Securitization past, present and future

x List of AbbreviationsEUR Euro FCIC Financial Crisis Inquiry Commission FHA Federal Housing Administration FNMA Federal National Mortgage Association Freddie Mac Federal Home Loan Mortg

BANKING AND FINANCIAL INSTITUTIONS

SERIES EDITOR: PHILIP MOLYNEUX

Solomon Y Deku and Alper Kara

Securitization: Past, Present

and Future

Palgrave Macmillan Studies in Banking and

Financial Institutions

Series editor

Philip MolyneuxBangor UniversityBangor, United Kingdom

tems in particular countries or regions as well as contemporary themes such as Islamic Banking, Financial Exclusion, Mergers and Acquisitions, Risk Management, and IT in Banking The books focus on research and practice and include up to date and innovative studies that cover issues which impact banking systems globally.

More information about this series at

http://www.springer.com/series/14678

Solomon Y Deku • Alper Kara

Securitization: Past, Present and Future

Palgrave Macmillan Studies in Banking and Financial Institutions

ISBN 978-3-319-60127-4 ISBN 978-3-319-60128-1 (eBook)

DOI 10.1007/978-3-319-60128-1

Library of Congress Control Number: 2017946324

© The Editor(s) (if applicable) and The Author(s) 2017

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This book provides an overview of the historical and recent ments in the global securitization markets It explores how and why securitization is created and examines multiple securitization instru-ments It investigates, by reviewing the academic evidence, how securiti-zation influenced bank lending behaviour and why securitization, once acclaimed as an innovative mechanism for economy-wide efficient risk distribution, became a contributing factor to the 2007–2009 financial crisis It also looks at the future of the securitization markets in light of the regulatory changes after the financial crisis

develop-The book has several purposes Firstly, it aims to explore if and how securitization changed financial intermediation and lending behaviour

by reviewing the pre- and post-financial crisis theoretical and empirical literature The book’s distinctive feature is bringing the growing post -crisis academic research to the attention of a wider audience by critically appraising the recent empirical evidence in comparison with pre-crisis arguments on securitization Secondly, it aims to examine the interac-tion between originator banks and investors under the inherent pres-ence of information asymmetries in ABS transactions Here the book provides fresh insights from recent academic research on whether and how banks misled investors in buying poor quality securitization securi-ties prior to the financial crisis Thirdly, it aims to evaluate regulatory weaknesses in the years leading to the financial crisis and whether the

Preface

new regulatory measures are impeding the desired level of activity in the securitization market.

Another distinctive feature of the book is the comparison of the US and European markets throughout the text These are the two main secu-ritization markets in the world and they display several differences in terms of structure, products, historical developments and regulation With its thought-provoking insights, the book should prove to be of par-ticular value for students, practitioners and academics

We specifically thank Martin Scheicher and Stefanie Wehmeyer for their contribution by writing Chapter 8 We are grateful to David Marques-Ibanez, Steven Ongena, Yener Altunbaş, Philip Molyneux, Aydın Özkan, Mark Rhodes, Elvis Hernandez-Perdomo, Jingsi Leng, Alberto Franco Pozzolo, as well as to the participants of seminars held

at the University of Hull and Loughborough University for very helpful comments, suggestions and support on the papers that provided origi-nal material for the various chapters of the text Thanks are also due to Natasha Denby for editing of the manuscript and to Stéphanie Kara for providing the cover image of the book Finally, thanks to our families and loved ones for their patience and support during the project

The views expressed in this book are the authors’ own and do not necessarily reflect those of the Nottingham Trent University and the Loughborough University

Solomon Y Deku

4 A Historical and Regional Overview of Securitization 57

5 Effects of Securitization on Banks and the Financial System 93

6 Valuation of ABS Under Asymmetric Information 113

7 The Role of Securitization in the 2007–2009 Crisis 131

8 Securitization: Key Trends Since the Crisis 145

ABCP Asset Backed Commercial Paper

ABS Asset Backed Security

ABSPP ABS Purchase Program

AFME Association for Financial Markets in Europe

ARM Adjustable Rate Mortgage

BCBS Basel Committee on Banking Supervision

BoE Bank of England

CBO Collateral Bond Obligation

CCP Collateralized Commercial Paper

CDO Collateral Debt Obligation

CLO Collateral Loans Obligation

CMBS Commercial Mortgage Backed Security

CMO Collateralised Mortgage Obligation

CMU Capital Markets Union

CP Commercial Paper

CPR Constant Prepayment Rate

CRR Capital Requirements Regulation

EBA European Banking Authority

ECB European Central Bank

ECBC European Covered Bond Council

EIF European Investment Fund

EL Expected Loss

ESF European Securitisation Forum

x List of Abbreviations

EUR Euro

FCIC Financial Crisis Inquiry Commission

FHA Federal Housing Administration

FNMA Federal National Mortgage Association

Freddie Mac Federal Home Loan Mortgage Corporation

FSB Financial Stability Board

GAAP Generally Accepted Accounting Principles

GBP British Pound

GDP Gross Domestic Product

GNMA Government National Mortgage Association

GSE Government Sponsored Entity

HQA High Quality Assets

IFRS International Financial Reporting Standards

IO Interest Only

IOSCO International Organization of Securities Commissions IRB Internal Rating Based

