NationMaster - Encyclopedia: Securitization

Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment.^[1] It involves the selling of financial instruments which are backed by the cash flow or value of the underlying assets.^[2] Structured finance describes any non-standard way of raising money. ... Collateral could mean: Collateral in finance means a security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. ... www. ... Financial instruments package financial capital in readily tradeable forms - they do not exist outside the context of the financial markets. ... This article does not cite any references or sources. ...

Securitization typically applies to assets that are illiquid (i.e. cannot easily be sold). It is common in the real estate industry, where it is applied to pools of leased property, and in the lending industry, where it is applied to lenders' claims on mortgages, home equity loans, student loans and other debts. This article is about the business definition. ... Real estate is a legal term that encompasses land along with anything permanently affixed to the land, such as buildings. ... For other uses, see Loan (disambiguation). ... Introduction A mortgage is a device used to create a lien on real estate by contract. ... A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. ... This article needs cleanup. ...

All assets can be securitized so long as they are associated with a steady amount of cash flow. Investors "buy" these assets by making loans which are secured against the underlying pool of assets and its associated income stream. Securitization thus "converts illiquid assets into liquid assets"^[3] by pooling, underwriting and selling their ownership in the form of asset-backed securities (ABS).^[4] An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ...

Securitization utilizes a special purpose vehicle (SPV) (alternatively known as a special purpose entity [SPE] or special purpose company [SPC]) in order to reduce the risk of bankruptcy and thereby obtain lower interest rates from potential lenders. A credit derivative is also generally used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors. A special purpose entity (SPE) (sometimes, especially in Europe, special purpose vehicle) is a body corporate (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk, usually bankruptcy but sometimes a specific taxation or regulatory... Notice of closure stuck on the door of a computer store the day after its parent company, Granville Technology Group Ltd, declared bankruptcy (strictly, put into administrationâ€”see text) in the United Kingdom. ... // A credit derivative is a financial instrument or derivative (finance) whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded. ...

Securitization has evolved from tentative beginnings in the late 1970s to a vital funding source with an estimated total aggregate outstanding of $8.06 trillion (as of the end of 2005, by the Bond Market Association) and new issuance of $3.07 trillion in 2005 in the U.S. markets alone.^{[citation needed]}

Structure

Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates. Domestic credit to private sector in 2005 Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. ... For other uses, see Loan (disambiguation). ... In finance, a bond is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. ... For other uses, see Stock (disambiguation). ... A credit rating assesses the credit worthiness of an individual, corporation, or even a country. ... For other senses of this word, see interest (disambiguation). ...

The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the debts.

A suitably large portfolio of assets is "pooled" and sold to a special purpose vehicle (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote," meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities. A special purpose entity (SPE) (formerly special purpose vehicle) is a firm created by a company to fulfill narrow or temporary objectives. ... Notice of closure stuck on the door of a computer store the day after its parent company, Granville Technology Group Ltd, declared bankruptcy (strictly, put into administrationâ€”see text) in the United Kingdom. ...

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing.^[5] In a sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator.^[6] Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE". Image File history File linksMetadata Securitisation. ... Image File history File linksMetadata Securitisation. ... It has been suggested that Accounting scholarship be merged into this article or section. ... An arms length financial market is a market where there is less interaction between the one who is being financed and the one who does the financing. ...

Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction. To meet Wikipedias quality standards, this article or section may require cleanup. ...

Issuance

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities which are issued in order to provide an external perspective on the liabilities being created and help the investor make a more informed decision. Securities are tradeable interests representing financial value. ... An institutional investor is an investor who is an institution like a bank, insurance fund, retirement fund, or mutual fund manager. ... A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations. ...

In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors. Regulation AB was introduced in 2004 by the Securities and Exchanges Commission to regulate registration, offering and reporting of public deals of Asset Backed Securities Categories: | | | | ...

Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.

The securities can be issued with either a fixed interest rate or a floating rate. Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds. Floating rate securities may be backed by both amortizing and nonamortizing assets. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk^[7] For other senses of this word, see interest (disambiguation). ... In marketing a coupon is a ticket or document that can be exchanged for a financial discount or rebate when purchasing a product. ...

Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are "credit enhanced," meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest). Credit enhancement is a key part of a Asset-backed security Securitization transaction, and important for the Credit rating agency when rating a securitization. ... A surety bond is a contract among at least three parties: The principal - the primary party who will be performing a contractual obligation The obligee - the party who is the recipient of the obligation, and The surety - who ensures that the principals obligations will be performed. ... A surety is a person who agrees to be responsible for the debt or obligation of another. ...

Individual securities are often split into tranches, or categorized into varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascading effect between classes, this arrangement is often referred to as a cash flow waterfall. In the event that the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk. ^[7] In structured finance, the word tranche (sometimes traunche) refers to one of several related securitized bonds offered as part of the same deal. ... Subordination is a state in which one person or group of people has rights or privileges which rank below those of another. ...

The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.

Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. ... After a contract is concluded between buyer and seller, buyers bank supplies a letter of credit to seller. ...

Servicing

A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise as the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle.

The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.^[6]

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors. The court of chancery, which governed fiduciary relations prior to the Judicature Acts The fiduciary duty is a legal relationship between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary, that in English common law is arguably the most important concept within the portion...

Repayment structures

Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralized by fully amortizing assets such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The PSA prepayment model is a well-known example. ^[8]^[7] Look up amortise in Wiktionary, the free dictionary. ... A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. ... Student loans are loans offered to students to assist in payment of the costs of professional education. ... PSA Prepayment Model is a prepayment model by the PSA (Public Securities Association) that assumes increasing prepayment rates for the first 30 months of the lifetime and constant rates thereafter. ...

A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be nonamortizing. After a predetermined “revolving” period, during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.^[7]

On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.^[7]

Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth.^[7] Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.^[7]

Special types of securitization

Master trust

A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards. Look up credit card in Wiktionary, the free dictionary. ...

There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.

A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors.

A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur.^[6]

Issuance trust

In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations, that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities.^[6] Citibank is a major international bank, founded in 1812 as the City Bank of New York. ...

Grantor trust

Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.

Owner trust

In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.

Motives for securitization

Advantages to issuer

Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but a senior automobile backed securities issued by Ford Motor Credit in January 2002 and April 2002 continue to be rated AAA, because of the strength of the underlying collateral, and other credit enhancements.^[6] For other uses, see Debt (disambiguation). ... A basis point (often denoted as bp, bps or ; rarely, permyriad) is a unit that is equal to 1/100th of 1%. It is commonly used to denote the change in a financial instrument, or the difference (spread) between two interest rates; although it may be used in any case...

Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis."^[2] Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book. In finance, and particularly banking, an asset-liability mismatch occurs when the financial terms of the assets and liabilities do not correspond. ... A duration is an amount of time or a particular time interval. ...

Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to lessen the equity on their balance sheets while maintaining the "earning power" of the asset. Capital has a number of related meanings in economics, finance and accounting. ... In the context of government and public services regulation (as a process) is the control of something by rules, as opposed to its prohibition. ... At the start of a business, owners put some funding into the business to finance assets. ...

Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good example of this are Catastrophe Bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business. Credit as a financial term, used in such terms as credit card, refers to the granting of a loan and the creation of debt. ... Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. ... Prepayment is repayment (anticipation) of the total loan amount by a property owner whos mortgage is backing a Mortgage Backed Security (MBS). ... Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from the sponsor to the investors. ...

Off balance sheet: Derivatives of many types have in the past been referred to as "off balance sheet." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.

Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company. Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. ...

Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset. Admissible evidence, in a court of law, is any testimonial, documentary, or tangible evidence that may be introduced to a factfinder - usually a judge or jury in order to establish or a bolster a point put forth by a party to the proceeding. ...

Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates. Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. ...

Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.

Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization. Attorneys fees (note that the use of the word attorney connotes lawyers broadly: solicitors and barristers) are the costs of legal representation that an attorneys client or a party to a lawsuit incurs. ... Underwriting refers to the process that a large financial service provider (bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products like equity capital, insurance or credit to a customer. ...

Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.

Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis) In finance, rate of return (ROR) or return on investment (ROI), or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. ...

Opportunity to invest in a specific pool of high quality credit-enhanced assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.

Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be uncorrelated to their other bonds and securities. In finance, a portfolio is a collection of investments held by an institution or a private individual. ... Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash. ... The term hedge fund dates back to the first such fund founded by Alfred Winslow Jones in 1949. ... In probability theory and statistics, to call two real-valued random variables X and Y uncorrelated means that their correlation is zero, or, equivalently, their covariance is zero. ...

Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

Risks to investors

Additional risks to investors are 1). A reduction in the value of the underlying assets;and, 2). The rating of Junk as anything above JUNK. AAA JUNK is JUNK. Liquidity risk

Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.^[7]

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.^[7]

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.^[7]

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.^[9]

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.^[7]

History

"Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets). But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well."^[4] Credit risk is the risk of loss due to a debtors non-payment of a loan or other line of credit (either the principal or interest (coupon) or both). ...

In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans. ^[10] The United States Department of Housing and Urban Development, often abbreviated HUD, is a Cabinet department of the United States government. ... The Government National Mortgage Association (GNMA, also known as Ginnie Mae) was created by the United States Federal Government through a 1968 partition of the Federal National Mortgage Association. ...

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.^[4]

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).^[11]

The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.^[4]

Starting in the 1990's with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include Catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars. Reinsurance is a means by which an insurance company can protect itself against the risk of losses with other insurance companies. ... Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. ... This article is about the Atlantic hurricane of 2005. ... Alternative Risk Transfer (often referred to as ART) is the use of techniques other than traditional insurance and reinsurance to provide risk bearing entities with coverage or protection. ... Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from the sponsor to the investors. ... Life Insurance Securitization includes a number of techniques to covert life insurance policies or the risks within them to securities. ... Reinsurance sidecars, conventionally referred to as Sidecars, are financial structures which are created to allow investors to take on the risk and return of a group of insurance policies (a book of business) written by an insurer or reinsurer (henceforth re/insurer) and earn the risk and return that arises...

The first public securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods. ^[12] The Community Reinvestment Act (or CRA, Pub. ...

As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995-2004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion. ^[13]

At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases. ^[13]

References

^ Black's Law Dictionary (7th ed)
^ ^a ^b "The Handbook of Asset-Backed Securities", Jess Lederman, 1990.
^ Mark Fisher & Zoe Shaw, eds., Euromoney Books, London 2003
^ ^a ^b ^c ^d "Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of National Banks, 1997.
^ Financial Accounting Standards Board (FASB) Statement No. 140 "Accounting for transfers and servicing of financial assets and extinguishments of liabilities—a replacement of FASB Statement No. 125" September 2000
^ ^a ^b ^c ^d ^e ^f T Sabarwal "Common Structures of Asset-Backed Securities and Their Risks, December 29, 2005
^ ^a ^b ^c ^d ^e ^f ^g ^h ⁱ ^j ^k Fixed Income Sectors: Asset-Backed Securities - A primer on asset-backed securities, Dwight Asset Management Company (2005).
^ The Committee on the Global Financial System defined Structured Finance, "The role of ratings in structured finance: issues and implications", January 2005
^ Tavakoli, Janet. "CDOs: Caveat Emptor" GARP Risk Review (Journal of the Global Association of Risk Professionals), September/October 2005 Issue 26.
^ "Asset-Backed securities in Germany: the sale and securitization of loans by German credit institutions", Deutsche Bundesbank Monthly Report July, 1997.
^ "Hearing before the U.S. House subcommittee on Policy Research and Insurance in “Asset Securitization and Secondary Markets” (July 31, 1991), page 13
^ http://www.wachovia.com/inside/page/textonly/0,,134_307%5E306,00.html
^ ^a ^b "Common Structures of Asset-Backed Securities and Their Risks”, Tarun Sabarwal, December 29, 2005

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