Topics 35-36

Question 1

Define securitization, describe the securitization process and explain the role of participants in the process

Answer 1

• The two key participants in the securitization process are the originator and the issuer.
• The originator is the entity that seeks to convert its credit-sensitive assets into cash. The credit risk is then transferred away from the originator.
• The issuer is a third party who stands between the originator and the eventual investor that purchases the securities. The issuer buys the assets from the originator. The issuer must be a distinct legal entity from the originator in order for the sale of the assets to be considered a true sale. In a true sale, the assets are transferred off the originator’s balance sheet and there is no recourse.
• The structuring agent is the de facto advisor for the securitization issue. This agent is largely responsible for the security design (e.g., maturity, desired credit rating, credit enhancement, etc.) and forecasting the interest and principal cash flows. The structuring agent may also be the sponsor as the two roles have natural overlap.
• In the event of a default, a trustee is charged with the fiduciary responsibility to safeguard the interests of the investors who purchase the securitized products. The trustee will monitor the assets based on pre-specified conditions of the asset pool such as minimum credit quality and delinquency ratios.
• An insurance company referred to as the financial guarantor is sometimes used to wrap the deal by providing a guarantee of financial support in the event the SPV defaults.
• Financial guarantors are more common in a master trust arrangement.
• The custodian was initially responsible for safeguarding the physical securities. This role has evolved to also include the collection and distribution of the cash flows of assets like equities and bonds.

Question 2

Explain the terms over-collateralization, first-loss piece, equity piece, and cash waterfall within the securitization process

Answer 2

The quality of credit on the lowest rated assets can be enhanced by a method known as overcollateralization. The lowest class of notes is often overcollateralized by issuing notes with a principal value that is less than the principal value of the original underlying assets purchased from the originator.

For example, assume a mortgage pool was securitized based on 100 mortgages, but the originator included 101 mortgages in the pool. This issue is overcollateralized by one mortgage. Thus, investors in the mortgage pool can absorb one default before suffering any economic losses.

Question 3

Analyze the differences in the mechanics of issuing securitized products using a trust versus a special purpose vehicle (SPV) and distinguish between the three main SPV structures: amortizing, revolving, and master trust

Answer 3

• The three main special purpose vehicle (SPV) structures used in the securitization process are amortizing, revolving, and master trust.
• The master trust is a special type of structure that is used for frequent issuers. The difference in how payments are received over the asset-backed security’s life determines whether the ABS is better suited to the amortizing or revolving structure.
• In an amortizing structure, principal and interest payments are made on an amortizing schedule to investors over the life of the product. Because payments are made as coupons are received, this type of structure is referred to as a pass-through structure. Amortizing structures are very common with the securitization of products that have amortization schedules such as residential mortgages, commercial mortgages, and consumer loans.
• Amortizing structures are valued based on the expected maturity and the weighted-average life (WAL) of the asset. The WAL is the time-weighted period that the underlying assets are outstanding. Because borrowers of mortgages and consumer loans often have the option to pay off the loans early, the WAL must include pre-payment assumptions to estimate the rate at which principal is repaid over the life of the loans.
• Revolving structures are used with products that are paid back on a revolving basis. Thus, under the revolving structure, principal payments of the assets are paid in large lump sums rather than a pre-specified amortization schedule. Credit card debt and auto loans are examples of products that are securitized using a revolving structure due to their short time horizon and high rate of pre-payments. Under a revolving structure, payments are not simply passed through. Rather, principal payments are often used to purchase new receivables with criteria similar to assets already in the pool. Investors are repaid by principal payments through controlled amortization or in single lump sum payments referred to as soft bullet payments.
• Figure 3 illustrates the securitization process for credit card asset-backed securities (ABS) using the SPV master trust structure. The pool of credit card receivables is changing over time. However, the master trust structure enables the SPV to issue multiple ABS through the single trust. Investors from different series receive payments from the entire pool of credit card ABS.
• Excess spread is created from the high yield credit card debt less the cost of issuing the ABS. The excess spread is the difference between the cash inflows from the underlying assets and the cash outflows in the form of interest payments on the ABS issues. After administration expenses are covered, any remaining excess spread is held in a reserve account to protect against future losses. If there are no future losses, the remaining excess spread is returned to the originator.
• As illustrated by Figure 3, under a trust arrangement two distinct SPVs are created. The additional entity is created to further distance the originator from the issuer and the underlying assets. A common arrangement will involve a master trust, or special purpose vehicle (SPV), and a grantor trust. In contrast to the previous approach (i.e., corporation), the assets do not serve directly as collateral. Under this arrangement, the originator sells the assets to the master trust (SPV 1) for cash, but the master trust in turn deposits the assets in the grantor trust (SPV 2). The master trust receives a beneficial interest in the grantor trust, which represents the same economic position as if only one SPV was employed. Now the claims of the securitized products are backed by the beneficial claim on the master trust rather than on the assets themselves.
• Credit card debt is not collateralized and typically suffers from a low rate of recovery in the event of default. Therefore, a financial guarantor is used as a credit enhancement. If there are payment defaults for a series, the excess spread is shared to cover the losses. The ability of SPV master trust structures to sell multiple issues to investors that share excess spreads over these multiple series makes this structure very different from the amortizing and revolving structures.