LAPA Liquidity Asset Purchase Agreement

LBO Leveraged Buyout

LIBOR London Interbank Offer Rate

LLA Liquidity Loan Agreement

PSA Pooling and Servicing Agreements

REMIC Real Estate Mortgage Investment Conduit

RMBS Residential Mortgaged Backed Security

RTC The Resolution Trust Corporation

S&L Savings and Loans

SEC Securities and Exchange Commission

SEC-ERBA Securitisation External Ratings – Based Approach SEC-IRBA Securitisation Internal Ratings – Based Approach SEC-SA Securitisation Standardised Approach

SIFMA Securities Industry and Financial Markets Association SIV Structured Investment Vehicle

SME Small and Medium Enterprises

SPV Special Purpose Vehicle

STC Simple Transparent and Comparable

STS Simple Transparent and Standardised

TAC Target Amortization Class

UK United Kingdom

US United States

USD United States Dollar

WAC Weighted Average Coupon

WAL Weighted Average Life

WALA Weighted Average Loan Age

WAM Weighted Average Maturity

X-PAC Broken Planned Amortization Class

Solomon Y  Deku is a Lecturer in Accounting and Finance at Nottingham Trent University, UK He holds a BSc in Administration (Banking & Finance) from the University of Ghana and an MSc Financial Management from the University of Hull, UK Solomon started his career as a junior accountant in Accra, Ghana, before becoming a Billings Analyst for the Economist Group,

UK He became a Chartered Accountant in 2013 and was awarded a scholarship for his PhD program by the Hull University Business School, UK His research interests include securitization and financial exclusion.

Alper  Kara, PhD is a Senior Lecturer in Finance at the Loughborough University’s School of Business and Economics, UK Previously, Dr Kara worked

in various capacities at the Hull, Leicester, Robert Gordon and Bangor Universities, UK Dr Kara’s research interests and publication record cover a range of topics, including securitization, syndicated bank lending, bank gover- nance and households’ access to finance and financial exclusion Preceding his academic career, Dr Kara worked in the banking industry as a trader in the international bond and foreign exchange markets.

About the Authors

Fig 2.4 US RMBS issuances after the financial crisis (billion USD)

(Source: Authors own figure Data source is

Fig 2.5 All issues in the US and European market (billion USD)

(Source: Authors own figure Data source is

Fig 3.3 Historical US and European ABCP outstanding (billion

EUR) (Source: Authors own figure Data source is

Fig 3.4 US CDOs outstanding by purpose (billion USD)

(Source: Authors own figure Data source is

xvi List of Figures

Fig 3.5 US CDOs outstanding by type (Source: Authors own figure

Data source is http://www.sifma.org/research/statistics ) 52 Fig 4.1 US and European securitization issuances (billion USD)

(Source: Authors own figure Data source is

Fig 4.2 European securitization issuance (billion USD)

(Source: Authors own figure Data source is

Fig 4.3 European covered bond outstanding (million EUR)

(Source: European Covered Bond Fact Book 2016) 75 Fig 4.4 Covered bonds outstanding (million EUR)

(Source: European Covered Bond Fact Book 2016) 76 Fig 4.5 Number of European covered bond issuers

(Source: European Covered Bond Fact Book 2016) 78 Fig 4.6 UK securitization issuances (1985–1999) (billion USD)

(Source: Authors own figure Data source is

Fig 4.7 UK securitization issuances (1999–2016) (billion USD)

(Source: Authors own figure Data source is

Fig 4.8 Covered bond and securitization issuance – Europe

(Source: Authors own figure Data source is

http://www.sifma.org/research/statistics , European

Fig 4.9 European and US securitization outstanding (billion USD)

(Source: Authors own figure Data source is

Fig 4.10 European securitization outstanding by collateral

(Source: Authors own figure Data source is

Fig 4.11 Securitization outstanding by country of collateral

in 2016 (billion EUR) (Source: Authors own figure

Data source is http://www.sifma.org/research/statistics ) 85 Fig 4.12 European issuance (Source: Authors own figure

Data source is http://www.sifma.org/research/statistics ) 86 Fig 4.13 US issuance (billion USD) (Source: Authors own figure

Data source is http://www.sifma.org/research/statistics ) 87 Fig 4.14 European issuance by collateral (Source: Authors own figure

Data source is http://www.sifma.org/research/statistics ) 87

Fig 4.15 2016 European issuance and outstanding by region

(Source: Authors own figure Data source is

Fig 4.16 Securitization outstanding by rating (Source: Authors

own figure Data source is http://www.sifma.org/

Fig 8.1 Index of iBoxx collateralised bond spreads

(Source: Authors own figure Data source is Markit) 155 Fig 8.2 Partially funded synthetic securitization (Source:

Fig 8.3 Unfunded synthetic securitization (Source:

Table 4.1 Distinction between ABS and covered bonds 79 Table 8.1 Key initiatives to revive the securitization market 147 Table 8.2 Risk weights current and future regime 149 Table 8.3 Tranche premia for iTraxx Europe Main with

