BF 330 RISK

MANAGEMENT-
Securitisation
Lecture outline
• Introduction
• Securitisation process
• Benefits of securitisation
• Securitisation and the credit crunch of 2007
• Securitization the way forward
Introduction
• Securitisation is a process whereby homogenous financial
assets are packaged, underwritten, and sold in the form of
asset-backed securities.
• It is a credit risk management technique that allows banks to
transfer the credit risk of originated assets to investors in the
issued asset-backed securities.
• Securitisation markets have been expanding from the mid-
1990s:
• The U.S. market increased from $2.9 trillion in 1996 to $11.6
trillion outstanding at year-end 2007;
• The EU market reached $1.97 trillion at year-end 2007 from $7.9
billion in 1996 (SIFMA).
Intro cont’d
• It has modified the functioning of the banking markets from
the traditional “originate-to hold” model to the “originate-
to-distribute” model.
• After the extended period of growth, global securitisation
markets collapsed during the financial crisis of 2007-2009.
• The 2007-2009 crisis has revealed the potential risks in
securitisation process and underlined the importance of
understanding the risk implications of securitisation for the
originating institutions and for the banking system as a
whole.
SECURITISATION PROCESS
PARTICIPANTS AND FUNCTIONS
• A typical securitisation transaction involves the pooling of
assets that are then transferred to a special purpose vehicle
that in turn finances the purchase through the issuance of
securities backed by the pool.
• This process involves a number of participants:
• borrowers
• originator
• Servicer
• special purpose vehicle
• credit enhancer
• underwriter
• trustee and
• investors.
Participants cont’d
• BORROWER
• The originator’s debtor whose debt is transferred to the SPV.
• As the borrower is responsible for the payment on the loan
underlying the securitisation transaction, his/her credit standing
determines the ultimate performance of the asset-backed
securities.
• ORIGINATOR
• An entity that creates the assets to be securitised.
• May include commercial banks, insurance companies, airlines,
manufacturers, etc.
• SPONSOR
• The institution that initiates the securitisation process.
• Sometimes the same as the originator; sometimes an agent
earning a fee.
Participants cont’d
• SPECIAL PURPOSE VEHICLE (SPV)
• A bankruptcy-remote entity set up by the originator for the
specific purpose of the securitisation(s).
• The SPV acquires the assets and issues securities to investors.
• CREDIT ENHANCER
• A third party that provides guarantees protecting investors in the
event that cash flows from the underlying assets are insufficient
to pay the interest and principal due on the securities.
• The third-party credit support is used to improve the credit
rating and thereby the pricing and marketability of the
securities – this requires the credit enhancer to have a rating at
least as high as the rating sought for the securities.
• Third-party credit enhancement is often provided by a highly
rated bank or insurance company.
Participants cont’d
• RATING AGENCY
• Performs a critical role in the process - evaluating the credit quality
of the transaction.
• The credit rating for the asset-backed securities assigned by the
agency depends on then quality of underlying assets, the soundness
of the structure, and the extent of provided credit support.

