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Download Securitization 201: Analytics for Cash Securitization American Securitization Forum – Education Institute Seminar January 2006 CONFIDENTIAL

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  • Securitization 201: Analytics for Cash Securitization American Securitization Forum Education Institute Seminar January 2006 CONFIDENTIAL
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  • 2 Executive Summary Issuer Considerations Traditional Structure and Enhancements Investor Considerations Spread Methodology and Valuation Analysis Model Input Assumptions and Results Appendix Rating Agency Consideration Table of Contents
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  • Executive Summary
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  • 4 The objective of this sessions is to present the framework and pricing analysis for most types of cash structure securities The presentation will cover the following items: Rating agency considerations and collateral level risk measurements as inputs Issuer considerations and benefits of issuing asset backed securities Investor considerations for purchasing asset backed securities Valuation of structured securities for amortizing and non-amortizing asset types
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  • 5 Asset Backed Securities Amortizing Loans Credit Sensitive structured products must deal with credit and prepayment risk Amortizing Loans (Mortgages, Auto) Borrowers make periodic monthly payments over the life of the loan that includes scheduled and unscheduled principal and interest Set Repayment schedule Amortization Schedule Projection of cash flow requires projection of non contractual prepayments (excess principal payments) and defaults Recovery of defaults will lead to prepayments (involuntary prepayment) of the principal balance Defaults can lead to decrease of cash flow due to non payment though only after recovery has been received
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  • 6 Asset Backed Securities Revolving Loans Revolving Loans (Credit Cards, Trade Receivables) Do not have a schedule for the periodic payment Instead borrower makes a minimum periodic payment If payment less than the interest than the outstanding balance will increase If payment is greater than the interest or additional borrowings than the outstanding balance will decrease The concept of prepayment does not apply (e.g. Credit Cards)
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  • Issuer Considerations
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  • 8 Benefits of issuing an asset backed security The creation of a bankruptcy remote Special Purpose Vehicle (SPV) allows for higher credit rating based on the credit quality of the isolated asset in a stand alone entity compared to the corporate issuer leading to a lower cost of funds SPV requirements Bankruptcy remote/non consolidation opinion based on legal opinions True Sale of Asset to separate legal entity validates sale of asset Based on credit enhancement will be rated by the rating agency for collateral and enhancement levels and not corporate issuer A sub-investment grade originator may issue at AAA if they have the appropriate enhancement level and legal structure Ratings Factors Credit quality of the collateral based on the historical default and recovery rates Longer external and/or internal credit enhancements The quality of the Seller/Servicer Cash flow and stress payment structure model to assess cash flow deviation from the payment schedule (may be as simple as historical pattern or as extensive as a macroeconomic model) Legal Structure Facilitates the liquidity and growth of certain consumer finance products (Credit Card, Mortgages)
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  • 9 Corporate Bond vs. Asset Backed Securities Credit Analysis Only requirement is evaluation of cash flows under certain stressed scenarios to determine the timing and magnitude o f shortfalls on schedule cash receipts Delinquencies Defaults/Recoveries Prepayments In a true securitization repayment is not dependent on the ability of the Servicer to replenish the pool with new collateral or to perform more than routine administrative functions (1) (1) Standard and Poors, Rating Hybrid Securitizations Structured Finance (October 1999)
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  • Traditional Structure and Enhancements
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  • 11 Traditional Structure Bankruptcy Remote Special Purpose Vehicle (SPV) Originator (1)(2) Trustee Servicer (1) Investors Internal Credit Enhancement External Credit Enhancement True Sale Services Service Fee Trustee Fee Services $ Assets $ Principal and Interest (1) Originator and Servicer often are the same entity (2) Sometimes Servicer/Originator may take a subordinate position in the pool providing some of the structural credit enhancement
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  • 12 Revolving Structures Structured securities from revolving, not amortizing pools of collateral, tend to fall into one of four categories Credit Card Series Collateralized Debt Obligation Single Seller Conduits Asset Backed Commercial Multi-Seller Conduits
