The Securitization Process

1 Asset-Backed Securities The Securitization Process Prof. Ian Giddy Stern School of Business New York University Asset-Backed Securities q The basic idea q What's needed? q The technique q Applications q Typical sequence Copyright 2001 Ian H. Giddy The Securitization Process3. Securitization of Assets q Securitization is the transformation of an illiquid asset into a security. q For example, a group of consumer loans can be transformed into a publically-issued debt security. q A security is tradable, and therefore more liquid than the underlying loan or receivables. Securitization of assets can lower risk, add liquidity, and improve economic efficiency. q Sometimes,assets are worth more off the balance sheet than on it.

2 Copyright 2001 Ian H. Giddy The Securitization Process4. What is the Technique for Creating Asset-Backed Securities? q A lender originates loans, such as to a homeowner or corporation. q The Securitization structure is added. The bank or firm sells or assigns certain assets, such as consumer receivables, to a special purpose vehicle. q The structure is legally insulated from management q Credit enhancement and rating agency reviews q The SPV issues debt, dividing up the benefits (and risks) among investors on a pro-rata basis Copyright 2001 Ian H. Giddy The Securitization Process5. Securitization : The Basic Structure SPONSORING. COMPANY. ACCOUNTS. receivable . SALE OR. ASSIGNMENT SPECIAL. PURPOSE. VEHICLE.

3 ISSUES. ACCOUNTS. ASSET-BACKED. receivable . CERTIFICATES. Copyright 2001 Ian H. Giddy The Securitization Process6. The Process IsIsthe thecompany company ready? ready? Are Arethe theassets assets suitable? suitable? What Whatpool? pool? What Whatlegal legal structure? structure? What Whatcredit credit enhancement? enhancement? Copyright 2001 Ian H. Giddy The Securitization Process8. Is the Company Ready for ABS? q Does the originator currently face a high cost of funding assets that would be recognized as sound, cash-generating assets if taken in isolation? q Does it have a regulatory or capital constraint that makes freeing up the balance sheet important? q Does it have data about the assets (required by rating agencies and financial guarantors)?

4 Q Does it have the servicing Process and systems that can meet the more demanding standards of the asset- backed market? q Is the originator willing to undertake a complex, time- consuming transaction to obtain a broader, potentially cheaper, ongoing source of funding? Copyright 2001 Ian H. Giddy The Securitization Process9. Are the Assets Suitable? The Pool of Assets Should Have: n Volume which is sufficiently large and homogenous to facilitate statistical analysis n A stable history of rates, defaults, delinquencies, prepayments and so forth n Sufficient diversification--for example, geographic and socio- economic-- to reduce vulnerability to economic stresses n Basic lender's credit quality standards that are capable of being evaluated and approved by rating agencies and specialized financial guaranty companies n Assets must be transferable and unencumbered In short, the assets themselves must be sufficiently strong to support a high credit rating without the backing of the originating lender.

5 Copyright 2001 Ian H. Giddy The Securitization Process11. What is the Technique for Creating Asset-Backed Securities? q A lender originates loans, such as to a homeowner or corporation. q The Securitization structure is added. The bank or IO N. firm sells or assigns certain assets, such as A T. consumer receivables, to a special purpose N T. vehicle. M E. PL E. q The structure is legally insulated from management IM. q Credit enhancement and rating agency reviews q The SPV issues debt, dividing up the benefits (and risks) among investors on a pro-rata basis Copyright 2001 Ian H. Giddy The Securitization Process12. Finance Finance Company Company Limited Limited Case Study: The Company (Finance Company Limited).