• SERVICER
• An agent that collects regular payments on the underlying assets and
transfers the proceeds to the special purpose vehicle.
• This servicing function is typically retained by the originator for a
fixed servicing fee.
• TRUSTEE
• A third party retained for a fee to administer the trust that holds the
assets supporting asset backed securities and is primarily concerned
with preserving the rights of the investor.
Participants cont’d
• UNDERWRITER
• Responsible for advising the originator on the structure of the asset-
backed securities as well as the pricing and marketing them to investors.
• INVESTOR
• May include individual and institutional investors.
• The largest investors are typically fund managers, pension funds,
insurance companies, and commercial banks.
SECURITISATION PROCESS:
PARTICIPANTS AND FUNCTIONS
MAIN STAGES – Securitization
processs
• The structuring process includes five major stages:
1. Segregating the assets from the originator
• The originator designates the accounts’ receivables to be sold to the SPV
so that to create a portfolio whose performance is consistent with the
target quality of asset-backed securities.
• The selection criteria might include the default performance,
geographic location, maturity date, size of the credit, or age of the
account relationship.
2. Creating a special purpose vehicle and transferring the asset pool to be
securitised to the SPV
• The legal form of the SPV may be a limited partnership, a limited liability
company, a trust, or a corporation.
• Typically, the SPV is thinly capitalised; it has no independent
management or employees; the administrative functions are performed
by the trustee and the assets are serviced via a servicing arrangement.
SECURITISATION PROCESS: MAIN
STAGES
• 3. Credit enhancing the asset pool
• The SPV obtains credit enhancements in order to reduce
credit risk for investors, thereby increasing the credit rating of
asset backed securities.
• The nature and the amount of contractual credit
enhancements required to obtain a specific credit rating for
asset-backed securities are determined by the rating agency
and underwriter depending on characteristics of underlying
assets.
SECURITISATION PROCESS:
MAIN
STAGES
• 4. Issuing securities backed by the pool
• Securities are issued in tranches of different risk, duration, and
other characteristics with the senior tranche of investment
grade being supported by mezzanine tranches, which in turn
are supported by an unrated subordinated equity tranche.
• Tranching enables the SPV to split the credit risk and place it
with parties that are willing or best able to absorb it
Isuance of securities cont’d -
Tranching
MAIN STAGES - Tranching
Advantages of tranching:
• It allows to create one or more classes of securities whose rating is higher than the average
rating of the underlying collateral assets.
• The equity/first-loss tranche absorbs initial losses, followed by the mezzanine tranches.
Thus, the most senior claims are expected to be insulated - except for particularly adverse
circumstances - from default risk of the underlying asset.
• Tranching allows investors to further diversify their portfolio.
Costs of Tranching:
• Adds complexity to deals.
• With increased complexity, less sophisticated investors have a harder time understanding
the products offered and are, therefore, less able to make informed investment decisions.
• Modelling the performance of tranched transactions based on historical performance may
have led to the over-rating (by ratings agencies) and underestimation of risks (by end
investors) of asset-backed securities.

• These factors have come to light in the subprime mortgage crisis.