List of Tables

© The Author(s) 2017

S.Y Deku, A Kara, Securitization: Past, Present and Future,

Palgrave Macmillan Studies in Banking and Financial Institutions,

interme-to increase lending further This transformation has implications on bank performance and lending behaviour Prior to the 2007–2009 financial cri-sis, securitization was acclaimed as an innovative mechanism for economy-wide efficient risk distribution, increasing the credit supply and enhancing the resilience and stability of the financial system In contrast, the scepti-cal view was that securitization reduces banks screening and monitoring incentives, leads to retention of riskier loans, enhances risk appetite, leads

to lax lending standards and, overall, destabilizes the financial system.Securitization is considered to have been a major contributing factor

to the 2007–2009 financial crisis Post crisis empirical studies find more evidence of the negative impact of securitization on bank behaviour The activity in the securitization market came to an abrupt halt with demand drying up after ABSs values plummeted severely Investors have failed to protect themselves by being excessively reliant on credit ratings Credit ratings agencies’ methodologies were not consistent with the complexity

of these securities and prudential regulation was inadequate Today, a decade after the financial crisis, policy makers, recognizing the potential benefits of securitization to the financial system, are considering policy options to transform and revive the securitization markets

In this book, we provide an overview of the historical and recent opments in the securitization markets We aim to investigate whether and how securitization influenced bank lending behaviour and its role in the 2007–2009 financial crisis by reviewing the extant literature and the empirical evidence Authorities around the world, especially in Europe, are eager to revive the securitization market in the post-crisis period for its potential benefits to the financial system A well-functioning market for securitised assets can enhance long-term financial stability A revital-ised market is potentially beneficial to banks and non-bank issuers, bor-rowers and investors Having a better understanding of what happened

devel-in securitization markets devel-in the pre-crisis period can help to develop a robust securitization market We hope to the book will provide insights

on the ABS. The assets that underlie a securitization transaction are ated when banks extend loans to borrowers The originator bank conveys the loans to a bankruptcy remote special purpose vehicle (SPV) which

cre-1 Introduction

then issues the debt securities in the capital markets to be sold to other investors The proceeds from the issuance of the securities are then used

by the SPV to finance the purchase of loans from the originator bank ABSs are supported by credit enhancement to lower the risk of these securities for investors Forms of credit enhancement include subordina-tion, over-collateralization, letters of credit and monoline insurance In the final section of Chap 2, we look at the US and the European mar-ket, the two largest securitization markets in the world by comparing the market structure, volume, types of ABS issuance and demand, before and after the financial crisis

In Chap 3, we define different classifications of securitization tures and instruments Securitization structures are commonly classified based on the method of risk transfer or legal ownership of the underly-ing asset The chapter starts by explaining securitization structures and subsequently describes the main securitization instruments such as asset backed commercial paper, mortgage-backed securities, other asset backed securities, and collateralized debt obligations

struc-Chapter 4 looks at the history of securitization markets and regional developments Modern securitization owes its origin to the Government Sponsored Entities (GSEs) established by the US government in the 1970s to stimulate the mortgage credit markets and homeownership They sought to achieve these goals by instituting a secondary market for mortgages Although securitization originated in the US and has been used by banks since the early 1970s it became popular as a financial instrument in the early 2000s and grew swiftly both in Europe and the

US.  The securitization markets grew tremendously between 2003 and

2007 and suddenly contracted afterwards during the financial crisis This chapter covers the advent and development of securitization in the two largest securitization markets: the US and the European markets The chapter also provides details of the European covered bond market, an alternative to securitization

The transformation of banks from traditional lenders to originators and distributors of loans have had implications on bank performance and behaviour For banks, securitization provides an alternative source

of financing, improves liquidity and profitability For borrowers, it ers financing costs On the other hand, a sceptical view of securitization

is that it reduces banks screening and monitoring incentives, leads to retention of riskier loans and enhances risk appetite Securitization also has implications for the financial system The risk distribution effect of securitization is expected to make the financial system more stable and resilient However, it could also threaten financial stability and make the financial system more fragile as credit risk may be transferred to mar-ket participants who are less capable of managing this risk In Chap

5, we consider the impact of securitization on banks and the financial system by surveying the extant literature Securitization has significantly changed banks’ role of acting as intermediaries between borrowers and depositors We start by reviewing the drivers of securitization from the bank’s perspective followed by how securitization was expected to be ben-eficial to the overall financial system Subsequently, we discuss how and why securitization increases bank risk Finally, we explain how securitiza-tion may lead to financial instability at a systemic level

Securitization transactions are vulnerable to three related but distinct information problems The first of which is the classic adverse selection problem associated with the lender-borrower relationship where borrow-ers possibly have more private information about their projects than is available to lenders (originators) The intermediate information barrier materialises due to poor monitoring, where these possibly opaque loans are securitised, thereby incidentally resulting in asymmetric information between underlying borrowers and end ABS investors Finally, there are moral hazard problems between the originator of the ABS and investors

In Chap 6, we survey the literature regarding whether, and how, tors attempt to circumvent perceived information barriers by looking beyond ratings and deal characteristics

inves-The global financial crisis of 2007–2009 has drawn much attention

to securitization and its role during and in the build up to the crisis During the crisis, securitization markets collapsed after mortgage related instruments experienced severe credit quality deterioration Subsequent spill over to other types of ABS resulted in large losses Overall, the finan-cial crisis exposed lapses in the securitization process and consequently pivoted the financial markets’ scrutiny towards non-traditional financing mechanisms such as structured finance Securitization has been under scrutiny for fuelling credit growth, lowering credit standards and creating