6 Q Finance company whose growth is constrained q Has pool of automobile receivables q Has track record q Plans to use this as an ongoing source of financing Copyright 2001 Ian H. Giddy The Securitization Process14. Key Decisions Securitize the assets Decisions Form of Form of transfer Form of special Form of credit Form of cash flow transformation of of asset purpose vehicle enhancement allocation cash flows Copyright 2001 Ian H. Giddy The Securitization Process15. Case Study: Initial Exchanges Finance Co.'s Customers Hire- purchase agreement Finance Co. Ltd (Seller). Copyright 2001 Ian H. Giddy The Securitization Process16. Case Study: Initial Exchanges Finance Co.'s Customers Hire- purchase agreement Proceeds Proceeds Finance Co.

7 Ltd FCL 1997-A. Investors (Seller) (Special Purpose Co.). Copyright 2001 Ian H. Giddy The Securitization Process17. Case Study: Initial Exchanges Finance Co.'s Customers Hire- purchase Servicing agreement agreement Proceeds Proceeds Finance Co. Ltd FCL 1997-A. Investors (Seller) (Special Purpose Co.). Sale of Assets Asset-Backed Securities Trustee Trust agreement Copyright 2001 Ian H. Giddy The Securitization Process18. Case Study: Initial Exchanges Finance Co.'s Rating Agency Customers Hire- purchase Top Rating Servicing agreement agreement Proceeds Proceeds Finance Co. Ltd FCL 1997-A. Investors (Seller) (Special Purpose Co.). Sale of Assets Asset-Backed Securities Trustee Trust agreement Copyright 2001 Ian H.

8 Giddy The Securitization Process19. Case Study: Ongoing Payments Finance Co.'s Customers Hire- purchase Servicing Fees Payments Monthly HP Monthly ABS. Finance Co. Ltd Payments FCL 1997-A Payments Investors (Seller) (Special Purpose Co.). Financial Guarantee Trustee Trustee Guarantee Provider Responsibilities Responsibilities Copyright 2001 Ian H. Giddy The Securitization Process20. Getting a Rating: The Risks q Credit risks q Liquidity risk q Servicer performance risk q Swap counterparty risk q Guarantor risk q Legal risks q Sovereign risk q Interest rate and currency risks q Prepayment risks Copyright 2001 Ian H. Giddy The Securitization Process21. Risk-Management Techniques in ABS. SPONSORING CREDIT.

9 CREDIT. COMPANY ENHANCEMENT. ENHANCEMENT. ACCOUNTS. receivable . SOVEREIGN. SOVEREIGN. PROTECTIONS. PROTECTIONS. SALE OR SPECIAL. ASSIGNMENT. PURPOSE. VEHICLE. INTEREST. INTERESTRATE/. RATE/. ACCOUNTS. ISSUES CURRENCY. CURRENCY. ASSET-BACKED. receivable CERTIFICATES HEDGES. HEDGES. CASH. CASHFLOW. FLOW. REALLOCATION. REALLOCATION. Copyright 2001 Ian H. Giddy The Securitization Process22. Credit Enhancement: Guarantee Method Finance Co.'s Rating Agency Customers Hire- purchase Top Rating Servicing agreement agreement Proceeds Proceeds Finance Co. Ltd FCL 1997-A. Investors (Seller) (Special Purpose Co.). Sale of Assets Asset-Backed Securities Financial Guarantee Trustee Provider Trust Guarantee (if required).

10 agreement agreement Copyright 2001 Ian H. Giddy The Securitization Process23. Credit Enhancement: Rating Agency An Alternative Approach Top Rating Senior Lower Rating Proceeds Finance Co. Ltd FCL 1997-A. Subordinated (Seller) (Special Purpose Co.). Sale of Assets No Rating More Subordinated Financial Guarantee Provider Guarantee (if required). agreement Copyright 2001 Ian H. Giddy The Securitization Process24. Asset-Backed Securities The Rating Process and Credit Enhancement Prof. Ian Giddy Stern School of Business New York University Moodys Rating Agencies nn Moodys Standard nn Standard&&Poors Poors nn Fitch Fitch Why bother with a rating? q Compare equivalent credit risks across different kinds of debt: corporate, sovereign, ABS.