SECURITISATION

Primer and analysis of a financial technique

Andrea Durante
November 2010
Table of contents

I. What is securitisation?

I a. Definition
I b. Building blocks
II. Post 2008 - analysis of securitisation

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Definition of Securitisation

Securitisation is a process by which an economic agents assets (e.g. loans, receivables, real estate
properties) are pooled together and converted into tradable securities through a Special Purpose Vehicle
(SPV)

Originator ABS Investors

True Sale
AAA Notes
Assets ABS
AA Notes
Assets SPV
BBB Notes
Initial Price Cash
NR / Equity

The scope of a securitisation is to transfer the pure(st) credit risk linked to a collateral of assets to third party
investors.
The tradable securities are called Asset Backed Securities “ABS”

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It’s all about disintermediation

Reducing intermediation by the banking sector – favouring direct access of borrowers (economic agents with
a deficit of liquidity) to end investors (economic agents with surplus liquidity)

Disintermediation usually applied to sophisticated economic agents (sovereigns, corporations) who would
access capital markets directly via bond issuances.
Securitisation made disintermediation available to households for the debt instruments: mortgages, personal
loans.

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Originate to Distribute (OtD) Model

In the extreme version of the OtD model the banking sector is no longer involved in the process. Perfect
disintermediation occurs:

Idealized Borrower’s Idealized Banking Sector Idealized Institutional

balance sheet balance sheet Investor Community
Flow of Flow of
Funds Corporate Funds Pension
Investment Capital
Loan Funds

Real Estate

Consumption
Loans
X
Mortgages

Personal
Loans
Senior Debt

Deposits
Insurance
Cos

MM Funds

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 Illiquid to Liquid Value Chain

Financial Assets Value Chain

Sourcing Financial
“Raw Material”
from Client needs

Liquid Bonds to External Investors

Warehousing
“Raw Material” Structuring:
Households need Hedging,
mortgages, personal Tranching,
Illiquid assets from Clients

loans, car leases Purchasing the loans

via a dedicated
Enhancing Placement and
portfolio or SPV Sales
financed via short
term lines Creating the new
financial instrument
Using issuance
proceeds to refinance
warehousing facility

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I. What is securitisation?

I a. Definition
I b. Building blocks
II. Post 2008 - analysis of securitisation

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The SPV
The SPV:

Is a bankruptcy remote company specially (created ad hoc)

Is an entity structured to be legally independent from the originator, which usually continues to service
the assets

Will issue different classes of notes (ABS) in order to pay the purchase price to the originator

Is managed in the sole interest of the noteholders
What are the criteria which an SPV should satisfy to be deemed a « bankruptcy remote » vehicle by rating
agencies?

Independence of SPV directors

Limitation of the SPV’s activities in its by-laws

Bankruptcy remote shareholder (e.g. trust or “stichting”/foundation)

No employees – all services are outsourced
What is the rationale?

Protect investors against voluntary & involuntary insolvency risk
How is it achieved?

Via the relevant organisational / transaction documents

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True Sale

Strong influence of legislation in Europe: specific legislation regarding securitisation in countries with civil law
In a true sale the assets are sold and transferred to the SPV in a manner that the transaction cannot be
challenged, voided or otherwise reversed (e.g. in case of insolvency of the Originator)
What is the aim of a true sale?

There is no recourse to the originator / seller

The ABS investor benefits of the property of the asset
What makes it a true sale? Depends on specific legislation, however in general terms:

The form and treatment of the transaction

The nature and extent of the benefits transferred

The irrevocability of the transfer

The level and timing of the purchase price

Who possesses the documents

Notification when the assets are sold

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Credit Quality & Credit Enhancement

Credit quality: asset-backed securities are generally rated by one or more agencies (S&P, Fitch or Moody’s)
When analyzing the credit risk of an ABS, the rating agencies will usually examine factors such as the:

Credit quality of the underlying assets

Credit quality of the seller / servicer

Payment structure

Payment performance under severe stress
Credit enhancement occurs when a security’s credit quality is raised above that of the originators’ unsecured
debt or that of the underlying asset pool.
There are two types of credit enhancement:

Internal Credit enhancement:

Overcollateralisation

Tranching
External Credit Enhancement:

Cash reserves

Excess spread
Letters of credit

Collateral

Insurance

Financial Guarantee (Wrap)
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Cash Flow Waterfall

The cash flow waterfall:

Organises the way in which investors receive payments from the collateral pool and reflects the priority
of payments of the deal

Outstanding payments on the senior notes are paid first, and other tranches are then paid in order of
seniority
Allocation of the Cash Flows
DECREASING
SENIORITY
& CREDIT QUALITY
AAA OF THE NOTES
tranche

AA
tranche

Pool of assets A
Tranche

BBB
Tranche

Equity
Tranche

Allocation of Losses

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 Tranching

The different layers of protection for each class of

notes, enabling to slice initial BBB risk into its
Class A
different components
AAA rating
Notes
79%

Class B Notes
AA rating
10%

21% + 2.5% = 23.5%

Class C Notes
B rating
11% + 2.5% = 13.5%
11%

Cash reserve (2.5%)

+ Excess Spread (0.5%)

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What are Credit Ratings

Source: Moody’s

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Hedging

Remeber securitisation is about transferring “pure credit risk” to investors

In order to remove all other financial risks, hedging is used, via:

Currency risk hedging

Interest rate risk hedging

Basis risk hedging

Swap Counterparty exposure is mitigated via “downgrade language” forcing:

Substitution

Collateralization

BUT: EUROSAIL USD ISSUANCE DEFAULT on 16th September 2008.

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I. What is securitisation?

I a. Definition
I b. Building blocks
II. Post 2008 - analysis of securitisation

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Securitisation is good...

Securitisation was conceived a a way of reducing banking industry risks:

Diversifying industry exposure

Reducing geographical exposure

Introduction of mathematical / statistical credit scorings / ratings
To sum it up with the IMF’s words in 2006: ”the dispersion of credit risk by banks to a broader and more
diverse set of investors, rather than warehousing such risk on their balance sheets, has helped make the
banking and overall financial system more resilient.”

And it makes economic sense:

Reduces intermediation costs

Greater completeness of the market

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Securitisation is successful...

Source: IMF GFSR Oct 2009

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But then **** happens

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Did we overdo something? Excessive size....

Source: Turner Reveiw March 2009

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Excessive sophistication? CDOs...

Third Second First

securitisation securitisation securitisation

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Excessive reliance on sophisticated maths? Fat tails...

Basic assumption: the analysis of past behaviour of a

statistical variable delivers statistically robust inferences
about probability of its future movements:

“The problem we have with statistics is that although
we know something about distributions, we know very
little about processes. A process is a distribution that
has time in it, and things change with time. People
look at fat tails and say, "We can simulate distributions
with fat tails." But the reason distributions have fat tails
may be because these distributions don't have stable
properties over time.” T. Nassim (1997)

And... short observation periods are inherently procyclical

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Some initial flaws: where is the prudential regulation?

Prudential Regulation NO Prudential Regulation

Idealized Borrower’s Idealized Banking Sector Idealized Institutional

balance sheet balance sheet Investor Community
Flow of Flow of
Funds Corporate Funds Pension
Investment Capital
Loan Funds

Real Estate

Consumption
Loans
X
Mortgages

Personal
Loans
Senior Debt

Deposits
Insurance
Cos

MM Funds

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Was it really OtD or was it Originate to Arbitrage?

Securitisation can only achieve its risk reduction role if the final investor is not within the banking sector. But
looking at the figures, real money investors accounted for a small minority of final investors.

“You only find out who is swimming naked when the tide goes out” – Warren Buffet

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Excessive leverage in the financial sector?

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Other issues

Is liquidity necessarily good for all instruments?

Rating / Price triggers and procyclality

Principal / Agent problems and quality of underlying debt

Rating agency incentives

Investor transparency and comprehension

Decision makers comprehension

Bankers’ benefits

Etc

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