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  • SecuritizationThe Financial Instrument

    of the Future

    Vinod Kothari

    ' ; ! ' . ' * )


    John Wiley & Sons (Asia) Pte Ltd

  • Table of Contents

    Preface to the Second Edition xxx

    Preface to the First Edition xxxi

    Part I Securitization: Conceptsand Markets 11. Securitization and Structured Finance 3

    Basic meaning of securitization 4Asset securitization 4Some definitions of securitization 8

    Securitization of receivables 9Quick guide to jargon 10Securitization and asset-backed finance 12Securitization and structured finance 13Some quick features of securitization 14

    What receivables are securitizable 14Creation of security 15Special purpose vehicle 15Re-distribution of risks 16Rating 17

    The big picture of securitization of finance 17Changing structure of financial markets 17Securitization and financial disintermediation 22

    Securitization as a tool of risk management 25Economic impact of securitization 26

    1. Facilitates creation of markets in financial claims 262. Disperses holding of financial assets 263. Promotes savings 264. Reduces costs 275. Diversifies risk 276. Focuses on use of resources, not their ownership 27

    7. Smooths the impact of recession 27The alchemy of securitization: .Is the sum of parts more than the whole? 28

    The alchemy of structured finance 28Risks inherent in securitization 30Notes - 36Securitization Terminology 39

  • Securitization: The Financial Instrument of fee Future

    2. Securitization: Methodology, Structures, Motivators and Demotivators 59

    Modus operandi of securitization briefly explained 59Economic substance of securitization:Where does the alchemy lie? 62Features of securitization of receivables , 63

    1. Mode of asset-based financing 632. Mode of structured financing 643. Securitization of claims against third parties 644. Limited Recourse 645. Asset features 656. Originator features 697. Issuer/SPV features 708. Investor features 71

    Securitization and factoring 72Securitization and ring fencing , 72Asset classes 73

    Balance sheet and arbitrage transactions 74Asset-backed securities and asset-backed commercial paper 74 ,

    Broad types of securitization structures 75Cash vs. synthetic structures 75True sale vs. secured loan structures 76Pass-through vs. collateral structure 76Discrete trust vs. master trust 77

    Direct portfolio transfers 77Pass-through structure . 79Pay-through structure 84

    Economic argument against pay-throughs 86Collateralized mortgage obligation bonds , 87

    Refinements in CMO structure 89/ Revolving structure 91

    Impact and suitability of the revolving structure 92Future flows securitization 93Advantages of securitization for the issuer 97Advantages to the investors 102Threats in securitization 104Notes 106

    3. The World of Securitization 108f

    * History of securitization 108Deeper in history 109|The U.S. mortgage market 109Spreads over to non-mortgage assets ^ 110Securittzation through recession . I l l

    The life cycle of securitization 111Present state of securitization 112

    North America 112

  • i Table of Contents Ix

    Europe 115Central and South America 147Origin of securitization in Latin America 147Asia . 152The Pacific 179

    Trends in global securitization 183Notes 186

    Part II Financial Substance and Ratings 189

    4. Structuring and Credit-enhancing Securitization Transactions 191

    Basics of securitization structuring 191Structuring variables 193

    Asset pool 193Selection criteria ' 194Identification of risks 195Sources of credit support 196Size of credit support 196Financial structure - pass-through or reinvestment type ' 196Classes of liabilities ' 197Time tranching of liabilities 198Pay down of securities - 198Liquidity support - need and sources 198Prepayment protection 199Mitigation of other risks 199Creation of cash reserve and investment 199Structural protection triggers , 200Profit extraction methods 200Clean up call 200

    Parties involved 201Primary parties 201Supportive agencies 201

    Steps in a securitization transaction 202Initial feasibility study 203Key appointments - 204Asset analysis and selection 204Due diligence audit 205Determination of the structure 206Credit enhancements 206Intervening reinvestments 207,?ixing the legal structure 207Legal opinions 208Rating* . 208Offer 209Appointment of servicer/administrator 209Post-completion routines 209

  • x.. Securitization: The Financial Instrument of the Future

    Ongoing reportingClean up call

    Credit enhancementsFirst, second and subsequent lossInternal and external credit enhancements

    Originator credit enhancementsExcess spread or profitCash collateralCredit-enhancing IO stripOver-collateralization

    Structural credit enhancementsTransaction-wide support vs. structural support

    Third-party credit enhancementsSources of external credit enhancementsSuitability of third-party enhancements

