The Mechanics of Securitization: A Practical Guide to Structuring and Closing Asset-Backed Security Transactions

Foreword

It is regrettable that many of securitization's contributions to modern finance have been overshadowed by infamy since the financial crisis. While it has made for popular journalism to debate securitization in the abstract, there has been surprisingly little attempted commentary to actually explain what securitization is or does. Possibly, this is due to the fact that most pundits seem to underappreciate the regularity with which securitization techniques can be found in the financial system. The volume of securitized debt alone warrants more study and transparency in terms of the technology's inner workings. Thus, rather than discounting its utility, current thought leaders of finance (and certainly future students) would be best served by having better access to information around securitization's basic value proposition. Surely a more enlightened understanding would allow the debate to move beyond the rhetorical and reorient efforts toward identifying and deploying more practical uses of the technology. With that in mind, a book focused on explaining the basic mechanics of securitization is long overdue.

In its most basic form, a securitization vehicle acts as a small, single-purpose bank. As such, it plays the role of a financial intermediary between end borrowers and end investors. Where it does depart from a traditional bank, though, is in its balance sheet construct. Although it still finances itself by issuing debt and equity like a bank, its assets consist of a single, focused asset strategy. The single-purpose nature of its balance sheet is a distinct value creator for the financial system. It affords an investor the practical ability of taking exposure to a virtual bank that has a clearly defined risk mandate (financing only consumer loans, corporate loans, or real estate loans, for instance). In this regard, securitization is a uniquely powerful financial technology; it redefines the investible universe for investors and increases the options they have to diversify their portfolio risk. In the context of an overall portfolio investment strategy, the ability to take pure asset class exposure provides for better risk calibration and more flexibility for investors to shape their targeted risk-return profiles.

The aforementioned diversification benefit made available to an individual investor can be expanded into a global context. Prior to the availability of securitization, the realistic ability of a lender to diversify globally was limited by practical access to foreign markets. Though a regionally concentrated lender may want to diversify its loan book, a lack of origination infrastructure in the new market would deem it prohibitive. Given such practical constraints, the lender would be limited to only indirect methods, which would mean either purchasing a stake in a foreign lender or sourcing a loan participation. The former approach lacks asset-class risk clarity and brings risks perhaps far beyond what the lender had initially desired (as it captures the foreign banks' entire business). The latter is restrictive in that it typically only works for exposures to large corporate loans (i.e., ones that can be parsed and syndicated). The fact that it practically allows for regionally sourced risk to be diversified with clearly defined alternative asset exposure makes securitization a key lever in reducing overall global systemic risk.

For both the individual and global examples, however, one needs to be careful not to confuse risk dispersion with risk transformation: Securitization in itself does not change the risk of an underlying asset class. This has been the biggest challenge with how securitization has been falsely characterized and hence tainted in the context of the U.S. subprime mortgage market. It is incorrect to suggest, as some have, that it was the securitization technology in itself that caused the losses experienced by global investors. In the end, securitization was only the vehicle by which investors chose to take exposure to the U.S. subprime mortgage asset class. It was the flawed understanding and choice of asset class that caught out the affected participants (originators, investors, rating agencies, and regulators).

The lesson is very clear from this experience: One should not forget that securitization is only a tool. And as with all tools, users need to understand its purpose so it can be used effectively, and most importantly, appropriately.

For the skeptic, it is also important to recognize how mainstream securitization technology has become. As a start, one only needs to look at the magnitude with which central banks have utilized the technology. For instance, securitized debt (asset-backed securities, covered bonds, and so on) has been the primary source of collateral used to back the liquidity provision made to the monetary system. For that matter, the European Financial Stability Facility, established to provide financial assistance to euro area member states, is built on the back of securitization technology. Specifically, the EFSF borrows from the capital markets on the back of collateral (i.e., security) provided by a portfolio of guarantee commitments from euro area members. Interestingly, the most notable example is the German Pfandbrief market; it is believed to be the oldest securitized market and has been in operation for approximately 200 years. Perhaps ironically, the principal underlying collateral in this market is personal home mortgages, and it is still the largest source of funding for German banks to this day.

More generally though, securitization principles can be found in any circumstance where there exists a financial obligation and such obligation's creditworthiness is enhanced by the contribution of collateral. The collateral afforded can take many forms, of course (financial assets, property rights, future revenue streams). All these forms can serve as further consideration to help strengthen an outstanding general promise to repay debt. The pledging of collateral to reshape the credit risk profile for a lender is a basic fundamental principle of securitization, and examples of its use are evident throughout the fixed income landscape (municipal revenue bonds, high-yield bonds, bank loans, repurchase obligations).

