“PROCESS OF TRANSFORMING OTHERWISE FINANCIAL ASSETS

INTO MARKETABLE CAPITAL MARKET SECURITIES”

SECURITIZATION

EARLY TYPICAL SECURITES

• GNMA ‘PASS THROUGH’

• AUTOMOBILE LOANS

• CREDIT CARD RECEIVABLES

• COMMERCIAL LEASES

• COMPUTER LEASES

• NOW: BUSINESS LOANS

EXAMPLE

• DAYTON HUDSON CREDIT CARD MASTER TRUST

• GO OVER

SECURITIZATION PROCESS

• LOAN ORIGINATON - SETS TERMS

• TRUST - BUYS LOANS FROM BANK AND ISSUES SECURITIES

• INVESTMENT BANKER - SELLS SECURITIES FROM TRUST

• GUARANTOR -

• INVESTORS

BUSINESS LOAN SECURITIZATION

• VERY SMALL SO FAR:

– LOANS OUTSTANDING - $155 BILLION

– SECURITIZED LOANS - <$900 MILLION

COMPARISON

• TRADITIONAL LENDING - originate, fund, service, monitor

• SECURITIZED LENDING - originate,sell, service

Asset(loan) Securitized

• Illiquid• imprecise valuation• lender monitoring• high operating costs• limited rates/terms• local investor market

• Liquid• efficient market val.• Third party assesses• low operating costs• wide range of rates• national/global market

REQUIREMENTS

• STANDARD CONTRACTS

• RISK RATING SYSTEM

• REPUTABLE CREDIT ENHANCERS

• STANDARDIZED LEGAL FRAMEWORK

• STANDARDIZED SERVICING QUALITY

LOW GROWTH=HIGH COST

• Specific borrower /local condition info. Needed for prediction of repayment

• Lack of standard loan term– line of business/credit quality– loan maturity– pricing/covenants/collateral– bank underwriting standards

• Lack of long term performance info.

SBA GUARANTEED LOANS

• GUARANTEED PORTION = SECURITIZED

• MONEY STORE INC. -$380 MILLION SBA LOANS

• FREMONT FINANCIAL - $330 MILLION IN LOANS SECURED BY A/R, INV. AND F/A

WHY THESE WORKED

• RIGOROUS UNDERWRITING STAND.

• SBA LOANS - VERY STANDARDIZED

• SIMILAR COLLATERAL/DOCUMENT.

• SBA CAN SUPPLY HISTORICAL LOSS EXPERIENCE DATA

• HIGH VOLUME LENDERS

BACKUP REQUIRED

• LOSS PROTECTION ON 11-20% OF THE LOAN POOLS

• OR

• PURCHASE PRIVATE BOND INSURANCE

MAIN BENEFITS TO LOAN ORIGINATOR

• LOANS SOLD/NO FUNDING NEEDED

• REDUCES MONITORING COSTS

• LOWER BORROWING COSTS DUE TO PREDICTABLE CASH FLOW FROM POOL OF ASSETS, NOT ONE

CONT.

• RELEASE BANK CAPITAL TO OTHER PURPOSES

• MANAGE CREDIT RISK

• DIVERSIFY LOAN PORTFOLIO

WHY FIRMS USE ASSET-BASED DEBT

• AVOID ASSET SUBSTITUTION COSTS

• “Mgmt. Often replaces low risk assets with high risk after debt financing. Only the stockholder get the higher return.

• Only securitized debt ties the bond to specific asset - thus, no substitution

Cont.

• Avoid underinvestment

• “Equity holders of stressed companies unwilling to make marginal investment as only bondholders get the return.”

• Use of asset-based security removes general company risk

Cont.

• Secured debt reduces information asymmetry problem of management not acting in bondholders’ interests

ISSUES FACED BY INVESTORS

• GUARANTEE ONLY PROVIDES LIMITED CREDIT PROTECTION

• INTEREST RATE RISK LIMITED BY BUYING “TRANCHES” IN DIFFERENT MATURITIES

CONT.

• LIQUDITY RISK NOT A PROBLEM

• PERFORMANCE RISK - EX. CREDIT CARD RECEIVABLES IN A RECESSSION

CONT.

• PREPAYMENT RISK - PARTICULARLY IN SECURITIES BACKED BY MORTGAGES

• GEOGRAPHIC CONCENTRATION

MAIN BARRIERS TO BANK LOAN SECURITIZATION

• SIZE CONSIDERATIONS– MIN. POOL FOR PRIVATE PLACE. -$50m– MIN. POOL FOR PUBLIC OFFER.-$100m

• RECOURSE - INVESTOR HAS CLAIM IF SECURITY DEFAULTS

• RISK EXPOSURE - POOLED ASSETS ARE DIFFICULT TO MONITOR

Cont.

• Lack of long term performance information