA
Special
Purpose
Entity
Retained
Unrated
Purchaser
Issuer
BBB
Investor
B
• Securities precisely targeted to credit risk
profile desired by investors
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Credit Risk; Tenor
3 mo.
6 mo.
Purchaser
Issuer
1 year
5 years
bullet
bullet
bullet
amortizable, etc.
• Securities precisely targeted to tenor profile
desired by investors
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Further Allocation of Credit Risk
Credit
Enhancer
Originator
transfer of
assets
Special Purpose
Entity
transfer of
assets
Allocation
of
Risk
Purchaser
Issuer
securities
1) 1st loss originator
2) 2nd loss credit enhancer
3) 3rd loss investors by category
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investors
Servicing Risk
Originator
transfer of
assets
servicer of assets
100% ownership
interest
Special Purpose
Entity
transfer of
assets
Purchaser
Issuer
• Retention of servicing risk by originator
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securities
Allocation of Interest Rate Risk
Originator
transfer of
fixed rate assets
Special Purpose
Entity
transfer of
assets
potential
back-to-back swap
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Purchaser
Issuer
floating
rate
issuance of
securities
fixed
floating rate
rate
Swap Provider
What is the History of Securitization?
MBS:
• 1970s securitization of residential mortgages
 Government sponsored entities (“GSEs”)
• Federal Home Loan Mortgage Corporation (FHLMC/“Freddie
Mac”)
• Federal National Mortgage Association (FNMA/“Fannie
Mae”)
• Allocation of credit risk to GSEs
• Retention of interest rate risk by originators
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What is the History of Securitization?
ABCP:
• Early 1980s securitization by “Multi-Seller
Commercial Paper Vehicles”
Originator
transfer of
interest in assets
ABCP Vehicle
Sponsoring
Bank
• Capital arbitrage
• Allocation of risk as in paradigm
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issuance of
CP
liquidity and
credit
enhancement
facilities
What is the History of Securitization?
• Middle 1980s securitization of non-mortgage
related assets, or ABS
• Late 1980s securitization of commercial
mortgage related assets, or CMBS
• Allocation of risk/rewards as in above paradigm
• Trade receivables, autos, credit cards, home
equity loans, manufactured housing, leases,
commercial loans, cross-border
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U.S. Public Mortgage Backed Activity, 1980-2002
(Proceeds in millions)
800000
700000
600000
500000
400000
300000
200000
100000
0
1980
1982
1984
1986
1988
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1990
1992
1994
1996
1998
2000
2002
Source: Thompson Financial
U.S. Public Asset Backed Activity, 1985-2002
(Proceeds in millions)
400000
350000
300000
250000
200000
150000
100000
50000
0
1985
1987
1989
1991
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1993
1995
1997
1999
2001
Source: Thompson Financial
U.S. Public Asset Backed Activity 1996
by Type of Assets Securitized
5.5%
8%
31%
5.5%
6%
20%
24%
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Credit Card Rec.
Home Equity
Auto Loans
Equip. Leases
Mfgd. Housing
Student Loans
All Others
Source: Thompson Financial
U.S. Public Asset Backed Activity 2002
by Type of Assets Securitized
1.5%
11.3%
39.4%
6%
1%
Home Equity
Credit Card Rec.
Auto Loans
Mfgd. Housing
Student Loans
Equip. Leases
All Other
22.9%
17.9%
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Source: Thompson Financial
U.S. Public Mortgage Backed Assets 1996
by Type of Assets Securitized
6%
6.5%
27%
6.5%
8%
9%
12%
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25%
FHLMC
FNMA
Residential
Fixed Rate
Comm.
GNMA
Mortgage Loan
All Other
Source: Thompson Financial
U.S. Public Mortgage Backed Assets 2002
by Type of Assets Securitized
4.6%
8.6%
0.6%
39.7%
FHLMC
FNMA
Residential
Comm.
GNMA
Multifamily
27.1%
20.5%
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Source: Thompson Financial
Why do Entities Securitize?
• Securitization satisfies current macro economic
trends
• What are those trends? 3 produced a need for
securitization ... 1 made it possible
 Over-regulation of financial institutions
 Search for cheaper sources of capital
 Convergence of capital markets into one
 Improving computer-based technology
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Why do Entities Securitize?
• Largest trend of all:
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Why do Entities Securitize?
What are the precise, originator-driven motivations?
• Balance sheet relief
• Cheaper cost of financing
• Increased liquidity
• Matching assets and liabilities
• Sources of funds in times of economic stress
• Gain on sale
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Balance Sheet Relief
• FAS 140: Isolation of financial assets
• Why does an issuer want balance sheet
relief?