Question 4

Explain the reasons for and the benefits of undertaking securitization

Answer 4

Benefits to Financial Institutions

• The three main reasons for a financial institution to use securitization are for funding assets, balance sheet management, and risk management.
• Asset-backed securities (ABS) issued by a SPV often have higher credit ratings than the original notes issued by the originator. If the SPV has a higher credit rating, then the originating institution benefits by lowering the cost of issuing debt when going through the SPV.
• Another reason financial institutions securitize assets is to manage the capital on their balance sheets.

Benefits to Investors

• Securitization also provides benefits for investors. As a result of securitizations, investors have access to new liquid assets that were previously not available to them. This allows investors to create different risk-reward profiles and diversify into new sectors.
• In addition, holding a securitized asset diversifies the risk exposure because the securitized asset is purchased from an SPV with a pool of assets as opposed to a corporate bond from one entity.

Question 5

Describe and assess the various types o f credit enhancements.

Answer 5

The different types of credit enhancements used in securitization include:
overcollateralization, pool insurance, subordinating note classes, margin step-up, and excess spread.

• The first two types of credit enhancements are designed to increase the ability of collateral to absorb losses associated with defaults in the underlying asset pool. The lowest class of notes often exhibit overcollateralization where the principal value of the notes issued are valued less than the principal value of the original underlying assets. The additional collateral of the ABS issues absorbs initial losses with no impact to investors. The credit rating can also be enhanced by offering pool insurance. A composite insurance company provides pool insurance on the ABS issues that covers the loss of principal in the collateral pool in the event an SPV defaults.
• Subordinating note classes of a collateral pool into different tranches is another type of credit enhancement. Junior or class B notes are subordinate to more senior class A notes. Therefore, investors in class B do not receive payments of principal until the class A notes are fully redeemed or until rating agency requirements are met. The collateral pool is required to pass certain performance tests over a period of time before making principal payments on subordinate notes.
• ABS issues sometimes use a margin step-up that increases the coupon structure after a call date. The issuer has the option to redeem the notes after this call date. The margin step-up provides investors with an extra incentive to invest in the issues. However, the issuer may refinance if the increased coupons are greater than market rates.
• The excess spread is the difference between the cash inflows from the underlying assets and the cash outflows in the form of interest payments on the ABS issues. The securitization is structured such that the liability side of the SPV (issued notes) has a lower cost than the asset side of the SPV (receivables from mortgages, loans, or credit card debt). After administration expenses are covered, any remaining excess spread is held in a reserve account to protect against future losses. If there are no future losses, the remaining excess spread is returned to the originator.

Question 6

A key difference between the collateralized debt obligations (CDOs) and ABS structures is?

Answer 6

A key difference between the collateralized debt obligations (CDOs) and ABS structures is the number of underlying loans. A CDO portfolio typically consists of less than 200 loans, while ABS or MBS structures often have much greater diversity with thousands of obligors.

Question 7

Auto Loan Performance Tools

Answer 7

Auto loans have features that are very favorable for investors in this ABS product.

• Auto loans are collateralized with assets that are highly liquid in the event of default. In addition, most loans have a short three to five year horizon. Thus, there is virtually no prepayment risk and losses are relatively low compared to other ABS.
• A good measure of performance for auto loan ABS is the loss curve. The loss curve shows the expected cumulative loss for the life of the collateral pool. The expected losses based on the loss curve are compared to actual losses. Originators of prime loans typically have evenly distributed losses. Subprime or non-prime loan originators have higher initial losses resulting in a steeper loss curve. Losses for all types of loans typically decline in later years of the curve.
• Another important performance tool for the auto loan ABS is the absolute prepayment speed (APS), which indicates the expected maturity of the issued ABS. The APS measures prepayment by comparing the actual period payments as a percentage of the total collateral pool balance. The APS is an important measure that is used to determine the value of the implicit call option of the ABS issue at any time.

