Securitization transaction
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How to complete a Securitization transaction is important in understanding securitization, structured finance, and asset-backed securities.
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[edit] Illustrative Example
A typical securitization will start with a company that has a steady amount of receivables (cash flow) coming from a consistent source. This could be any company with consistent cash flows from a particular source - a good example is an auto loan company. This company, auto loan company X, which is rated BB, wants to make a large purchase of $1 billion. Unfortunately, auto loan company X does not know the best way to do this so they contact an Investment Bank, Investment Bank Y. The investment banker assigned to autoloan company X analyzes the situation. The investment banker traditionally has the following options for the auto loan company: Take a loan, make a bond issuance, or give up equity (stock). Each of these options has downsides - borrowing money through the bond market or a loan; a BB rating on the company would cost the auto loan company a huge loss in interest, and issuing stock would give up part of the control of the company.
The cost of a traditional bond issuance is expensive because of the company's rating. The auto loan company is rated BB because the company sometimes participates in risky ventures with outside businesses. It is not very large, and though it is always at risk of a car market downturn, the underlying assets that it originates are very reliable. The investment banker figures that if they could create a bond issuance where they promise the funds from a set of autoloans to pay down the bonds, they should be able to get a significantly better interest rate. The auto loans are AAA assets, not BB like the company as a whole.
The investment banker then contacts a rating agency to explain his idea and to see if they agree and would rate the bonds higher than the parent company. Unfortunately, the investment banker finds out it is not so easy. If the parent company goes bankrupt, under the US bankruptcy law, the judge would order an automatic Stay provision, thus halting payments on all liabilities. Very possibly, those funds promised to the AAA rated bondholders would be consolidated with all other funds and liabilities, and those bonds would be lumped together with all other debt obligations that the now-bankrupt company has. Clearly, more has to be done.
[edit] Typical Participants in a Structured Finance Deal
- The Arranger
The Arranger sets up the entire deal. This type of participant is typically an investment banker who sets up the structure, tranches, liabilities, and then markets these to potential investors.
- The Originator
The Originator is the entity that created the assets that are engaged in a structured finance deal. This typically is a company looking to either raise capital, restructure their debt, or is looking to engage in some other structured finance operation. It typically needs the help of the Arranger because the Originator's expertise is in its own industry, not in Structured Finance or financial engineering.
- Servicer
The 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.
- Asset Manager
This entity sometimes does not exist, but asset managers may assemble the securities and assets, and work with the financial markets in order to move the collateral or assets.
- Trustee
The Trustee is a vital part of a typical Structured Finance deal. It is the gate-keeper of the assets that are being held typically in a SPE(Special Purpose Entity) that is usually a wholly owned subsidiary of the Originator. Even though the Trustee is part of the SPE, which is totally owned by the Originator, the Trustee's loyalties and obligations are towards the assets and those who own the assets, typically the Investors.
- Financial Guarantors
This role also may or not be filled depending on the nature of the deal. If utilized, the financial guarantor will provide guarantees or partial guarantees for the assets, the principle and the interest payments, for a fee.
- Investors
With the Originator on one end, these other players in the middle, the Investors make up the other end of the deal. Investors purchase the assets of the Originator, the Arranger intermediates the transaction, the Servicer services it and the Trustee takes care of the new asset.
- Credit Rating Agency
Rating agencies play an important part of this process by rating the securities created in the process. These agencies give an outside perspective on the liabilities being created and allow the Investor make a more informed decision.
[edit] Structure of a securitization
"The structure of an asset-backed security [securitization transaction] determines how cash flows are allocated to different investors, the service, and the seller, what protects promised cash flows to investors, and the responsibilities of the seller and servicer of the collateral." [1]
"[securitizations] have the following three general features -- pooling and transferring receivables; structuring and issuing securities; servicing, allocating payments, and monitoring." [1]
[edit] Pooling and transferring receivables
"First, a lender pools together and transfers loans (or, other receivables) to a special-purpose entity (SPE). Standard accounting rules [2] govern when such a transfer is a sale, a financing, a partial sale, or a part sale and part financing. These distinctions are important, because a transferor can take the transferred assets off its balance sheet in a sale, but it cannot do so in a financing... The transfer of assets to a SPE as a sale should be legally clear enough so that these assets are separate from the transferor even in the event of the transferor's bankruptcy. Such a transfer is sometimes called a bankruptcy-remote transfer, and a SPE is thought of as a bankruptcy-remote entity."[1]
[edit] Structuring and issuing securities
"Second, the SPE issues several securities backed by the receivables on these loans. Securities issued by a SPE can be rated differently, depending on the credit risk associated with them. Credit risk in asset-backed structures depends on the performance of the underlying collateral pool of receivables, and on credit enhancements. Important factors affecting collateral credit quality are a lender's underwriting criteria such as borrower credit score, credit history, loan-to-value ratio, and debt-service coverage ratio-economic variables such as unemployment and bankruptcies, and payment patterns over the age (or, seasoning of the loans). 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. Common credit enhancements are a senior/subordinated security structure (in such a structure, payments - either interest or principal or both - on a subordinate security are made only after payments on senior securities have been made), a reserve or spread account (in such an account, funds remaining after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and these can be used when SPE expenses are greater than its income), third party insurance or guarantee of principal and interest payments on the securities, and over-collateralization (usually created by using finance income to pay off principal on some securities before principal on the corresponding share of collateral is collected). Other credit enhancements include cash funding or a cash collateral account (which usually consists of short-term, highly rated investments purchased either from the seller's own funds, or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows), a third party letter of credit, a corporate guarantee, a back-up servicer for the loans, discounted receivables for the pool, or other related measures." [1]
[edit] Servicing, allocating payments, and monitoring
"Third, the servicer (usually the same as the seller) collects proceeds on the loans, and these are allocated to the investors, the seller, and the servicer according to the structure of the particular transaction. A servicer can significantly affect cash flows available to an asset-backed transaction, because it controls the collection policy, which influences proceeds collected, charge-offs and recoveries on the loans. Any income remaining after expenses such as investor and seller payments, charge-offs, and servicing fees are paid off is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Moreover, bond rating agencies publish ratings of asset-backed securities, and update these rating based on their monitoring of performance of collateral pool, credit enhancements, and probability of default."[1]
[edit] Sequential Payments/Cash Flow Waterfalls
It is common that the SPV issues several tranches of investment, each of which has a different claim on the cash flows that come into the SPV. Usually there is a hierarchy where some classes have access to the cash before others.