 Removal of assets and related debt improves
ratios and need for more expensive capital
 Note rating agency discount
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Assets
100
100
Liabilities/Capital
75
Debt
25
Capital
100
Securitization of 50 assets
& 37.5 of related debt
so reduced capital to 12.5
Assets
50
Liabilities/Capital
37.5 Debt
12.5 Capital
50
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50
Less expensive capital necessary, or same capital, but
capital/assets ratio improved
Assets
Liabilities/Capital
62.5*
37.5 Debt
25
62.5
Capital
62.5
*retained interest of 12.5 in asset pool of 50
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Capital/Assets Ratio
Before:
After:
.25
.40
Other ratios may improve similarly
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Cheaper Cost of Financing
• GMAC A
• GMAC Securitization
 Up to 94% of debt rated AAA because of
isolation of assets from bankruptcy risk of
parent
• Transactions Cost
• Asset-backed premium AAA = AA+
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Increased Liquidity
• Investors who prefer mix of credit risk and
tenor that is different than senior debt
• Originator’s name can be divorced from
securities altogether
 ABCP
 Credit enhancers
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Sources of Funds in Time of
Economic Stress
• Rated v. unrated
• Bankruptcy remote structures
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Matching Assets and Liabilities
3 mo.
Issuer
6 mo.
1 year
3 year revolver
& 5 year bullet, etc.
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Gain on Sale
• FAS 140:
 Net gain equals proceeds minus basis
 Allocation of basis based on fair market value sold and
retained portions
 Valuation of retained portion based on variety of
assumptions
• Defaults
• Payment speed
• Interest rates
 Ability to “create” regular flow of net income appears to
create need for less “other capital”
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Three Steps to Creating our own
Securitization
1) Pool and package individual loans or debt
instruments
2) Convert the package into securities
3) Enhance the credit of the securities to
facilitate their sales to investors
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Borrowers
• A group of
significant economic
scale and geographic
diversity, with
• An unfulfilled or
underfulfilled need
for funds, and
• A body of historical
data about their
ability to repay debt
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Borrowers
Graduate
Students
• Securitize loans
collateralized by the
future flow of expected
earnings
• Discretionary use of
funds above and
beyond tuition payment
• Defer payment of
principal and interest
for 1-3 years
• Will not compete with
government-sponsored
tuition lending
programs
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Seeks to lower the cost of
moving funds from
investors to borrowers
Borrowers
Originator
B&B.com
• Using technology to
streamline the loan
application, qualification
and approval process
• Use historical
information to mitigate
risk by isolating the lowrisk students -- Best &
Brightest
• Package the pool of loans
to meet the risk appetites
of institutional investors
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Offers credit cards over
the Internet @ 11%
interest to students at
qualified graduate schools
• Verified student I.D.
• Access to records
(privacy)
• Variety of means for
delivery of funds
• School branding
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Acceptance and credit
limit depends upon:
 Type and Quality of
School
• Law, business, medicine
• Graduation rate
• Placement statistics
• Average starting salaries
• Alumni contribution
statistics
• Tuition loan repayment
record
• Overall reputation
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Acceptance and credit
limit depends upon:
 Type and Quality of
Student
• Degree pursued
• GPA
• Class rank
• Internships
• Anticipated graduation
date
• Credit check
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Borrowers
Special Purpose Vehicle is
created to:
Originator
• Purchase the debt
• Issue securities
SPV
Sub of
B&B, LLC
• Administer the
collection of cash flows
and servicing of debt
• Pass interest and
payments on to
investors
• Avoid taxation
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Underwriter or issuer
prices and markets
securities to investors
Borrowers
Originator
• Knows how to package
securities for market
• Sets prices and
tranches
SPV
Underwriter
Investment
Bank A
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• Understands legal
requirements of
institutional investors
• Works with the rating
agency
Borrowers
Rating Agency
Originator
Rating
Agency
Poor &
Moody
SPV
Underwriter
• Sets a defined credit
standard
• Protects investors
against unknown
assumption of risk
• Increases marketability
of securities
• Reduces yield that
must be paid to
investors
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Borrowers
Rating Agency Evaluates
Originator
Rating
Agency
Poor &
Moody
SPV
Underwriter
• Historic record of loan
defaults
• Rate of bankruptcy
• Size of default losses
• Debt seasoning -- what
% of borrowers are
now making payments
• Geographic
diversification
• Quality of borrowers
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Borrowers
SPV
To give $100 million pool of
securities a AAA rating, Poor &
Moody demands a credit
enhancement to cover
Underwriter
$15 million in losses
Originator
Rating
Agency
Poor &
Moody
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Borrowers
Options for Credit Enhancement
• A series of tranches
Originator
 $85 million of senior
securities
Rating
Agency
SPV
Credit
Enhancer
Underwriter
 $15 million of first-loss
subordinated securities
• Insurance protection
from a AAA rated surety
company
• Spread account
• Letter of credit
• Cash collateral loan
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Borrowers
Which Option Do We Choose?
Originator
Rating
Agency
SPV
Credit
Enhancer
Underwriter
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Arrange for Bank B to
service the loans -process payments,
compute interest, issue
statements, etc. -- and
SPV provides a $15
million capital
contribution as buffer
against investor loss
What’s in it for Bank B?
• Preemptive access to high-end financial
product consumers





Brokerage services
Insurance products
Auto loans
Jumbo mortgages
Business loans
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Borrowers
Investors can buy
Originator
Rating
Agency
SPV
• AAA-rated
securities
Credit
Enhancer
• Fixed-rate or
floating rate interest
payments
Underwriter
• Short- or long-term
debt
Investors
• Lower-rated, higheryield securities
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Access to historical
information
Loan origination
Fund transfer
Superior data on
asset pool
Sale of securities
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What’s asset
securitization?
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