1 Introduction

a false sense of diversification of risks – in other words, being one of the main causes of the financial crisis In Chap 7, we explore the reasons for the failure of the securitization markets and ABSs during the cri-ses by reviewing the relevant research and evidence produced after the 2007–2009 financial crisis We start by explaining why sub-prime lend-ing was the root cause of the crisis, followed by reviewing the empirical evidence showing the link between declining credit quality induced by securitization and the financial crisis The chapter continues to examine the role and failure of credit rating agencies and the inadequacy of regula-tion in preventing the build-up of risks in banks and the financial system through securitization.

The main changes in the EU securitization market since the break of the global financial crisis in 2007 are discussed in Chap 8 The financial crisis has profoundly affected the securitization market in the

out-EU. The high level of activity in the cash market observed in the early 2000s has come to a virtual standstill Nevertheless, since the crisis, some specialised segments continue to see genuine issuance to the market and therefore also material transfer of credit risk away from banks As a result, the European securitization market has been transformed from an active sector of the fixed income market towards the status of a relatively small niche market The chapter explains the regulatory changes and the evo-lution in key market segments, both from the perspective of issuance as well as market pricing

Finally, Chap 9 summarizes the main points and draws some brief conclusions

© The Author(s) 2017

S.Y Deku, A Kara, Securitization: Past, Present and Future,

Palgrave Macmillan Studies in Banking and Financial Institutions,

In practice however, securities backed by mortgages are termed mortgage backed securities (MBS) while securities backed by any other underly-ing assets are known as ABS in a narrow sense The future cash proceeds

of these underlying financial assets are then channelled to support ments to ABS investors This mechanism can be used by both financial and non-financial institutions as a funding and a risk management tool Securitization is essentially a bridge between balance sheets and capital markets

pay-In this chapter, we explain the key components of the securitization mechanism We start by defining securitization and how it has paved the way for the “originate to distribute” model We then describe the securitization process including the counterparties, the types of Special Purpose Vehicles (SPV), tranching, forms of credit enhancement, the

credit rating process and the underwriting procedure In the final tion, we look at the US and the European market, the two largest secu-ritization markets in the world by comparing the market structure, volume, types of ABS issuance and demand, before and after financial crisis.

grow-Modern securitization involves aggregating cash flow generating assets

as opposed to the sale of individual assets Securitization enables the transformation of a portfolio of financial assets (contractual debt) into marketable securities that have differing risk profiles from the original underlying assets (Saleuddin 2015) Mortgages were the traditional col-lateral used in securitizations, however, as the market evolved, a wider array of assets have been securitised The most common of which include auto loans, credit card receivables, student loans, corporate loans and negotiable financial instruments  – bonds and other debt contracts Therefore, even existing ABS could also be recursively securitised to cre-ate additional ABSs Securitizations have three distinct characteristics (Fender and Mitchell 2009)

1 Creating a pool of eligible assets either cash based or synthetically

2 Isolating the credit risk of this pool from the originators estate by transfer to a bankruptcy remote special purpose vehicle

Traditionally, loans originated by depository institutions were ily deposit funded hence a fall in deposits was likely to result in a fall in loan supply These loans were typically held until maturity or default while monitoring the borrower’s performance on behalf of depositors, and portfolio diversification was the primary risk management tool Therefore, these institutions performed both the origination and invest-

primar-ing functions This model of bankprimar-ing – known as originate-to-hold model,

was the predominant banking model prior to the 1980s

The emergence of securitization initiated a paradigm shift in the cial system Securitization allowed depository financial institutions to aggregate loans and sell interests in this pool to a wide array of investors The default risk of the underlying assets was allocated differentially into multiple tranches by subordination Subordination ensured that senior tranches were collectively insulated from losses by mezzanine and equity tranches, and mezzanine tranches were protected by equity tranches (or

finan-the first loss piece) Multiclass tranches were designed to minimise costs

while meeting the risk and maturity preferences of diverse investors Therefore, the most sophisticated and informed investors tend to invest

in the subordinated tranches with higher loss probabilities in return for higher yields to compensate for their higher risk positions The subordi-nation of tranches defines the loss distribution sequence among investors

Securitization engendered the originate-to-distribute model where

financial assets were generated credit for the purpose of securitization This model provides lenders with an alternative form of financing to moderate their reliance on retail deposit funding

From Originate-to-Hold

Securitization can be used as a vehicle to raise funds and to transfer credit risk This process involves a number of parties however the key roles are dominated by banks The main actors in a typical transaction are originator, underwriters, rating agencies, servicers, and trustees.

