The Securitization Process

Asset-Backed Securities

Prof. Ian Giddy Stern School of Business New York University Asset-Backed Securities

q The basic idea q What’s needed? q The technique q Applications q Typical sequence

q Securitization is the transformation of an illiquid asset into a security. q For example, a group of consumer loans can be transformed into a publically-issued debt security. q A security is tradable, and therefore more liquid than the underlying loan or receivables. Securitization of assets can lower risk, add liquidity, and improve economic efficiency. q Sometimes,assets are worth more off the balance sheet than on it.

Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process4 What is the Technique for Creating Asset-Backed Securities? q A lender originates loans, such as to a homeowner or corporation. q The securitization structure is added. The bank or firm sells or assigns certain assets, such as consumer receivables, to a special purpose vehicle. q The structure is legally insulated from management q Credit enhancement and rating agency reviews q The SPV issues debt, dividing up the benefits (and risks) among investors on a pro-rata basis

SPONSORING COMPANY

ACCOUNTS RECEIVABLE

SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE

ISSUES ACCOUNTS ASSET-BACKED RECEIVABLE CERTIFICATES

IsIs the the company company ready?ready?

AreAre the the assets assets suitable?suitable?

WhatWhat pool? pool?

WhatWhat legal legal structure?structure? WhatWhat credit credit enhancement?enhancement?

q Does the originator currently face a high cost of funding assets that would be recognized as sound, cash-generating assets if taken in isolation? q Does it have a regulatory or capital constraint that makes freeing up the balance sheet important? q Does it have data about the assets (required by rating agencies and financial guarantors)? q Does it have the servicing process and systems that can meet the more demanding standards of the asset- backed market? q Is the originator willing to undertake a complex, time- consuming transaction to obtain a broader, potentially cheaper, ongoing source of funding?

The Pool of Assets Should Have: n Volume which is sufficiently large and homogenous to facilitate statistical analysis n A stable history of rates, defaults, delinquencies, prepayments and so forth n Sufficient diversification--for example, geographic and socio- economic-- to reduce vulnerability to economic stresses n Basic lender’s credit quality standards that are capable of being evaluated and approved by rating agencies and specialized financial guaranty companies n Assets must be transferable and unencumbered In short, the assets themselves must be sufficiently strong to support a high credit rating without the backing of the originating lender.

Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process11 What is the Technique for Creating Asset-Backed Securities? q A lender originates loans, such as to a homeowner or corporation. q The securitization structure is added. The bank or firm sells or assigns certain assets, such as consumer receivables, to a special purpose vehicle. q The structure is legally insulated from managementIMPLEMENTATION q Credit enhancement and rating agency reviews q The SPV issues debt, dividing up the benefits (and risks) among investors on a pro-rata basis

q Finance company whose growth is constrained q Has pool of automobile receivables q Has track record q Plans to use this as an ongoing source of financing

Securitize the assets

Decisions

Form of Form of transfer Form of special Form of credit Form of cash flow transformation of of asset purpose vehicle enhancement allocation cash flows

Finance Co.’s Customers

Hire-Purchase Agreement

Finance Co. Ltd (Seller)

Finance Co.’s Customers

Hire-Purchase Agreement

Finance Co. Ltd Proceeds FCL 1997-A Proceeds Investors (Seller) (Special Purpose Co.)

Finance Co.’s Customers

Hire-Purchase Servicing Agreement Agreement

Finance Co. Ltd Proceeds FCL 1997-A Proceeds Investors (Seller) (Special Purpose Co.) Sale of Assets Asset-Backed Securities

Trustee Trust Agreement

Finance Co.’s Rating Agency Customers

Hire-Purchase Servicing Agreement Top Rating Agreement

Finance Co. Ltd Proceeds FCL 1997-A Proceeds Investors (Seller) (Special Purpose Co.) Sale of Assets Asset-Backed Securities

Trustee Trust Agreement

Finance Co.’s Customers

Hire-Purchase Servicing Fees Payments

Monthly HP Monthly ABS Finance Co. Ltd FCL 1997-A Payments Payments Investors (Seller) (Special Purpose Co.)