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  • 13 Credit Enhancement Mechanics External 3 rd party guarantee Parental guarantee (this jeopardizes the possibility to issue debt rated above the parent rating) Letter of Credit (provided by Banks, tied to the Banks Rating) Bond Insurance (Monoline) Disadvantage to external credit enhancement is the subjectability to the credit risk of the 3 rd party (weak link test) Internal Reserve Fund Cash reserve fund (cash deposit invested in eligible investments) Excess Servicing Spread Account (allocation of the excess spread into a reserve account) Overcollateralization Seller Interest taken by the Originator Amount of collateral in excess of the amount of the liability Senior/Sub Structures Most popular form Level of protections changes over time due to prepayments Shifting interest mechanisms may offset prepayment but need to assess contraction vs. credit risk
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  • 14 Cash flow and Payment Structure Passthrough Senior Tranche and the CF distributed pro rata to the bond holders (e.g. participation certificates) Paythrough Senior tranches divided into additional tranches that follow different payment priorities from the cash flow of the collateral Cash flow needs to pay the following: Principal Interest Fees (Servicer Fee, Credit Enhancement, Trustee Fee etc.) Agency will analyze if the Cash flows match the obligations and stress the cash flow by shocking the following: Losses (seasoned loss curves): Delinquencies, Gross Losses and Net Losses Interest rates Prepayments (CPR, MPR, SMM)
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  • 15 Rating Agency Risk Measurement Framework Two parallel risk measurement systems have evolved within the rating agency world for securitization, one focused on defaults, the other focused on loss or yield. And so there are at least three types of scores at use in todays market: Defaults: the cash runs out and the investor is not paid in full; Expected Losses: the shortfall by which the initial bond price exceeds the present value of cash flows to the investor, discounted at the promised level of yield; or Structuring a transaction means selecting the metric by which to rate the deal, obtain cash flow results from different scenarios, and use the score as an internal feedback to develop a final transaction structure. Two traditions of scenario analysis have developed alongside the two philosophies of risk scoring. In one tradition, stresses are developed based upon a consensus determination of what severity means in historical terms, and they are used to make the structure bullet-proof. In the other tradition, a microstructure of risk is ascribed to the collateral, and a simulation of the impact of the asset risk microstructure on liability cash flows is examined in a simulation framework.
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  • Investor Considerations
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  • 17 Investor Considerations Upside Relative Value return for Investor Ratings needs, Insurance companies need the NAIC bands Payback/paydown needs Appetite for prepayment and interest rate risk - need compensation for negative convexity effect on HELOC and MBS related products Better security through direct claim to assets Rating resilience Higher rating stability than comparably rated corporates Key Reason for subordinated investors is the possibility of upside Existence of a legally binding payment waterfall in a structured transaction Trustee controlling money High standard of ongoing data disclosure Orderly transition of certainty in bond performance with the passage of time from less certain to more retain Downside Uncertainty of cash flows Modeling specialized knowledge required in some sectors
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  • 18 Extension and Contraction Risk for Amortizing Asset Increased prepayment risk refinancing Increased reinvestment risk at lower rate Reduced prepayments competitive rates Inability to reinvest to generate higher return Contraction RiskExtension Risk Decrease Interest Rate Environment Increase Interest Rate Environment t0t0 tntn tntn Collateral Cash Flow
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  • Methodology and Valuation Techniques
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  • 20 Valuation Methodology Yield to Maturity (YTM) = interest rate that makes the Present Value of the expected Cash flow = Market Price The benchmark for an amortizing asset is based on the weighted average life and not the maturity Bond Equivalent Yield allows comparison of Yield to Treasury For Bonds 2X Semi-annual which is not true for ABS/MBS due to monthly cash flow and ability reinvest Bond Equivalent Yield = 2 [(1+i m ) 6 1] where I m = Yield Assume monthly yield 0.6% BEY = 2 x [1 + 0.06%] 6 -1] = 0.0731 = 7.31%
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  • 21 Limitations to Cash flow yield curve For YTM (IRR) as a measure the investor must assume Reinvest the coupon payments at a rate equal to the Yie