Servicer

Investors Borrower

Fig 2.1 The securitization process (Source: Authors own graph)

Originator

The originator (also known as the sponsor, issuer or seller) is responsible for generating the assets required for the transaction This is likely to be a bank or a specialty lender as securitization is an avenue to dispose of their assets This institution advances loans or mortgages to borrowers (obli-gors) Securitizations are typically done to isolate the credit risk of the underlying asset pool from the credit risk of the issuer In order to achieve this, the assets are sold on to a bankruptcy-remote legal entity known as

a Special Purpose Vehicle (SPV) The vehicles are established for the sole purpose of purchasing the asset pool based on certain pre-specified char-acteristics such as LTV, fixed or floating rate This sale must achieve an absolute transfer or a true sale legal opinion to guarantee that the transfer cannot be unwound if the originator becomes bankrupt Also, if done appropriately, the assets of the originator should be insulated, if the SPV

is declared insolvent Investors only have recourse to the cash flows erated by the asset pool and not the originator The SPVs balance sheet reflects the assets purchased and the liabilities issued

Servicer

Servicers are tasked with the administering the credit and collection policy as stipulated in the pooling and servicing agreements They are also responsible for the loss recoveries The servicer reports on the per-formance of the portfolio as well as the status of collections on a regular basis to the issuer Lenders tend to retain the servicing rights to the loans they originate, therefore the issuer and servicer might be the same institu-tion Despite the fee motive, some lenders would prefer to maintain their relationship with borrowers

Trustee

An independent firm, a trustee, is appointed by the issuer to represent investors The trustee has a fiduciary responsibility of administering the SPV and representing the interests of investors The main duty of the

The Securitization Process

trustee is to disburse payments to investors and to verify the mance of the asset pool based on information provided by the issuer and servicer.

Underwriter

The underwriter, typically an investment bank, is charged with analysing investor demand, structuring and marketing the issue The structuring process involves allocating the pool risks into tranches The ABS also undergoes some credit enhancement to achieve the desired rating and to increase the issue’s appeal to investors (these are explained below) Similar

to corporate bond issues, the underwriter buys the entire ABS issue at

a discount and then sells the securities to investors In order, to ensure that the issue is successful, the underwriter provides liquidity support

by acting as a broker-dealer/market maker since ABS are traded over the counter

SPV Types

There are at least three SPV structures (i) amortising (or pass through), (ii) revolving and (iii) master trust structures that are commonly used in securitization

Amortising Structures (Pass Through)

Amortising structures collect interest and principal payments from the underlying loans and in turn make principal and interest payments to noteholders via regular coupons until the security matures These struc-tures return principal to the investors throughout the life of the ABS, therefore these securities are fully amortising Thus, periodic payments

to noteholders consist of principal and interest payments These are

trived to reflect the scheduled principal and interest cash flows from the underlying assets These notes are valued based on their maturity and weighted average life The weighted average life of a security refers to how long the principal remains outstanding This weighted average life is heavily driven by prepayment assumptions and the variation in prepay-ment speeds determines the rate at which the principal is returned to noteholders

Revolving Structures

Revolving structures tend to be suitable for securitising debts with repaid relatively quickly – high prepayment speeds, such as credit card receivables, trade receivables and auto loans The interest and principal

of these debt contracts are usually paid within a relatively short period, commonly within three to four months This creates a maturity mis-match problem, as investors of ABS would prefer to hold their invest-ments for over a year This structure results in a relatively predictable repayment schedule, despite the fact the collateral is non-amortising The interest repayments are channelled to investors as coupon pay-ments while principal repayments are then used to acquire additional assets that meet specified criteria such that the collateral is a revolving pool of assets This predetermined period of replenishment is known

as the revolving period where only interest is paid to the noteholders The principal collected is used to pay off noteholders during the amor-tisation or accumulation period Thus, interest is paid over the life of the ABS and principal is repaid in the final period The principal pay-ment can be made by a series of defined, regular payments over a pre-determined period, typically within a year This is known controlled amortisation Alternatively, the principal could be trapped in fund until the expected maturity date and a lump sum payment is made to investors – soft bullet A soft bullet is so called because lump-sum pay-ment is not guaranteed on the expected maturity date In contrast, a hard bullet structure guarantees that payment is made on the expected maturity date in return for lower yields

SPV Types

Master Trusts

Master trusts are vehicles used by relatively frequent issuers in the US and UK. These structures can be used by originators to execute multiple securitizations using the same SPV. The originator transfers a very large pool of receivables to the SPV that significantly exceeds the value of ABS issued This vehicle is relatively flexible, that is, it allows the issue of sev-eral concurrent or subsequent issues from a significantly large pool of receivables The originator continuously transfers assets to this SPV and creates ABS to meet investor demand The unfunded portion of the pool (seller’s share) is typically retained by the issuer The structure decouples the payment pattern of the ABS with the payment schedule of the under-lying assets

Tranching

Tranches in securitization are equivalent to multiple classes of debt in the context of the firm Some securitization deals are structured such that tranches receive a pro rata share of principal payments despite their ranking in the structure More commonly however, most deals tend to follow a relatively strict priority of payments waterfall structure based

on sequential pay tranches Therefore principal collections are used to

retire senior notes, then mezzanine notes and finally subordinate notes

It is possible to switch from pro rata distributions to sequential ments when a credit event occurs such that senior tranches may not be repaid

pay-Tranches are delimited by attachment and detachment points Following this loss allocation mechanism, a given tranche is unaffected

by collateral losses below its attachment point The tranche, however, absorbs all losses above its attachment point but below its detachment point More importantly, the tranche is wiped out (absorbs its maximum loss) if the losses exceed the detachment point The goal of tranching is to redistribute losses of the reference pool to match the desired risk profile

of the prospective investors

Each tranche has an attachment and a detachment point These points determine the loss and default absorption rate of each tranche A tranche’s level of absolute risk depends on its attachment point (subordination) The attachment point also determines when the tranche begins to sustain losses For instance, the structure might dictate that the equity tranche absorbs the first 3% of collateral losses, the next mezzanine tranche absorbs losses in excess of 3% up to the maximum tranche size and so on (Table 2.1)

