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  • 67A special supplement to International Tax Review June 2000

    As outlined in the introduction, secu-

    ritization is a powerful financing tool

    that has gained prominence in recent

    times. The following discussion out-

    lines various ways in which an entity

    can raise funds using otherwise illiq-

    uid assets.

    SECURITIZATION DEFINED

    Securitization is a process whereby

    assets are pooled and security inter-

    ests in the pool are sold to investors.

    In other words, securitization refers

    to the process whereby securities are

    issued to investors and these securi-

    ties are backed by a dedicated pool of

    assets as collateral. A typical securiti-

    zation arrangement, if there is such a

    thing, is illustrated in Box 1 overleaf.

    Assume that the originator holds

    illiquid assets, typically debt instru-

    ments executed between the origina-

    tor (say a bank) and numerous

    obligors (such as individuals who

    have a mortgage with the bank). The

    assets are then packaged into pools by

    combining them with other homoge-

    neous assets (for example, other

    mortgages issued on substantially

    similar terms). The assets are then

    transferred to a trust or special pur-

    pose vehicle (SPV) which is the securi-

    tization vehicle.

    Depending on a number of factors,

    it may be appropriate to enhance the

    credit standing of the securitization.

    Credit enhancement can be catego-

    rized in three ways:

    ● Enhancements given by the origi-

    nator of the assets such as repur-

    chase commitments, indemnity

    clauses and letters of support.

    ● Enhancements built into the fund’s

    structure, including over-collater-

    alization, subordination and cash

    deposits or spread accounts.

    ● Enhancements from third parties

    (especially banks and insurance

    companies) such as letters of credit

    or guarantees and swaps. Alterna-

    tively, the enhancement may be

    provided by way of a government

    or government agency guarantee.

    The securitization vehicle sells

    security interests to investors. The

    funds raised from this issue are

    passed back to the intermediary or

    originator in consideration for the

    assets transferred to the securitization

    vehicle.

    During the term of the securitiza-

    tion arrangement, the investor has a

    right to certain cash flows paid by the

    obligor. The entitlement of the

    investor will be determined by the

    terms of issue of the security interest.

    The possibilities are numerous which

    means that the quantum and timing

    of the cash flow received by the

    investor may not be identical to the

    cash flows of the underlying asset

    pool.

    Securitization overview

  • Securitization: Overview

    www.internationaltaxreview.com68

    TYPES OF SECURITIZATION

    Assets created in this manner have typically been placed

    into two categories – mortgage-backed securities and asset-

    backed securities. Within each of these classes there have

    been numerous variations on the basic structure illustrated

    above.

    Mortgage-backed securities

    Mortgage-backed securities (MBS) are a form of securitiza-

    tion that is backed by mortgages. There are three core

    types of MBS:

    ● mortgage pass-through securities;

    ● stripped MBS; and

    ● collateralized mortgage obligations (CMO).

    Mortgage pass-through securities are backed by either

    fixed or floating rate mortgages. The investor purchases

    shares or participation certificates in the pool of mortgages.

    The cash flows received by the investor will depend on the

    cash flow characteristics of the underlying mortgages,

    namely interest, principal and prepayments (adjusted for

    the cost of service fees and the cost of credit enhancement).

    A stripped MBS is a derivative mortgage security. In its

    most common form, the distribution of interest and princi-

    pal amounts between investors is altered so that the

    price/yield characteristics will be different for each investor

    class. At its extreme, a stripped MBS could be structured so

    there is an interest-only investor class and a principal-only

    investor class.

    Finally, in a CMO the securitization vehicle purchases

    whole mortgages funded by debt issued in different

    tranches. As a result, cash flows from the underlying assets

    are redistributed to various tranches based on varying

    preferences and default risk or prepayment risk is amelio-

    rated. Specifically, the securitization vehicle uses the prin-

    cipal and interest it receives to pay interest to each tranche,

    but only the first tranche also receives principal (ie the

    fastest pay tranche). Once the first tranche principal is fully

    repaid, the second and then third etc becomes the fastest

    paid. In this way the CMO creates different risk/yield rela-

    tionships between investor classes by taking a single-class

    instrument (whole mortgages) and creating multi-class

    instruments. In recent years, this class of MBS has devel-

    oped very quickly and has been the subject of the greatest

    degree of innovation and financial re-engineering.

    Asset-backed securities

    Asset-backed securities (ABS) are securitizations which are

    backed by non-mortgage assets including (but not limited

    t o ) :

    ● automobile loans and leases;

    ● credit and department store charge card receivables;

    ● computer and other equipment leases;

    ● accounts receivables;

    ● legal settlements;

    ● small business loans;

    ● student loans;

    ● home equity loans and lines of credit;

    ● boat loans;

    ● franchise loans;

    ● time share property loans;

    ● real estate rentals; and

    ● whole business securitizations.

    ABS have been modeled on the MBS techniques. This

    has given rise to a wide range and variety of different ABS,

    such as collateralized debt obligations, that offer different

    risk-return characteristics. The summary above does not

    perhaps do justice to the flexibility of this financing tech-

    nique given the diverse structuring alternatives available

    and the fact that the resulting risk-return profile combina-

    tions are potentially unlimited.

    In recent times innovation has centred on an expansion

    of asset classes. As an example, some securitized assets

    involve no more than the right to collect a fixed or even

    undetermined amount in the future, such as tax liens. Tax

    lien securitizations may provide an affordable source of

    funding for municipalities. Naturally, the future tax collec-

    tion will depend on extraneous factors such as economic

    and political influences. The benefit for the issuer is that it

    receives certainty in terms of tax collections while also

    reducing its cost of collection by passing this cost and

    responsibility to the investor.

    BENEFITS OF SECURITIZATION

    Regardless of the type of securitization or the nature of the

    underlying assets, securitization offers many unique and

    important benefits to participants. Securitization is a

    means for the originator to do the following:

    ● Transform an illiquid asset into a liquid financial instru-

    ment. This allows the originator to use its illiquid assets

    offering future revenue and principal repayment

    streams as a means of raising current funding.

    ● Borrow at a better rate since the risk premium

    Box 1: A typical securitization

    Originator

    Obligor Securitiza-

    tion vehicle

    Guarantor

    Investor

    Asset

    pool

    Sale of

    assets

    Security

    interest

  • Securitization: Overview

    69A special supplement to International Tax Review June 2000

    demanded by the investor is commensurate with the

    underlying pool of assets (adjusted for credit enhance-

    ment facilities) rather than the risk characteristics of the

    originator. This advantage must be assessed after tak-

    ing into account the costs of issue (which is of particular

    interest for new structures):

    ● Remove risky assets from its balance, resulting in

    improved balance sheet management with reduced

    leverage and gearing ratios. This frees up capital to sup-

    port further loan writing or investment and is particu-

    larly important where the originator is subject to risk

    based capital requirements.

    ● Pass the prepayment risk of the underlying assets to the

    i n v e s t o r .

    ● Eliminate further exposure to credit risk or to adminis-

    tration of the asset.

    ● Gain access to a wider banking/investor base in the

    financial markets.

    For an investor, securitization may be attractive for the

    following reasons:

    ● Most deals entail some sort of credit enhancement (as

    outlined above). This enables the securities to obtain

    excellent credit ratings.

    ● The securities offer yields that exceed those on compa-

    rable corpo

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