Question 8

Credit Card Performance Tools

Answer 8

• Another type of ABS product is collateralized by pools of credit card debt. The fact that credit cards have no predetermined term for outstanding balances differentiates this class from other ABS products. Despite having no predetermined term, most credit card debt is repaid within six months. The repayment speed of a credit card ABS is controlled by scheduled amortization or a revolving period under a master trust framework.
• Three important performance tools for credit card receivables of ABS are the delinquency ratio, default ratio, and monthly payment rate (MPR). These three ratios serve as triggers to signal early amortization of the receivable pool.
• The delinquency ratio and default ratio measure the credit loss on credit card receivables pools. An early indication of the overall quality of the credit card ABS collateral pool is the delinquency ratio.
  
  • The delinquency ratio is computed by dividing the value of credit card receivables that are 90 days past due by the total value of the credit card receivables pool.
  • The default ratio is calculated by dividing the amount of written off credit card receivables by the total credit card receivables pool.
  • The monthly payment rate (MPR) is calculated as the percentage of monthly principal and interest payments divided by the total credit card receivables pool. Rating agencies require every non-amortizing ABS (such as credit cards) to set a minimum MPR as a trigger for early amortization.

Question 9

DSCR

Answer 9

The debt service coverage ratio (DSCR) is calculated by dividing net operating income (NOI) by the total amount of debt payments. Net operating income is the income or cash flows that are left over after all of the operating expenses have been paid. The DSCR is a performance tool that measures the ability of a borrower to repay the outstanding debt associated with commercial mortgages. A DSCR less than one indicates that the underlying asset pool of commercial mortgages do not generate sufficient cash flows to cover the total debt payment. Total debt service refers to all costs related to servicing a company’s debt. This often includes interest payments, principal payments, and other obligations.

Question 10

Weighted average coupon (WAC) and Weighted average maturity (WAM)

Answer 10

• The weighted average coupon (WAC) is calculated by multiplying the mortgage rate for each pool of loans by its loan balance and then dividing by the total outstanding loan balance for all pools. Thus, it measures the weighted coupon of the entire mortgage pool. The WAC is compared to the net coupon payable to investors as an indication of the mortgage pool’s ability to pay over the outstanding life of the MBS.
• The weighted average maturity (WAM) is the weighted average months remaining to maturity for the pool of mortgages in the MBS. To calculate the WAM, the weight of each MBS pool is multiplied by the time until maturity of each MBS pool, and then all the values are added together. (Note that the weight is determined by taking the total value of the pool for one maturity and dividing that by the total value of all loans.)
• The volatility of an MBS is directly related to the length of maturity of the underlying securities. The WAM is calculated based on stated maturity dates or reset dates. A WAM calculated based on stated maturity dates includes the liquidity risk of all mortgage securities in the portfolio by using the actual maturity date. A WAM calculated based on reset dates captures the effect of prepayments on the maturity of the loans.

Question 11

Weighted average life (WAL)

Answer 11

The pool factor, PF(t), is the outstanding notional value adjusted by the repayment weighting.

Question 12

Explain the prepayment forecasting methodologies and calculate the constant prepayment rate (CPR) and the Public Securities Association (PSA) rate

Answer 12

• Common methodologies used to estimate prepayments for an MBS or ABS collateralized by mortgages or student loans are the constant prepayment rate (CPR) and the Public Securities Association (PSA) method. Assumptions regarding the rate of prepayment are required to estimate the cash flows for an MBS. Prepayments will reduce the yield of an MBS, assuming principal payments remain unchanged.
• The CPR is calculated as: CPR = 1 — (1—SMM)¹². The single monthly mortality (SMM) is the single-month proportional prepayment. Factors that influence the CPR are market environment, characteristics of the underlying mortgage pool, and the outstanding balance of the pool.
• The PSA typically assumes that prepayments will increase as a pool approaches maturity. The MBS pool of mortgages has a 100% PSA if its CPR begins at 0 and increases 0.2% each month for the first 30 months.