One might ask, Why are the borrowers in these markets willing to pledge security against their debt? In simple terms, it is all about optimizing risk and return between different borrowers and lenders. By offering collateral, the borrower will generally benefit by getting better loan terms. Equally, the borrower will often be able to attract more willing lenders to offer the same loan (i.e., better pricing and capacity). This example should be familiar to anyone who has purchased a home with a mortgage; the smaller the size of the mortgage relative to the value of the home (the collateral in this instance), the better the mortgage terms and overall availability. I have used this simple example purposefully; it highlights how germane securitization concepts are, even in our personal lives.

I suspect practitioners of securitization would question my use of a single loan, or single secured borrowing, as the basis for framing securitization mechanics. This is not surprising, given that most industry participants assimilate securitization with the packaging of large numbers of small individual loans. If one steps back, however, and truly looks at the basics of what securitization does, it's simply a scalable version of the secured lending business. Secured borrowing is an old technology that predates the term securitization and is in itself a simple technology. In fact, it is not surprising that it is in use today, given that the concept has been used throughout history by individuals, corporations, and government borrowers alike. I suppose what is new is the fact that in today's high-tech world it can be scaled. The advent of computer technology during the tail end of the last century is what has enabled secured borrowing to be industrialized, hence warranting its own nomenclature. Without computers, it would not be easy for loan originators to efficiently aggregate and track large numbers of loans such that they could be financed or sold in bulk.

In the end, words at times attract a connotation that drifts away from their intended meaning. I would suggest the inappropriate negative connotation ascribed to securitization is misplaced in this way. Like many new technologies introduced during the industrial revolution, securitization is simply a more efficient version of an old technology. In a world where loans are generally no longer recorded in paper format nor are they decisioned in a bank branch, it is not surprising that the way they are financed should evolve as well. So, as one proceeds through the text of this worthwhile book, one should take due care to truly understand the specific workings of securitization-based financing. As mentioned previously, many of securitization's basic features are quite mainstream and are not as obscure as its name suggests.

Securitization has a genuine role to play in the global financial system and will not disappear. One needs only to reflect on experiences of other markets for context (e.g., the junk bond market of 1980s, the high-tech bubble of 1990s): These markets didn't disappear, either. And like securitization of the 2000s, each of these episodes can make the financial markets stronger, provided we take a lesson from them and act on the message.

Oldrich Masek

Managing Director

JPMorgan Chase

October 23, 2012

Preface

In 2009 The Times newspaper of London carried an interview with Paul Volcker. The former chairman of the Federal Reserve berated bankers for their failure to acknowledge a problem with personal rewards and questioned their claims for financial innovation. According to The Times, Mr. Volcker rebuked senior figures in the financial world for failing to grasp the magnitude of the financial crisis and belittled their suggested reforms. As bankers demanded that new regulation should not stifle innovation, Mr. Volcker was quoted as saying, The biggest innovation in the industry over the past 20 years has been the cash machine.

It's a pity that this impression is now fairly commonplace in business, media, and political circles. One only has to look at the mobile telephone industry, and to be aware that it was financed mainly by recourse to financial engineering techniques that included securitization, to understand that innovation in finance has often been a force for much good in the world. It is worthy of preservation, and if one was to observe a rickshaw puller on the streets of Dhaka, Bangladesh (average salary $1 per day) using a cell phone, one would indeed be convinced of this. The technology needed to make the cell phone available to a mass population worldwide required hundreds of billions of dollars in investment, and a fair proportion of these funds were raised via the securitization markets.

This book is not a general textbook on banking or finance, much less a polemic on the virtues of free markets and capitalism. It is a very focused guide aimed at practitioners in structured finance who are involved with originating, structuring, or arranging securitization transactions. Essentially it has been written to act as a checklist of necessary tasks for commercial banks that are interested in closing a securitization of assets either off their own balance sheet or on behalf of a third-party bank. These assets might be corporate loans, mortgages, credit card loans, or other more esoteric future flow cash receivables, but the essential principles that must be followed when securitizing any asset class are virtually identical, and differ only in detail. These essential principles are covered here. Much securitization activity in the immediate post-2008 era was of the in-house variety, with an objective of creating tradeable securities that could then be used as collateral when obtaining funding from their central bank. The templates in this book are of equal application to someone planning such a transaction.

Ultimately we hope this book is of most value to practitioners looking to close a securitization deal for the first time, and for whom the checklist format of this book is intended to act as a project management guide.

Organization of the Book

This book is organized into three parts.