Securitization

A securitization is a financial transaction in which assets are pooled and securities

representing interests in the pool are issued. An example would be a financing company that
has issued a large number of auto loans and wants to raise cash so it can issue more loans.
One solution would be to sell off its existing loans, but there isn't a liquid secondary market for
individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the
pool to investors. For the financing company, this raises capital and gets the loans off its
balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a
diversified pool of auto loans, which may be an attractive alternative to a corporate bond or
other fixed income investment. The ultimate debtors—the car owners—need not be aware of
the transaction. They continue making payments on their loans, but now those payments flow to
the new investors as opposed to the financing company.

All sorts of assets are securitized:

auto loans

student loans

mortgages

credit card receivables

lease payments

accounts receivable

corporate or sovereign debt, etc.

Assets are often called collateral.

In a typical arrangement, the owner—or "originator"—of assets sells those assets to a special
purpose vehicle (SPV). This may be a corporation, US-style trust, or some form of partnership.
It is established specifically to facilitate the securitization. It may hold the assets—collateral—on
its balance sheet or place them in a separate trust. In either case, it sells bonds to investors. It
uses the proceeds from those bond sales to pay the originator for the assets.

Cash flows from the assets—minus the servicing fees—flow through the SPV to bond holders.
In some cases, there are different classes of bonds, which participate differently in the asset
cash flows. In this case, the bonds are called tranches. If the securitization is structured as a
pass-through, there is only one class of bonds, and all investors participate proportionately in
the net cash flows from the assets.
When assets are transferred from the originator to the SPV, it is critical that this be done as a
legal sale. If the originator retained some claim on those assets, there would be a risk that
creditors of the originator might try to seize the assets in a bankruptcy proceeding. If a
securitization is correctly implemented, investors face no credit risk from the originator. They
also face no credit risk from the SPV, which serves merely as a conduit for cash flows.
Whatever cash flows the SPV receives from the collateral are passed along to investors and
whatever party is providing servicing.

Depending on the nature of the collateral, it may or may not pose credit risk. For example,
people may fail to make their credit card payments, so credit card receivables entail credit risk.
On the other hand, many mortgage-backed securities in the Uniited States have little or no
credit risk. If collateral entails credit risk, a securitization will often be structured with some sort
of credit enhancement. This may include over-collateralization, a third party guarantee, or other
enhancements. Also, by their nature, securitizations diversify the default risk of the underlying
assets.

Credit ratings are often obtained for those securitizations that entail credit risk, and most ratings
are investment grade. If a securitization has different classes of bonds, each may receive a
different credit rating. Credit ratings can be misleading for novices. The fact that a securitization
has a AAA rating doesn't mean it is risk free. It only means that the chance of a bond holder
incurring a loss attributable to default on the underlying assets is remote. Other risks, which can
affect the timing of payments, may be considerable. Also, because valuing the underlying assets
is often difficult, there is a risk that an investor will overpay for a securitization the investor is ill-
equipped to value on its own.

Standard categories of securitizations are

mortgage-backed securities (MBS), which are backed by mortgages;

asset-backed securities (ABS), which are mostly backed by consumer debt;

collateralized debt obligations (CDO), which are mostly backed by corporate bonds or other
corporate debt.
GENERAL BACKGROUND

Mortgage backed (MBS) and asset backed (ABS) securitizations, or more generally, the
securitization of financial assets (for purposes of this outline, Securitizations), is a form of
structured finance initially developed in the early 1980's in MBS format. It matured in the late
1980's in both MBS and ABS formats and is now a $400 billion industry in the U.S. alone. In
recent years, it has spread to Europe (the largest market outside the U.S.), Latin America and
Southeast Asia (primarily Japan).

Virtually all forms of debt obligations and receivables (Receivables) have been securitized in
the U.S.: residential mortgages; home equity loans; manufactured housing loans; timeshare
loans; auto, truck, RV, aircraft and boat loans and leases; credit card receivables; equipment
loans and leases; small business loans; student loans; trade receivables (just about any type,
i.e., airline tickets, telecommunications receivables, toll road receipts); lottery winnings; and
record album receivables (David Bowie and Pavarotti). Although the basic concepts, many
based upon tax and accounting effects and desired results, are essentially the same, each
asset class presents unique structuring considerations, and the players are constantly looking
for ways to improve structures to achieve higher ratings (and thus lower costs) and reduced
expenses.

BASIC STRUCTURE

In its simplest form a Securitization involves (1) the sale of a large pool of Receivables by an
entity (Originator) that creates such Receivables (or purchases the Receivables from entities
that create them) in the course of its business to a "bankruptcy-remote," special purpose entity
(SPE) in a manner that qualifies as a "true sale" (vs. a secured loan) and is intended to achieve
certain results for accounting purposes, as well as protecting the Receivables from the claims of
creditors of the Originator, and (2) the issuance and sale by the SPE (Issuer/Trust), in either a
private placement or public offering, of debt securities (Securities) that are subsequently
satisfied from the proceeds of and secured by the Receivables. When the Securitization is
"closed," funds flow from the purchasers of the Securities (Investors - usually banks, insurance
companies and pension funds) to the Issuer and from the Issuer to the Originator. All of these
transactions occur virtually simultaneously.

In the United States, the Issuer in the basic structure is normally a trust (grantor, owner or
business, depending upon the Originator's objectives and the structure), which issues Securities
consisting of notes or other forms of commercial paper (debt securities) and certificates
evidencing an undivided ownership in the Issuer (certificates of ownership). Frequently, there
is also created a residual interest in the Issuer that entitles the holder (usually the Originator) to
funds remaining after all obligations to the holders of the Securities and Certificates have been
satisfied.
The above description of the Securitization structure is very basic. Actual structures involve
many more elements and participants. The classes of assets also result in different and, in
many cases, more complex structures.

ADVANTAGES

The Securitization structure is intended to provide significant advantages to Originators, such

as:

1. The Receivables are moved "off balance sheet" and replaced by a cash equivalent (less
expenses of the Securitization), thus improving the Originator's balance sheet and resulting in
gain or loss, which itself is usually an intended, beneficial consequence.

2. The Originator does not have to wait until it receives payment of the receivables (or, in a
"future flow" securitization, until it even generates them) to obtain funds to continue its business
and generate new Receivables. In many cases this is essential, and a role otherwise filled by
more traditional methods of financing, including factoring (in some ways Securitization is a very
sophisticated form of factoring). This is more significant when the Receivables are relatively
long term, such as with real property mortgages, auto loans, student loans, etc., and not as
significant with short term Receivables, such as trade and credit card Receivables.

3. The Securities issued in the Securitization are more highly rated by participating rating
agencies (because of the isolation of the Receivables in a "bankruptcy-remote" entity), thus
reducing the cost of funds to the Originator when compare to traditional forms of financing. In
instances where the Receivables bear interest, there is usually a significant spread between the
interest paid on the Securities and the interest earned on the Receivables. Ultimately, the
Originator receives the benefit of the spread. In addition, the Originator usually acts as Servicer
and receives a fee for its services.