Financial Guarantee Trustee Trustee Guarantee Provider Responsibilities Responsibilities

q Credit risks q Liquidity risk q Servicer performance risk q Swap counterparty risk q Guarantor risk q Legal risks q Sovereign risk q Interest rate and currency risks q Prepayment risks

SPONSORING CREDITCREDIT COMPANY ENHANCEMENTENHANCEMENT

ACCOUNTS RECEIVABLE SOVEREIGNSOVEREIGN PROTECTIONSPROTECTIONS SALE OR SPECIAL ASSIGNMENT PURPOSE VEHICLE INTERESTINTEREST RATE/ RATE/ ISSUES CURRENCY ACCOUNTS ASSET-BACKED CURRENCY RECEIVABLE CERTIFICATES HEDGESHEDGES

CASHCASH FLOW FLOW REALLOCATIONREALLOCATION

Finance Co.’s Rating Agency Customers

Hire-Purchase Servicing Agreement Top Rating Agreement

Finance Co. Ltd Proceeds FCL 1997-A Proceeds Investors (Seller) (Special Purpose Co.) Sale of Assets Asset-Backed Securities

Financial Guarantee Trustee Provider Trust Guarantee (if required) Agreement Agreement

Senior

Lower Rating

Finance Co. Ltd Proceeds FCL 1997-A Subordinated (Seller) (Special Purpose Co.) Sale of Assets No Rating

More Subordinated

Financial Guarantee Provider Guarantee (if required) Agreement

The Rating Process and Credit Enhancement

Prof. Ian Giddy Stern School of Business New York University n n MoodysMoodys Rating Agencies n n StandardStandard & & Poors Poors n n FitchFitch Why bother with a rating? q Compare equivalent credit risks across different kinds of debt: corporate, sovereign, ABS q Compare alternatives across different ratings levels q Obtain a relative as well as an absolute measure of credit risk q Be reasonably sure of a market to sell the security.

Source: Fitch, “Bank CLOs”

q General reports on a sector, like CLOs q Pre-sale report on an individual CLO, once risks have been evaluated but final terms and credit enhancement have not yet been finanized q Final deal report q Periodic updates

q Asset portfolio analysis q Legal structure of the transaction q Quality of the originator/servicer q The trustee q The cash flow structure q The counterparties

q Organization and management structure q Financial performance q Business strategy and planning processes q Controls and procedures q Asset origination and credit assessment procedures q Quality of its loan documentation q Credit administation and debt recovery procedures

q Senior/Sub or overcollateralization q Reserve and liquidity accounts and lines q Excess cash flow q Third-party guarantees

Standard & Moody’s Poor’s Interpretation Aaa AAA High-quality debt instruments Aa AA A A Strong to adequate ability to Baa BBB pay principal and interest Ba BB Ability to pay interest and B B principal speculative Caa CCC Ca CC C C D In default

Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process32 Typical Rating Analysis Originator’s credit underwriting standards Pre-securitization Screening of assets to be included in the portfolio risk reduction Diversification of the portfolio

Legal structure based Legal insulation from originator default credit risk reduction Legal insulation from servicer default

Originator/Seller/Servicer Credit quality of deal participants Trustee, swap counterparties Guarantors

Cash flow sufficiency and mismatches Integrity of cash flow structure Safeguards and agreements such as swaps or caps

Direct recourse “Internal” Senior/subordination or overcollateralization credit enhancement Reserve or spread accounts Credit enhancement

“Third party” Cash collateralized accounts credit enhancement Financial guarantees Rating

q Overcollateralization q Senior/Sub or q Reserve and liquidity accounts and lines q Excess cash flow q Third-party guarantees

SPECIAL-PURPOSE VEHICLE

SENIOR COLLATERAL POOL ASSET-BACKED SECURITIES

“EQUITY” ABS OVER-COLLATERAL (owned by seller)

Class Rating Subordination A1,A2,A-x AAA 28% B AA 22% C A 16.5% D BBB 12% E BB 8.5% F B 5.5% Issuer balance NR 0%