Question 13

ABS and MBS Performance Tools

Answer 13

Question 14

Explain the decline in demand in the new-issue securitized finance products following the 2007 financial crisis

Answer 14

• A shadow banking system was created where entities are not bound by the same regulatory requirements of normal banks. These entities in the shadow banking system were referred to as special investment vehicles (SIVs). SIVs funded loans through commercial paper and did not rely on the central bank’s discount window as a backup source of funding. This worked until the shadow bank was no longer able to find investors in this market. The inability to refinance the securitized products led to a liquidity crisis
• SIVs were highly leveraged just prior to the market collapse in 2007.
• The lack of transparency resulted in increasingly complex products. Valuing products with no transparency is extremely difficult. As the credit crisis progressed, the wide variety of ABS tranches that existed in the market became very difficult to mark-to-market due to the widening of credit spreads for tranches and the changing correlation risk for ABS portfolios. To complicate matters even further, the changes in correlations had different impacts for different seniority levels of tranches.
• Credit rating agencies (CRAs) were overly optimistic in their ratings due to poor credit quality models and a lack of understanding of the degree of correlation risk for ABSs. High ratings were justified for lenders on the assumption that the residential real estate market would continue to increase in value. The models used by rating agencies did not correctly incorporate the impact of correlations or sharp declines in real estate values.
• Investors viewed securitized products as AAA rated with high liquidity. Unfortunately, the liquidity of ABS was overestimated. As the first losses were realized in the subprime lending market, SPVs needed to unwind or sell off investments in securitized paper. The SPVs mispriced the securities initially by failing to include a liquidity premium.
• The impact of the liquidity crisis was even greater due to mark-to-market accounting rules. As investments were marked-to-market, it created a downward spiral effect in asset prices of securitized products. In the flight-to-quality environment of a liquidity crisis, financial institutions were required to mark down asset values based on highly stressed prices in the secondary market. To complicate things further, securitized products were more negatively impacted than plain vanilla commercial paper, which is characteristic of markets where participants are attempting to shed risky assets for safer ones.

Question 15

Identify and describe key frictions in subprime mortgage securitization, and assess the relative contribution of each factor to the subprime mortgage problems

Answer 15

Moral hazard denotes the actions one party may take to the detriment of the other. A classic example is the shareholder-manager relationship where the managers may use their position for personal gain rather than for the shareholders to whom they owe a fiduciary duty. On the other hand, adverse selection is when one party possesses important hidden information. For example, a person’s driving ability is private knowledge and a potential buyer of auto insurance will have the incentive to represent themselves as good drivers even if they are not.

There are seven frictions in the mortgage securitization process. Each friction is discussed as follows:

• Friction 1: Mortgagor and originator. The typical subprime borrower is typically financially unsophisticated. As a result, the borrower may not select the best borrowing alternative for themselves. In fact, the borrower may not even be aware of the financing options available. On the other hand, the lender may steer the borrower to products that are not suitable.
• Friction 2: Originator and arranger. The arranger (issuer) purchases the loans from the originators for the purpose of resale through securitized products. The arranger will perform due diligence but still operates at an information disadvantage to the originator. That is, the originator has superior knowledge about the borrower (adverse selection problem). In addition, the originator may falsify or stretch the bounds of the application resulting in larger than optimal lending.
• Friction 3: Arranger and third-parties. The arranger of the pool of mortgages will possess better information about the borrower than third parties including rating agencies, asset managers, and warehouse lenders. The adverse selection problem gives the arranger the opportunity to retain the higher quality mortgages and securitize the lower quality mortgages (i.e., lemons).
• Friction 4: Servicer and mortgagor. The servicer’s role is to manage the cash flows of the pool and follow up on delinquencies and foreclosures. A conflict of interest arises for delinquent loans. The homeowner in financial difficulty does not have the incentive to upkeep tax payments, insurance, or maintenance on the property. Escrowed funds can minimize this problem but ultimately efficient foreclosure must comply with federal regulations.
• Friction 5: Servicer and third-parties. The servicer faces a moral hazard problem because their (lack of) effort can impact the asset manager and credit rating agencies without directly affecting their own cash flow distribution. In delinquency, the servicer is responsible for the property taxes and insurance premiums. These funds are reimbursable upon foreclosure so there is a temptation to exaggerate the fees and expenses particularly with high recovery rates.
• Friction 6: Asset manager and investor. The investor relies on the asset manager’s expertise to identify and analyze potential investments. It is difficult for the investor to comprehend the investment strategy and the investor will not be able to observe the effort of the management team (same moral hazard problem as shareholder-manager). Investment mandates and proper benchmarking can mitigate some of the distortion.
• Friction 7: Investor and credit rating agencies. Rating agencies are compensated by the arranger and not the end user, the investor. To the extent that the rating agencies are beholden to the fee structure of the arranger, a conflict of interest arises. In addition, it is very difficult to judge the accuracy of their models particularly with complex products and rapid financial innovation.