Methods of Tranching

In designing the loss priority structure, two of the common approaches are probability of default (PD) based tranching and expected loss (EL) based tranching Both methods are used iteratively to determine the attachment and detachment points required for a tranche to meet the pre-specified target (maximum) probability of default or expected loss rate The probability in this context refers to the probability that col-lateral losses will exceed the attachment point This approach essentially tries to adjust tranches to match the credit enhancement levels required

by ratings agencies to achieve the desired ratings

Alternatively, for pre-specified attachment and detachment points, a workaround is implemented to determine the probability of default or expected loss for a given tranche In this case, the issuer indicates the capital structure as well as the credit enhancement available, and the rat-ings agencies award ratings based on this capital structure and its implied credit enhancement (Das and Stein 2013) A key distinction between

Table 2.1 An example of tranching

Tranche

Attachment

point

Detachment point

Expected

Implied rating

both approaches is that the probability based (PD) method is insensitive

to tranche thickness while the expected losses (EL) approach depends

on the collateral loss distribution as well as the tranche size The target levels under both methods vary from issuer to issuer, therefore, without reference to the collateral loss distribution, it is impossible to say which method requires higher credit enhancement levels Neither approach produces more conservative tranche levels, as both are dependent on the capital structure, underlying loss distribution, and the relevant target measure The EL measure may be suitable for issuers seeking to manage economic loss while the PD approach is more suitable for issuers seeking

to avoid defaults altogether

Credit Enhancement (Credit Support)

Credit enhancement is equivalent to borrowers’ equity in conventional credit agreements For instance, the borrowers’ equity in mortgage loans are forms of credit enhancements as the borrowers’ equity sustains any losses before the lender does The difference between mortgage loan advanced and the value of the property purchased represents credit enhancement to the lender Also, the level of equity posted by a borrower

is a function of the required level of confidence Thus, credit ments are equivalent to an originator’s equity in a securitization (Kothari

enhance-2006) Consequently, the leverage of the transaction is a function of credit enhancement and the required level of credit enhancement is determined

by the target rating of the ABS. The required level of credit enhancement

is determined under close guidance from the ratings agencies

The securities undergo credit enhancement in order to boost their credit quality beyond the intrinsic quality of the underlying pool and thereby augment the credit rating as well as the attractiveness of the issue

to investors The provision of credit support is also assumed to extend security’s credit quality beyond the credit quality of the sponsor or the collateral As the credit enhancements could either be provided by the originator or the structure internally or secured externally from third par-ties (ESF 2006) The most common credit enhancements are subordina-tion and excess spread

Internal Credit Enhancement

Subordination, excess spread and over-collateralisation are mainly used

as internal credit enhancement mechanisms to support securitization transactions

Subordination

Subordination is the most common form of credit support in tization transactions This support is achieved by tranching the securi-ties according to a senior/subordinate structure – technically a form of over-collateralisation Thus, losses are allocated to junior tranches first

securi-so senior tranches are unaffected unless losses exceed the value of junior tranches Conversely, repayments are made to senior tranches first and then to junior tranches The upper classes are highly rated (low yielding) and the subordinate tranches either receive lower ratings or are unrated and pay higher yields The topmost tranche/higher rated class tends to the thickest as way of ensuring low financing costs

Excess Spread

This generally refers to the surplus cash flows from the underlying assets over payments to the bondholders, charge-offs, servicing fees, and any other trust expenses The monthly excess spread could either be retained (trapped) to offset current period losses or be paid into a reserve fund

to boost credit enhancement, where a reserve fund is a fund designed to recompense the SPV for losses arising from non-payments of the under-lying receivables This excess interest can also be used to support the most senior tranche if necessary Thus, these funds may be used to redeem the highest rated tranche(s) or to purchase additional assets to reconfigure the pool A positive excess spread is a good indicator that the SPV can cover all its costs, thus this is a proximate measure of an SPV’s profitabil-ity This is a form of credit enhancement as it serves to absorb expected as well as unexpected losses

Credit Enhancement (Credit Support)

Over-Collateralisation

The issuer could also transfer assets with nominal values in excess of the consideration paid by the SPV. Therefore, the face value of the pool exceeds the value of the ABS. This difference is transferred to a reserve fund as a cushion for delinquencies and pool losses

External Credit Enhancement

External credit enhancement mechanism includes surety bonds and third party guarantees such as letters of credit, cash collateral account and col-lateral invested amount

Surety Bonds (Insurance)

A rated third party such as a monoline insurer or the parent company

of the originator can also guarantee payments to bondholders in the event that the SPV is unable to do so The insurance company typically requires another pre-existing form of credit enhancement before insur-ing the investment grade tranches Since the insurance firm guarantees timely repayments to bondholders, the rating of the ABS typically tracks the ratings of the insurer, typically AAA