1 • Determination of structure • Information Memorandum

• Commencement of documentation 2 • Detailed cash flow analysis

• Preparation for rating process 3 • Result of cash flow analysis

months • Determination of eligible receivables

• Approach rating agencies and introduction of the structure envisaged 4 • Founding of the SPV

• Initiation of stock exchange approval process (in case of a Bond issuance)

5 • Draft of Offering Circular (in case of a Bond issuance)

• Comments of the Rating agencies (Rating confirmation)

• Determination of funding strategy 6 • Publication of Offering Circular (in case of a Bond issuance)

• Marketing (in case of a Bond issuance)

7 • Completion of documentation

This schedule serves as an indication only and may • Purchase of receivables and issuance of securities vary from transaction to transaction.

q The implementation of a transaction usually takes between two and six months, provided all necessary data and information is readily available.

q This time frame does not take into account the rating process.

Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process38 The Securitization Process - 1 One Bank’s List A private placement for a client who has done If new client, this previous securitizations would follow screening of Ø Select securitization counsel and accountants corporation and loan pool for suitability Ø Consider tax, accounting and securitization objectives Any info used in the PPM Ø Discuss data fields required for loan data file or in the pool analysis must be audited. Ø Define data to be audited by accountants

Ø Begin drafting Private Placement Memorandum (PPM) If it’s a public offering, need a Ø Begin drafting legal documents public Prospectus or Prospectus Ø Assemble preliminary pool and create initial data tape Supplement.

Ø Consider preliminary bond structure A discussion with rating Ø Select rating agencies agency be necessary for selection of legal structure Ø Perform integrity check on data tape (cracking the tape) and pool selection if it’s a new type of ABS.

Data from companies come in many different forms. Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process39 Most investment banks The Securitization Process - 2 active in ABS have One Bank’s List developed modelling software Ø Model cash flow and bond structure Invariably, with the amount of Ø Prepare rating agency presentation information be supplied by the issuer via the tape, there Ø Select trustee/backup servicer will be mistakes/discrepancies to resolve, mostly with regard Ø Reconcile discrepancies with accountants to loan data that’s been Ø Distribute rating agency presentations provided.

Ø Meet with rating agencies During this process, the issuer is still originating Ø Determine pending loan closings collateral going into the deal. The bank has to Ø Select rating agencies and sign engagement letters decide what else it want to include, and Ø Optimize loan pool and revise bond structure has to establish a “cut- off date”. Ø Rating agency borrower visits (if necessary)

Ø Rating agency due diligence (if necessary) Which asset should not go into the pool? Ø Complete loan closings and finalize loan pool Its not necessarily bad collateral, but it Ø Obtain preliminary subordination levels from rating agencies may still hurt the overall profile of the pool

Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process40 The Securitization Process - 3 One Bank’s List Alternative would be for originator to keep sub tranche Ø Market transaction to sub-bond buyers (if necessary) The collateral cash Ø Tie out collateral cash flow with accountants flows in aggregate are Ø Final subordination levels from rating agencies structured to pay bonds. The bonds are Ø Finalize bond structure based on final loan pool and sub-levels then sold based on the likelihood that the Ø Tie out bond cash flows with accountants bonds will receive those payments at a Ø Finalize PPM and legal documents certain period in time. Therefore, the cash Ø Arrange distribution by other banks flows that pay the bonds are what the Ø Finalize internal marketing material investor is purchasing. Ø Issuer presentation to salesforce The bond cash flow characteristics are Ø Print red herring PPM and distribute to investors presented in the prospectus to investors Ø Market transaction to investors and if they aren’t tied out, there is a huge Ø Price bonds and execute Bond Purchase Agreement legal liability for the underwriter and issuer Ø Print final PPM if they aren’t correct. Ø CLOSE TRANSACTION This is the agreement to purchase the bonds from Copyright ©2001 Ian H. Giddy globalsecuritizationthe SPV.com by the investor or investmentThe Securitization banks Process41 Asset-Backed Securities