Five of these factors are direct contributors to the recent subprime crisis.

• First, the complexity of the product and naive nature of the borrower led to inappropriate loans (friction 1).
• Second, managers sought the additional yield from structured mortgage products without fully assessing the associated risks (friction 6).
• Third, the problem became more expansive as underperforming managers made similar investments with less due diligence on the arranger and originator (friction 3).
• Fourth, as the asset managers reduced their oversight, it was natural that the arranger would follow suit (friction 2). This left the credit rating agencies as the last line of defense but they operated at a significant informational disadvantage.
• Finally, the assigned ratings were hopelessly misguided (friction 7).

Question 16

Excess spread, shifting interest, performance triggers

Answer 16

• Mortgages pools are typically constructed so that the weighted average coupon (less servicing, hedging, and other expenses) exceeds the weighted average payout. The difference is called the excess spread which is paid to equity tranche investors when available. Thus, the excess spread protects all tranches.
• Under shifting interest, the senior investors receive all principal in the pool while the mezzanine investors receive only interest. The senior holders may receive the principal for a set period of time (“lockout period”) or until a cutoff ratio is reached.
• Performance triggers denote the release of overcollateralizion which is applied from the bottom of the capital structure up.

Question 17

Are agency credit ratings through-the-cycle or point-in-time?

Answer 17

The ratings represent an unconditional view of the rating agency as they rate “through-the-cycle.”

Question 18

Explain the implications of credit ratings on the emergence of subprime related mortgage backed securities

Answer 18

Credit ratings for subprime securities, and more generally asset-backed securities (ABS), differ from corporate ratings in several important ways.

• First, corporate bond ratings are based on the firm-specific characteristics of the issuer where as ABS is a claim on a portfolio. Hence, systematic risk and degree of correlation between assets is important in the latter but not the former.
• ABS represents claims on a static pool and cannot infuse additional capital or restructure as a corporation can.
• In addition, the forecasts for ABS incorporate future economic conditions since the cash flow stream is tied to the macro environment.
• Finally, while corporates and ABSs with the same rating may indicate similar default probabilities, the ABS will exhibit much wider variation in losses.

Question 19

Cash Flow Analysis of Excess Spread

Answer 19

• First, the credit enhancement identifies the amount of collateral that can be impaired before the tranche suffers an economic loss.
• The timing of losses is also important because as losses accumulate, less excess spread will be available. A more conservative approach would front-load the losses.
• Prepayments will directly impact the excess spread. Prepayments may be voluntary (refinance, sales) or involuntary (default) so the prepayment assumption directly impacts the cash flow analysis. Prepayments typically follow the CPR (conditional prepayment rate) convention. However, it is important to note that hybrids will have higher than predicted defaults on or about the reset date due to the sudden change in rates and financial condition of the subprime borrower. A more conservative view would accelerate prepayments reducing further interest collections.
• Finally, the path of interest rates introduces uncertainty into the projected cash flow stream. Interest rates determine the adjustments (i.e., cash inflows), and influence refinancing.

Question 20

Loss coverage ratio (LCR)

Answer 20

It is current practice to annually review each individual pool. An important performance measure used during this review is the loss coverage ratio (LCR), defined as: (current credit enhancement for tranche) / (estimated unrealized losses).

Question 21

Compare predatory lending and borrowing

Answer 21

Predatory lending results in the borrower becoming worse off after the loan than before. This may happen because the rates are deceptively high, the appraisals are inflated allowing the borrower to extract equity and then cannot refinance, and prepayment penalties are extreme, steering borrowers unnecessarily to subprime products and similar ruses. Predatory lending may also include outright fraudulent activity in addition to deception.

Predatory borrowing is misrepresentation in the mortgage application from the borrower side. The temptation is driven by increasing housing prices whereby the borrower feels that he cannot catch up with housing prices. Therefore, lying on the mortgage application allows the borrower to the buy the house with the expectation that continued appreciation will allow a favorable refinancing. The fraud may be perpetrated by the buyer alone or in concert with lawyers, broker, and appraisers.