Third Party (Related Party) Guarantees

An insurance company or the parent of the issuer could also pledge to indemnify the SPV for losses incurred to a pre-specified value limit

Letter of Credit

A letter of credit, secured from a bank for a fee, ensures that a cash pledge

is available to compensate SPV is compensated for losses incurred to the limit of the required credit enhancement threshold Thus, the bank promises to make payments, up to an agreed limit, to bondholders in case the SPV lacks sufficient funds to do so

Cash Collateral Account

In this case, the SPV borrows the required credit enhancement funding and invests this cash in the highest quality short-term commercial paper This account is designed to neutralise any shortfalls in cash flows from the underlying assets Unlike the other third party credit enhancements, the cash collateral account secures cash, rather than a guarantee, therefore the ABS rating should not be dependent on the creditworthiness of the collateral account provider

Collateral Invested Amount

A collateral invested amount is funded by the sale of the subordinate or equity tranche via private placement to specific investors This class is typically tailored to the unique requirements of the investors

Internal credit enhancements could be provided by the originator or could be built into the structure A key distinction is that originator credit support tends to be pool wide while structural support is distinct to each tranche Excess spread and over-collateralisation are examples of origi-nator credit enhancements Subordination is an ideal example of struc-tural credit enhancement while insurance, surety bonds, guarantees, cash collateral account and collateral invested amount are third party credit enhancements Securitizations employing letters of credit, guarantees and surety bonds as credit enhancement devices are susceptible to third party risks, therefore, the credit rating of the ABS tends to track the credit qual-ity of the relevant third party

Retained Interest

The sponsor typically retains a residual interest or economic exposure

in the securitization as a form of internal credit enhancement Residual interests are equivalent to an equity/subordinated position in a multiclass

structure This could take the form of an equity tranche, vertical slice

Residual interests may also take the form of excess spread or nate loans to the SPV. The depth of the securitization markets is a reflec-

Retained Interest

tion of available demand for lower ranked notes In the absence of this demand, originators may be compelled to hold larger fractions of riskier notes on the balance sheet, which defeats the credit risk motivation of securitization.

The equity tranche is the first to absorb any collateral losses, thus investors only begin to incur losses when the equity tranche is wiped out The rationale of retaining the equity piece is to attenuate the asymmetry of information and align the incentives of originators and investors (Pennacchi 1988, Gorton and Pennacchi 1995) This risk retention however increases the originators’ insolvency risk The nature

of retained credit risk exposure has varying effects on the ing bank’s risk However, the first loss piece has the most significant implications for bank risk (Sarkisyan and Casu 2013) Evidently, the originators incentive to screen and monitor underlying borrowers effi-ciently is highly dependent on potential losses the investor will sustain during an economic downturn (These issues are explored further in Chaps 5 and 7)

originat-In early securitizations, originators typically retained equity tranches The form of retention and how much to retain was solely

at the discretion of the originator Over time, there was little or no evidence of retention However as the market deepened, demand for risky and equity tranches emerged Consequently, in the years lead-ing to the financial crisis, equity tranches were increasingly sold or hedged using credit derivatives thereby undermining the initial moti-vation for retention  – incentive alignment (Fender and Mitchell

2009) Also, even though the equity notes are originally retained, they could be used as collateral for further securitization – such as CMO/REMIC. Therefore, the effectiveness of this mechanism is debatable The magnitude of the originator’s exposure in a downturn will sub-stantially influence the bank’s screening/monitoring incentives Thin equity tranches may fail to align incentives while thicker tranches may increase the cost of securitization Clearly, the definition of an optimal level of exposure is elusive; however, just like the Basel I risk weights, specifying an arbitrary retention may be either inadequate or excessive Post crisis regulations now require originators/sponsors to hold and

disclose unhedged material interests in securitizations (These issues are explored further in Chap 8)

The Credit Ratings Process

The ratings agencies start by examining the management quality and administrative systems of the originator This stage typically requires col-lecting financial information, company history, ownership structure and biographies of senior executives Rating agencies also advise underwriters

on how cash flows should be structured in order to achieve the desired credit rating The ultimate rating decisions are made by a ratings com-mittee based on the evaluation of tranche specific documentation and additional information supplied by analysts The committee’s judgement

is converted to the standard alphanumeric scale indexed to the historical performance of corporate bonds

The ratings agencies assess five key aspects of securitization tions as (i) asset risks/credit risk modelling, (ii) legal and regulatory risks, (iii) structural analysis, (iv) operational and administrative risks and (v) counterparty risk (Kothari 2006; Fabozzi and Vink 2012) We explain these below

Asset Risks/Credit Risk Modelling

The first step in the ratings process typically involves assessing the credit quality of the asset pool and ascertaining the amount of credit support necessary to achieve the highest rating This is done by estimating the degree of losses to be incurred in extreme stress conditions The level of expected losses may also be estimated using historical performance of a similar asset class The asset pool to be securitised and historical perfor-mance of the originators assets are examined, subject to certain assump-tions Then the normally assumptions are tested to see how much stress can be withstood before worse case scenarios occur Consequently, the issue has to be structured such that if these scenarios do occur, investors are still repaid at maturity The ratings agencies calculate the expected losses, which are then used to derive the unexpected losses