    Sizing of credit enhancementsConfidence level for different ratingsStress testing of retail portfoliosSizing of enhancement for wholesale portfoliosStepping up credit enhancements

    Liquidity enhancementsPay-down structure

    Choice of the pay-down methodMaturity of the securitiesProfit extraction devicesCash flow waterfallNotes


    5. Understanding the Nature and Risks of Asset-backed Securities 231

    Asset-backed securities and the underlying collateral 231Risks in asset-backed securities 233

    Will the cash flow come in, or the credit risks? 233Who will get the cash flows in or servicing risk? 233Timing of the cash flow or prepayment risk 234Liquidity of the transaction 234Interest rate and other volatilities 234Other risks 234

    Modeling of asset risks 234

    6. Understanding Prepayment Risk in Asset-backed Securities 235

    , Prepayment as a risk 235Nature of the prepayment option 236

    Prepayment risk in asset-backed securities . 238Additional factors that cause

    " /prepayment of asset-backed securities 238Analogy using callable securities 239

  • " L-Table of Contents xi

    Impact of prepayment risk on the pool . 239Prepayment risk in mortgage pools 240

    Turnover 241Refinancing " 243

    Prepayment modeling 244Static prepayment models , 244

    Annual and monthly prepayment rates 244Various static prepayment models 245

    The PSA prepayment model 246The CPR and other static models 249Dynamic or econometric prepayment, models 250

    Establishing a relation between interest rates and prepayment rates 251Some econometric prepayment models 252

    Projection of interest rates 255Which interest rate matters? 255Interest rate models 255

    Prepayments for adjustable rate mortgages 256Prepayment model for commercial mortgages 258Prepayment models for non-U.S. pools ^ 258Notes 259

    7. Understanding Default Risk in Asset-backed Securities 261

    Nature of default risk - default as an option 261The option to default on mortgages 262

    LTV ratio 263Movement of the LTV ratio over time 263Prevailing mortgage rates 263Housing prices 1 264Cost of default . 264Non-economic factors 264

    Default rates as a function of seasoning 264Default risk for different securities 265Note 266

    8. Cash Flow Modeling for Asset-backed Securities 267

    Constructing the cash flow model .267Audit checks 269

    Understanding the asset and its repayment over time 269The factors that affect asset cash flows 270

    Incorporating prepayment in cash flow 271Incorporating delinquency 272Incorporating foreclosures and recoveries 272Incorporating the impact of seasoning on foreclosure 273

    The factors that affect the factors that affect cash flow 273Interest rate volatility and prepayment 274

    Understanding liabilities 275

  • xii Securitization: The Financial Instrument of the Future

    Claims on revenue and claims on principalManner of repayment of liabilitiesLoss allocation

    Understanding transaction structureExcess spread as a credit enhancementPooling excess spread into a reserveIncorporating a clean-up call

    Modeling a real life caseExample of an auto loan securitization

    Stress testing the modelLevel of stress to apply

    9. Securitization: Financial Evaluation for the Originator

    Securitization: The quantifiables and the non-quantifiablesSecuritization vs the unknown

    Securitization vs cost of borrowingWhat is equity in the case of securitization?Relevance of debt-to-equity ratio

    The NPV of originator's residual interestA sequential pay-down exampleProportional pay-down example

    Impact of prepaymentFactors affecting originator's residual interestExpected value of originator's residual interest

    10. Investor Evaluation of Asset-backed Securities

    Spreads inherent in asset-backed securitiesSpreads for asset-backed securitiesUnderstanding of Z spreadComparing Z spread, NPV and yield

    Understanding of durationUnderstanding of convexityImpact of prepayment on ABS investments

    Impact of prepayment on durationPrepayment and yieldPrepayment and negative convexityPrepayment and Z spread

    Computation of option-adjusted spreadUnderstanding default riskNote

    .11. Rating of Securitization Transactions

    Structured finance ratings vs. -other fixed income ratingsRating agency concernsThe rating process

  • * iLTable of Contents xii i

    Rating models 315Rating approaches for retail assets and wholesale assets 316

    Differences between structuredfinance and corporate finance ratings 316What credit ratings do not rate 318

    What rating upgrades of structured finance securities mean 318Servicer evaluation . 318Role of ratings in structured finance 319

    Some areas of critique 320Notes 320

    Part III Asset Classes 321

    12. Re


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