Financial InnovationSecuritization

P.V. ViswanathSummer 2007

SecuritizationThe repackaging of receivables or other cashflows in a tradable form.SEC definition: "the creation of securities that are primarily serviced by the cashflows of a discrete pool of receivables or other assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holder The goal is to sever the risk of originator insolvency from the risk of asset performance: the investor can rely on asset risk rather than the general corporate credit of the originator.

Earliest examples:The market for home

mortgagesBanks provided loans for the purchase of homes.Government agencies, such as the Government National Mortgage Association (GNMA), and the FHLMC (Freddie Mac); and private corporations, such as the Federal National Mortgage Association (FNMA) were charged with providing broader and more stable sources of capital to the residential mortgage market.

Mortgage Backed Securities

These agencies started securitizing mortgages by purchasing home mortgage loans from local lenders and guaranteeing securities backed by pools of residential mortgages.Result:

Volume of funds available for housing expanded.Redistribution of mortgage funds from capital-surplus to capital-deficit regions.

An example: GNMA pass-throughs

GNMA pass-throughs were issued by mortgage bankers and were backed by pools of newly issued FHA/VA single-family mortgages (i.e. loans guaranteed by the Farmers Home Administration or the Veterans Administration).GNMA guaranteed the timely payment of scheduled monthly principal and interest. These guarantees represent full faith and credit obligations of the US Government.

Structure of a GNMA Pass-through

Homeowners

Interest PrepaymentsScheduled Principal

(Amortization)

Originator/Servicer

Investors

Servicing Fee/ Guarantee Fee

Delinquencies Defaults

Credit Enhancements

The purpose is to improve the quality of the assetExternal Enhancements

Corporate GuaranteeLetter of Credit (a commitment by a bank on behalf of a client to pay under specified conditions)Pool Insurance: covers losses due to borrower’s economic circumstances, but does not cover fraudBond Insurance covers all types of losses unconditionally – usually bond insurers will not take the first-loss position.

Credit EnhancementsInternal Credit Enhancements:

Reserve FundsCash ReservesExcess Servicing Spread Accounts

OvercollateralizationEstablishing a pool of assets with principal principal amount of the securities issued.

Senior/Subordinated StructureThe subordinated class absorbs all losses on the underlying collateral, protecting the senior class.A Shifting Interest Structure redirects prepayments disproportionately from the subordinated class to the senior class according to a pre-specified schedule.

Collateralized Mortgage Obligations

CMOs are bond classes (tranches) created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk.

Sequential Pay tranches: Principal payments are directed to the seniormost tranche until it is paid off, then to the next senior tranche, etc.Accrual bond/tranche: The interest for this tranche accrues until more senior tranches are paid off.

CMO VarietiesFloating Rate Tranches:

can be created from fixed-rate tranches by creating a floater and an inverse floater.Useful for financial institutions that have floating rate/short term liabilities.

Planned Amortization Classes (PAC) Bonds: Created with support bonds that absorb fluctuations in principal payments, upto certain limits (collars).

Targeted Amortization Classes (TAC) Bonds:Protects against contraction risk (rapid prepayment), but not against extension risk.

Very Accurately Determined Maturity BondsProtection against contraction and extension risk.

Mortgage StripsInterest-Only CMOs: All interest is allotted to these strips.When interest rates rise, flows to IO CMOs rise. But these flows are discounted at a higher rate; hence the IO CMO price could rise or fall. If interest rates fall, IO CMO prices usually fall. Hence IOs have negative duration.Principal-Only: All principal payments are allotted to these strips.When interest rates rise, prepayments fall and flows to PO CMOs fall. Hence PO CMO prices fall.

Asset Backed SecuritiesSecurities created by pooling loans other than first-lien mortgage loans:

Auto-loan backed securitiesCredit Card Receivable-backed securitiesHome Equity Loan-backed securities

The underlying assets are purchased by a Bankruptcy-remote Special Purpose Vehicle (SPV), which issues the ABSs.The SPV is typically a wholly-owned subsidiary of the seller of the collateral.

ABS structure resembling notes

Chase, in Sep. 1999 sold an $18.5bn pool of receivables to a master trust, which issued a certificate, conveying an undivided interest in the whole pool.This certificate was placed in another SPV, which issued three tranches of bonds:

$850m of 5-yr senior bonds, rated AAA, priced at 98bp over Treasuries. $48.295m of single-A paper at 128bp over Treasuries.$67.615m BBB at 95bp over 1-month Libor.

The repackaging enabled the tranches to be called notes and hence all the tranches could meet ERISA investment guidelines followed by pension funds.

Securitization of Risks:Using Bonds to Buy

InsuranceInsurance companies can go bankrupt; traditional insurance requires a very large amount of capital.The problem is greater with insurance lines that have long tails – policies where claims can be filed long after the policy is issued.Insurance companies are locked into the deal for a long time. Investors in capital markets are more willing to hold these risks, because they can sell them off.Specialized bonds, such as cat bonds may be able to resolve these problems.

Catastrophe BondsOriental Land Company placed two $100 million catastrophe bonds with special purpose reinsurers to protect against earthquakes.First bond has a five-year maturity. Payment depends upon magnitude, location and depth of earthquake, regardless of actual property damage. (Why? Auditing problems?)Second provides post-earthquake financing: Oriental Land will issue a $100 million 5-yr bond to the reinsurer with no interest for the first three years. (Put like?)