The Credit Ratings Process

Legal and Regulatory Risks

The next step involves assessing the legal soundness of the transaction The ratings agencies evaluate the transaction to determine whether the transferred assets are insulated from the insolvency or bankruptcy risk

of other parties to the transaction The analysis assesses the bankruptcy- remoteness of the special purpose vehicle by ensuring that there are no features threatening the SPV remaining a going concern The ratings agencies then secure legal opinions on the legal and tax risks associated with the deal This phase can be quite costly as certain deals may be cross border transactions and a relatively higher degree of assurance is required

Structural Analysis

This stage involves inspecting the offering documentation and examining the cash flows using quantitative models The rationale for this step is to determine whether cash flows from the underlying assets, after consider-ing credit enhancements and transaction fees, will be adequate to make scheduled payments to the debt securities The payment priorities (sub-ordination hierarchy) and performance covenants (triggers) – which are likely to alter the payment priorities substantially if violated, are tested This stage deals with the allocation of losses amongst various classes of the ABS. Variables such as credit loss levels, delinquency levels, interest rates and corporation tax rates are introduced into the quantitative models to determine how much stress the structure can withstand under various conditions These assumptions are more restrictive for higher desired ratings

Operational and Administrative Risks

This aspect of the analysis entails determining whether the central action parties can perform their roles and responsibilities throughout the life of the deal

Counterparty Risk

The ratings agencies access the capability of third parties tasked with holding assets or making payments can influence the credit quality of the asset backed securities The creditworthiness as well as the extent of reli-ance on these parties is also taken into consideration

Underwriting and Issuance

An underwriter or placement agent advices on a cost-effective and efficient approach to structure the deal This agent facilitates designing tranches for public or private placement In order to meet investors’ desired risk profile, the issued notes are structured such that each tranche has a dis-tinct risk profile The issue is then rated by a renowned credit ratings agency The ratings are monitored over time and modified appropriately The senior tranches are less risky and hence usually rated AAA while the riskiest subordinate tranche – first loss piece – is usually the least rated

if rated at all and typically retained by the originator to mitigate moral hazard concerns from the investors’ perspective The rated issue is then brought to the market Investors rely on these credit ratings to decide whether to procure the securities Due to the legal form and financial sta-tus of the SPV, this rating is completely independent of and has no bear-ing on the quality of the originator’s assets (Choudhry 2013; ESF 2006)

A Comparison of the US and European Market

Securitization in its modern form originated from the US mortgage kets however, it has evolved into a global phenomenon The size of the

mar-US securitization market is unrivalled and the European market is the second largest At the end of 2013, the total stock of securitization out-standing was 59% of GDP compared to 11% in Europe Securitization

in both countries is mainly driven by the mortgage market Mortgage backed securities constituted 87% of outstanding volumes compared to

A Comparison of the US and European Market

62% in Europe On the supply side, the growth of European tion has been relatively limited primarily due to the institutional differ-ences between the mortgage markets of US and Europe On the demand side, investor base in the US is relatively diversified while the non-bank investor in European securitizations is practically non-existent.

securitiza-The growth in US securitization is driven by issuances by the Government Sponsored Enterprises (GSEs) (See Fig. 2.2) Approximately 85% of all MBS outstanding by year-end 2016 were issued by GSEs Private label (non-agency) issuance began in the mid-1980s but heavi-est issuance of private label securitizations occurred between 2003 and

2007 Post-crisis issuances have declined significantly, as investor fidence has waned in both markets (See Figs. 2.3 and 2.4) The losses suffered by MBSs were as a result of low quality mortgages originated

con-in the subprime US mortgage segment rather than the securitization mechanism per se as similar mortgages that were not securitised sus-tained large losses as well (These issues are further discussed in Chaps. 5

and 7)

The institutional differences between the mortgage markets in both regions explain the differences in household indebtedness and the rela-tive importance of securitization These differences include government support, mortgage contracts, and insolvency and foreclosure proce-dures (ECB 2009)

Agency MBS Non-Agency MBS Other ABS

Fig 2.2 US issuance (billion USD) (Source: Authors own figure Data source is

https://www.afme.eu/en/reports/Statistics/ )

Government Support

The Savings and Loans (S&L) crisis in the 1980s resulted in key tural changes Until the late 1970s, S&Ls funded long term mortgages primarily with short term deposits in periods of stable interest rates However, due to the deposit rate ceilings, customers withdrew funding

Manufactured Housing Resecuritization Risk Transfer Scratch & Dent

Single Family Rental Seasoned Subprime/Nonprime Other

Fig 2.3 US RMBS issuances before the financial crisis (billion USD) (Source:

Authors own figure Data source is https://www.afme.eu/en/reports/Statistics/ )

Manufactured Housing Resecuritization Risk Transfer Scratch & Dent

Single Family Rental Seasoned Subprime/Nonprime Other

Fig 2.4 US RMBS issuances after the financial crisis (billion USD) (Source: Authors

own figure Data source is https://www.afme.eu/en/reports/Statistics/ )

A Comparison of the US and European Market