Asset-Backed Securities: Legal and Regulatory Issues

Prof. Ian Giddy Stern School of Business New York University Asset-Backed Securities: Legal and Regulatory Aspects

q Legal uThe Transfer uThe Special-Purpose Vehicle q Taxation q Accounting Treatment q Bank Regulatory Treatment

q Goal: Credit quality must be solely based on the quality of the assets and the credit enhancement backing the obligation, without any regard to the originator's own creditworthiness q Otherwise, quality of the ABS issue would be dependent on the originator's credit, and the whole rationale of the asset-backed security would be undermined.

of the assets and the originator LEGAL

q The transfer must be a true sale, or its legal equivalent. If originator is only pledging the assets to secure a debt, this would be regarded as collaterized financing in which the originator would stay directly indebted to the investor. q The assets must be owned by a special- purpose corporation, whose ownership of the sold assets is likely to survive bankruptcy of the seller. q The special-purpose vehicle that owns the assets must be independent Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process45 The Form of Transfer: True Sale? LEGAL

Form of transfer of asset

True Sale

Alternative: Assignment Credit swap (Synthetic ABS)

Collateral

q The form and treatment of the transaction q The nature and extent of the benefits transferred q The irrevocability of the transfer q The level and timing of the purchase price, q Who possesses the documents q Notification when the assets are sold

CHASE (SPONSOR)

CREDIT CARD RECEIVABLES

SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE

ISSUES CREDIT CARD ASSET-BACKED RECEIVABLES CERTIFICATES

HVB (Originator)

REFERENCE POOL OF LOANS (Stay on balance sheet)

CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE

ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES

ACCOUNTING q Sale versus financing q Consolidation q Accounting for loan servicing

ACCOUNTING q The transferor relinquishes control of the future economic benefits embodied in the assets being transferred q The SPV cannot require the transferor to repurchase the assets except pusuant to certain recourse provisions q The transferor's obligation under any recourse provision are confined and can be reasonably estimated

q Goal: Ensure that the substance and not the form of the asset transfer is what governs capital requirements. The regulatory authorities may assess capital or reserve requirements as if the financing was a secured borrowing: u Where the transfer leaves the bank open to recourse deemed risky by the authorities, u Or where there is potential for a "moral hazard" whereby a bank may shore up potential or actual losses in the sold assets to protect its name even when not legally required to do so.

q Originating banks (“clean break”) q Investing banks (use of ratings) q Sponsor banks (for ABS conduits) q Synthetic securitization (degree of risk transference)

AAA to AA- 20% A+ to A- 50% BBB+ to BBB- 100% BB+ to BB- 150% B+ and below Deducted from capital

Source: Basel Committee on Banking Supervision, January 2001

Ford Ford Motor Credit

Sale Class A-5 and A-6 Ford Credit Auto Rec. Two LP Sale Ford Credit Auto Owner Trust

Class A-1 to A6

Class B Class D Receivables Class C

Class D

Receivables Class A-1 to A6

Class B

Class C

Class D

Receivables Class A-1 to A6

Class B

Class C

Class D

DBS Bank Loan portfolio US$ FRN Investors Seller/Servicer Singa

Mortgage Dah Sing Hong Kong US$ FRN portfolio SAR Investors Seller/Servicer Res Mort. Ltd

Currency Financial Swaps Guarantees

ASIA Ltd General Re CapMac

Franchisees (Borrowers)

Loan Agreement Loan Payments Atherton Capital Proceeds Atherton FLF 1998-A Proceeds Investors (Seller) (Special Purpose Co.) Sale of Assets Asset-Backed Servicing Advisor Securities Class Rating Subordination Mellon Mortgage A1,A2,A-x AAA 28% (Servicer) Servicing Agreement B AA 22% C A 16.5% D BBB 12% E BB 8.5% F B 5.5% Issuer balance NR 0%

Oil (under YPF Notes sales agreement) Oil Trading Co. (Argentinian Noteholders (Cayman Is. SPV) oil producer) US$ US$ Oil (under purchase Fixed agreement) debt payments

US$ Highly rated Trust U.S. oil buyer

Ian H. Giddy Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA

Tel 212-998-0426 [email protected] http://giddy.org