SECURITISATION PROCESS:
MAIN
STAGES
5. Allocating cash flows
• Includes allocation of the cash flows received from the
securitised assets among the holders of asset-backed
securities.
• Cash flows are allocated to tranches by specifying what is
known as a waterfall.
:MAIN STAGES – Cash flow
allocation (Water fall)
Risk & Return for Investors
in ABS
•BENEFITS OF SECURITISATION
BANK BALANCE SHEET BEFORE
AND
AFTER SECURITIZATION
BENEFITS OF
SECURITISATION
• Securitisation offers substantial benefits to each of the major parties in the
transaction, which explains the growth of the market over the past two decades.
• FOR ORIGINATORS:
i. Regulatory capital relief through transferring originated assets off the balance
sheet;
ii. Additional source of funding;
iii. Lower the cost of funding;
iv. Portfolio diversification through reducing firm-specific exposure, sectoral and
geographic concentrations;
v. Credit risk management through shifting the credit risk of the originated assets to
external credit enhancers and investors;
vi. Enhanced financial ratios as a result of the above and the fee income received for
continuing loan origination and the commonly retained servicing function.
BENEFITS OF
SECURITISATION
• FOR INVESTORS:
I. Access to new asset classes;
II. Higher yields compared to other financial instruments of a similar credit
quality and generally better credit risk protection by means of credit
enhancements;
• Higher yields may be offered as a compensation for a possible prepayment
risk and restricted secondary market for these securities.
III. Flexibility as the payment streams can be structured to meet an
investor’s particular requirements;
IV. No need to gain a detailed understanding of the underlying assets as a
result of structural credit enhancements and diversified asset pools.
• These features of asset-backed securities meet the requirements of
pension funds, insurance companies, and other institutional investors for
safe fixed-income securities with specific payment stream and attractive
yields and, therefore, boosted institutional investor demand.
BENEFITS OF
SECURITISATION
• FOR BORROWERS:
i. Increased credit supply as a result of lenders being able to raise
additional funding for new loans via the market;
ii. Lower borrowing expense - the funding raised by lenders via
the market typically has a lower cost which, in turn, can be
passed onto the borrowers in the form of lower interest rates;
iii. Availability of credit on terms that lenders may not have
provided had they kept the loans on their balance sheets.
SECURITISATION AND THE
CREDIT
CRUNCH OF 2007
• Securitisation played a part in the creation of the housing
bubble – the behaviour of mortgage originators was
influenced by their knowledge that mortgages would be
securitised.
• When mortgages were securitised, information about the
applicants income and other information on the application
were frequently not checked
• Why was the US govt not regulating the behaviour of
mortgage lenders?- expand home ownership
SECURITISATION AND THE
CREDIT
CRUNCH OF 2007
• Starting in 2000, mortgage originators in the U.S. relaxed their
lending standards and created large numbers of subprime first
mortgages.
• This, combined with very low interest rates, increased the
demand for real estate and prices rose.
• To continue to attract first time buyers and keep prices
increasing, they relaxed lending standards further.
• Features of the market: 100% mortgages, ARMs, teaser rates,
NINJAs, liar loans.
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
• Mortgages were packaged in financial products and sold to
investors.
• In 2007 the bubble burst → many borrowers could not afford
their payments when the teaser rates ended.
• U.S. real estate prices fell and products created from the
mortgages that were previously thought to be safe began to
be viewed as risky.
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
• Losses were magnified by increasingly illiquid markets and
worsened further with a global loss of confidence following
the failure of the investment bank Lehman Brothers in
September 2008 and subsequent signs of global recession.
• There was a “flight to quality” and credit spreads on
structured products increased to very high levels freezing
activities across global securitisation markets.
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
• The full extent of the risks embedded in structured products
and their potential impacts on the markets was not
appreciated until well into 2007.
• Since the collapse of the subprime lending market, from 2006
onwards the securitisation business has collapsed and banks
that were heavily engaged in this activity (both issuing,
underwriting, and investing in CDOs and other ABSs) suffered
major losses.
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
• As a result, the primary issuance of complex products has
almost disappeared and there has been a return to simplicity
or ‘back to basis’ in terms of the characteristics of the
securitisation products which is expected to continue in the
near future.
• Currently securitisation markets remain weak with almost no
public placement taking place and the most of new issues
being retained by banks and used as collateral in government
refinancing operations.
WHAT’S NEXT FOR
SECURITISATION?
• Improvements to the asset-backed securitisation process…
• Policy-makers acknowledge the potential benefits of
securitisation in credit risk transfer and diversification and aim
at reviving the securitisation market by introducing more
standardised and simple securitisation structures.
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
• Reforms include the credit risk retention or “skin in the game”
rule for securitisation transactions mandated by The Dodd-
Frank Wall Street Reform and Consumer Protection Act
(March 29, 2011).
• Section 941 of Dodd-Frank added a new Section 15G to the
Securities Exchange Act of 1934, which directs adoption of
rules that generally require sponsors of asset-backed
securities to retain at least 5% of the credit risk relating to the
assets that underlie such asset-backed securities (with an
exemption for “qualified residential mortgages”).
SECURITISATION AND THE
CREDIT CRUNCH OF 2007
• As a general matter, the proposed rules restrict a sponsor
from further transferring any interest or assets that it is
required to retain.
• The risk retention requirements are intended to provide
sponsors with a meaningful incentive to monitor and control
the quality of securitised assets and align the interests of the
sponsor with those of investors.
ADDITIONAL READING
• Citi Bank (2008) Does the World Need Securitisation? Yes, and Six
Actions to Restart the Market
http://www.europeansecuritisation.com/Market_Standard/121208-
Securitised%20Products-Restart%20Securitisation.pdf
• European Central Bank (2011) Recent Developments in
Securitisation
• http://www.ecb.int/pub/pub/prud/html/index.en.html
• Economist (2002) Bombe surprise: Who can understand, let alone
manage, credit risk?
• http://www.economist.com/node/976569
QUESTIONS?

• Thank you!