Weather BondsIn Oct. 1999, Koch Ind., of Wichita and Enron Corp, of Houston issued $200 m. of weather bonds.The interest on the Koch bonds depends on the weather in the 19 cities in which Koch operates. If temperatures are similar to historical levels, the coupon is 10.5%.If temps are colder (warmer) by ¼ degree on average, the coupon is 10% (11%).Koch’s objective: HedgingValue for investors: Diversification

Alternatives to Securitization of Insurance

RisksCatastrophe InsuranceCatastrophe Derivatives

Pros and Cons:Information Costs versus Basis Risk

Securitizing future cash flow

This is the purpose of standard bonds. However, they draw upon the general cashflows of a company.Project financing channels pre-specified subsets of a company’s cashflows to bondholders.More specialized “projects” like rock-n-roll bonds.

Rock-n-Roll bondsDavid Bowie, issued February 1997, raised $55 m. by selling securities.Backed solely by expected royalites from future sales of his first 25 albums.7.9% coupon, 15 yr maturity, 10 yr. av. maturity.Investment banker on the deal was David Pullman at Gruntal & Co.Prudential Insurance Co. is purchaser.Bonds guaranteed by EMI Group Plc.

Rock-n-Roll bonds Ethan Penner, in Sept. 1997, set up Nomura Capital Entertainment Finance to be sole investor in making $1 billion in loans to musicians, actors and studio executives. (not quite securitization).Bear Stearns is interested in securitizing the expected cash flows of existing and soon-to-be-released films.

Target: Insurance companies looking for diversification.

Problems/QuestionsWhat is the purpose of the loan for the issuer?

ConsumptionDiversificationArtists might want to repurchase artistic works that they were forced to sell earlier in their careers.To buy other artists’ intellectual properties.Tax reasons

What about the issue of Moral hazard?

Valuation of Rock-n-Roll Bonds

Actuarial approach is not possible. One-of-a-kind.The riskiness of cashflows from the asset itself as opposed to the issuer (e.g. if Citibank securitizes its credit card receivables)Collection of cashflows (from the entertainment industry) will have to be more scientific and specialized.How to evaluate cashflows that are projected to grow, rather than depreciate? (Lengthens the life of the asset.)

Rock-n-Roll Bonds

Possible solutions:Diversification of trust issuing the security. This is the Penner strategy.Securitize cashflows from known artists and/or known works with a history.Credit Enhancement

Tobacco BondsIn 1998, 46 states settled a major case against the Tobacco industry. The agreement was for approximately $205 Billion for 25 years. It is referred to the Master Settlement Agreement (or MSA). States, and various Counties in a few States, have opted to securitize their payments from the MSA. They have issued Municipal Bonds and taken an early lump sum payment instead of waiting for the Tobacco industry payments to come in over time. The bonds secured by these tobacco settlement revenues are called tobacco bonds.The risk for these bond investors is the strength of the Tobacco industry, cigarette sales and so on.

Train Securitization in the UK

Earliest deals securitized leases guaranteed by the UK government in 1994.In 1998, Porterbrook securitized unguaranteed leases on trains still under construction.In August 1999, the Royal Bank of Scotland placed £480m to fund Virgin Rail Group’s purchase of 53 hi-tech trains that were custom-made.

The transaction cannot rely on the diversity of its obligors (as with credit card debt) or the transferability of the hard assets. Also, the deal is non-recourse to Angel Trains.

Train Securitization in the UK

Porterbrook’s deal comprised £140m. of Floating rate loans in three tranches.Royal Bank of Scotland’s financing wing West Coast Train Finance Plc offered one fixed class of bonds, to be amortized according a schedule between 2003 and 2015; av. life = 10.4 yrs.A+ rating from Duff and Phelps, AA from Fitch IBCA and A from S&P.The bonds are delinked from the credit risk of the company operating the trains; permits a higher rating for the bonds than for the company.There is an assurance from the Office of Passenger Rail Franchising to take over the trains even if Virgin fails.

Special Facilities BondsMost debt issued by airports represents long-term bonds secured by a pledge of general airport revenues.Recently, however, more airports have been issuing special facilities secured debt where the lender has recourse only to revenues generated by the special facility.There is no equity investment by the airport authority.General airport revenues can be reserved for projects that are more central to airport operations or can only be funded through traditional avenues.

JFK Int’l Arrivals Terminal Bonds

Issued by the Port Authority of NY & NJSecured by Facility Rental Payments made by the lessee JFK IAT to the Port Authority, the lessor. However, JFK IAT agrees to set rates to provide revenues 125% of debt service on bonds.Bondholders have no recourse to JFK IAT, or the Port Authority, if the project fails to perform as projected.

Automobile ABSTraditional Auto ABSs price up to 10 bp wider than credit card ABSs because auto deals have amortizing tranches that depend on prepayments.In Aug. 99, GMAC securitized a pool of amortizing auto loans and created bullet maturity structures by having all the amortization that occurs between bullet payments get absorbed by a variable funding certificate.This structure matches corporate bonds and makes it easier to construct swaps.

Pub SecuritizationIn June 1999, Pubmaster, a UK corporation that owns pubs securitized beer revenues.This allows Pubmaster to tailor costs to revenues, and reduces the probability of bankruptcy.For the investors, it’s possible to obtain tighter covenants, because the source of the revenues is more defined.

Sport SecuritizationFormula One, the British company that manages the international car-racing championship has issued $1.4 b. in bonds securitized by all assets of Formula One’s business, including its TV and promotional contracts.Shows that intangible assets and intellectual property rights can be the basis for securitization.