Asset-Backed Securities The Securitization Process 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process3 Securitization of Assets 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process5 Securitization: The Basic Structure SPONSORING COMPANY ACCOUNTS RECEIVABLE SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE ISSUES ACCOUNTS ASSET-BACKED RECEIVABLE CERTIFICATES Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process6 The Process 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? Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process8 Is the Company Ready for ABS? 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? Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process9 Are the Assets Suitable? 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process12 FinanceFinance CompanyCompany LimitedLimited Case Study: The Company (Finance Company Limited) 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process14 Key Decisions 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process15 Case Study: Initial Exchanges Finance Co.’s Customers Hire-Purchase Agreement Finance Co. Ltd (Seller) Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process16 Case Study: Initial Exchanges Finance Co.’s Customers Hire-Purchase Agreement Finance Co. Ltd Proceeds FCL 1997-A Proceeds Investors (Seller) (Special Purpose Co.) Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process17 Case Study: Initial Exchanges 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process18 Case Study: Initial Exchanges 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process19 Case Study: Ongoing Payments 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process20 Getting a Rating: The Risks 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process21 Risk-Management Techniques in ABS 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process22 Credit Enhancement: Guarantee Method 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process23 Credit Enhancement: An Alternative Approach Rating Agency Top Rating 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process24 Asset-Backed Securities 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. Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process26 Default Matrix Source: Fitch, “Bank CLOs” Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process27 Rating Reports: Who Pays for Them? 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process28 ABS: Factors Agencies Examine 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process29 Rating Agencies: Business Analysis 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 Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process30 Credit Enhancement q Senior/Sub or overcollateralization q Reserve and liquidity accounts and lines q Excess cash flow q Third-party guarantees Copyright ©2001 Ian H. Giddy globalsecuritization.com The Securitization Process31 The Result: Bond Credit Ratings