The 'Senior Classes' have first claim on the cash that the SPV receives, the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascade effect, these arrangements are often referred to as a cash flow waterfall.
There are usually three different waterfalls in these types of transaction, with different groups of investors having different rights:
Revenue distribution during the normal life of the securities, i.e. when there has been no default in the underlying asset *portfolio
- Scheduled principal repayment
- Distribution of funds after a default
This means that each class of investor has a different 'payment risk' and will therefore receive a different return.
- 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 the extreme version, the equity class receives no coupon (either fixed or floating), just the residual cash flow (if any) after all the other classes have been paid. There may also be one other special class which will absorb 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.
[edit] Revenue Waterfall
Revenue usually consists of all income receipts and would be distributed according to the hierarchy of the different tranches.
If all goes well, there is sufficient cash to pay everyone. However, if there has been a default, thus reducing the income, the priority access to revenue would come into play.
[edit] Principal Waterfall
Principal would generally consist of all principal receipts from the redemption or sale of the underlying assets, together with receipts credited from the revenue waterfall if there are any.
Not only may there be a sequential pay structure for the whole of the principal, deals may also use a pro rata structure (i.e. different tranches of notes are amortised pro rata).
[edit] Merged Waterfall
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.
So the distribution could be shown as:
- Fees
- Class A interest
- Class B interest
- Class A principal
- Class B principal
- Release cash to the originator
But in the event of default the priority could change and there could be a structure such as:
- Fees
- Class A interest
- Class A principal
- Class B interest
- Class B principal
- Release cash to originator (equity tranche receives any residual cash)
As an example, if a CDO has 3 tranches, A, B, and C, and there is a default, with only $21 million for $27 million in total debt, this might be a structure for the payments, below.
| Tranche | Debt Type | Amounts due | Payment made | Balance |
|---|---|---|---|---|
| 0 | 0 | 21 | ||
| A | Interest | 5 | 5 | 16 |
| Principal | 8 | 8 | 8 | |
| B | Interest | 3 | 3 | 5 |
| Principal | 6 | 5 | 0 | |
| C | Interest | 1 | 0 | 0 |
| Principal | 4 | 0 | 0 |
[edit] Master Trusts and Issuance Trusts
Trusts are important part of the securitization process. These trusts are vehicles the originator uses to remove the assets from their balance sheet, and these trusts are the entities that coordinate the funds coming in from the receivables and the funds leaving to pay the investors.
[edit] Master Trusts
Master Trusts are a type of Special Purpose Entity (SPE) which are particularly suited to handle revolving credit card balances and have the flexibility to handle different securities at different times.
[edit] A typical Master Trust Situation
In a typical master trust transactions, 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.
Master trusts often differ in the way they allocate principal and interest, but the exact way in which the principal and interest is diveed up is always predetermined in the seniority structure. Obligations on senior tranches are fulfilled before those on junior, or subordinated tranches. Typically any interest that remains after expenses would go into an excess spread account up to a water mark, and any more than that would be returned to the originator.
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.
- Revolving period
-
- During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables
- Accumulation period
-
- During the accumulation period, these payments are accumulated in a separate account
- Amortization period
-
- During the accumulation period, new payments are passed through to the investors.
Master trusts and credit enhancements have evolved so that principal can be repaid over a predetermined time period (controlled amortization), close to a single date ("soft bullet" amortization), or exactly on a single date ("hard bullet" amortization).
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.[1]
[edit] Issuance Trusts
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 a Issuance trust as well, 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.[1]
[edit] Grantor Trusts, Owner Trusts, and Other Trusts
[edit] Grantor Trusts
Grantor Trusts are typically used in automobile-backed securities and REMIC's (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. Essentially grantor trusts work like this: A 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.
[edit] Owner Trusts
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.
[edit] References
- ^ a b c d e f g h i j T Sabarwal "Common Strictures of Asset-Backed Securities and Their Risks, December 29, 2005
- ^ 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
