The securitisation is one of the most important technique of the structured finance born in the past decades. Despite its first sight simplicity and linearity, it contains several critical elements. In order to understand which are the advantages and the risk of this instruments, it is essential to analyse in detail its nature and its elements. In this section a definition of securitisation will be given together with an analysis of the main character involved and their roles, followed by a paragraph dedicated to the different types of securitization, according to the active object involved. At the end, the different techniques of credit enhancement will be explained and the various contractual format will be discussed.
Definition
The securitization, in its basic format, in the financial technique where there is a transfer of the illiquid activities portfolio of the financial intermediary or a company (originator) to a purpose made company (Special Purpose Vehicle, SPV). The SPV, that is legally and economically separated from the originator, pays the activities through the issues of bonds, which are placed in the investors. The payment of the bond coupons is guaranteed by the cash flows generated from the related activities, whose cash flows are taken by the bank and then transfer to the SPV. That is the reason why the bonds issued in that way are called Asset backed security (ABS).
The following table shows the cash flows which are generated during a securitization operation.
Securitization players
The players involved in a securitization operation are several and can be grouped as follows:
Originator
Servicer
Special purpose vehicle (SPV)
Guarantor counter-party
Rating agency
Merchant bank
Other players
Originator
The originator is the company that decides to get rid of the illiquid activities on its balance sheet and give them to the SPV, collecting the equivalent from the sale. In particular, the originator is the player that give start to the whole process of securitization and that must select, inside its active side, an homogeneous pool of credits, which have the following characteristics of negotiability:
The possibility to forecast the credit risk
The attitude of producing the cash flows for the payment of the bond coupons and the repayment of the capital
The high level of standardization
On an hypothetic point of view, both the financial intermediaries and any kind of company can be an originator. However, in real and practical terms, the role of the originator is usually carried out by banks o financial intermediaries. That is due to the fact that non financial companies have alternative funding sources which are more convenient, such as the factoring. Moreover the financial intermediaries through the use of the securitisation are able to overtake some legal, fiscal and commercial obstacles due to national and international rules. However it has to be remarked that even non financial company can enjoy the securitisation (EXAMPLE).
Servicer
The servicer is the player who deals with the management of the given away asset, of the caah flows which are produced and with any kind of problems may occur. In fact it has the task to manage the flow of payments that come from the activities underlying the ABS, to transfer them to the SPV and to provide for the payment of the bond coupons and the repayment of the capital to the investors who put the money in the ABS. Moreover the servicer deals with the collection of the credits, in case of debtors insolvency.
The main activity are listed as follows:
Collect the credits and the interest payment from the debtors
Pay the coupons and repay the capital
Manage the excess of liquidity
Fix, when required, the credits interest rate
Communicate the performance of the active to the rating agencies and any other pieces of information about any other players involved in the secutitisation
Try to limit the debtors insolvencies
Look after the actives and the emission certificates of bonds
Arrange possible interventions in case of necessity
As said before the servicer may be a different entity from the originator, however, these two entities are usually the same. In fact, in the eventuality the Originator is also the Servicer, he can go on in maintaining good commercial relationships with customers, without loosing with direct communication, whose interruption could mean a lack of trust. Thus in that situation the originator receive the servicing fee, in other word the remuneration that is usually received by the servicer.
Special Purpose Vehicle (SPV)
Credit enhancer
The credit enhance has the task to guarantee pawns, in order to heighten the rating of the agency. In fact these pawns give an hand in minimizing the intrinsic ABS risks. In this way the rating assessment looks better and consequently the final investors are asked higher prices when buying them.
The role of the credit enhancer can be carried out by both the originator and a different entity. In that last case the entity is usually either a banking institution either an insurance company.
Rating agency
Merchant Bank
The merchant bank is a bank which cooperates with the originator when managing the securitization operation. Particularly, the merchant bank has the role of arranger or lead manager, or also both of them at the same time. The lead manager presides an placement unit, which has the task to place the shares to the final investors. Moreover the lead manager has to decide the breakdown of the commissions inside the unit, to write down the fact sheet and than monitory and take care of the shares in the market. Usually, the merchant bank also carries out consulting activities for the originator, dealing with legal, bookkeeping, and fiscal problems that may occur during the securitization process.
Other players
The securitization operation includes some other players not less important in the good result of the whole operation.
Some players to be kept in mind are:
The trustee, is the guarantor of the final investors rights toward the SPV
The law and fiscal offices, offer consulting services, in the legal and fiscal areas, during all the securitization process. They usually closely cooperate with the arranger and the originator.
The underwriter, is represented by financial institutions which work to guarantee that the SPV collect the money from the issue of bonds.
Assets Securitisation
In the previous paragraphs it was underlined the importance of the assets given to the SPV in the whole process of the securitisation. In fact those assets generate cash flows that are the roots for the securitisation itself. Theoretically, any kind of activities on a balance sheet could be securitised, however not all of them have some important features that allow a securitisation process. Those particular features are listed as follow:
Large and homogeneous volume, to facilitate statistical analysis
Good diversification, to reduce the vulnerability of the sold portfolio
Good financial profile
Availability of internal risk history, to measure the probability of outstanding debts
Possibility to assess the creditworthiness, using standard criteria, of the debtors
Activities legally different from the transferor capital
Moreover it is important to assess the implied warranties of the understudied asset, in other words if it is able to generates cash flows even in the eventuality of debtors’ default.
The principal categories of securitised assets are grouped in the following graph:
Asset backed Securities
Introduction
Nowaday it is not unusual that companies borrow money. One way of doing it is represented by borrowing money directly. However there is a range of alternatives. One of them is represented by the asset-backed securities (ABS).
ABS are similar to normal bonds, however they pay the lender a stream of coupons, at fixed times, whose amount is determined by the interest rate, either fixed or variable. (Franklin Allen 2008).
The asset backed securities are financial tools which are issued after securitization transactions. Securitization is a financial technique which transform activities with have deferred liquidity () in financial products which are represented by negotiable shares, through their transfer to a particular person or entity.
Further on, in an another paragraph of this chapter, a deeper definition and explanation of the securitization process will be given.
To summarize the concept of ABS, It can be said that it is created by the act of a company to spin off its balance sheet into a number of loans, which are packaged properly and then sold on the market together with the cash flows they generate. That is done through the creation of a special purpose company (SPV), whose aim is to improve liquidity. In this way the cash flows are moved from the credit market to the capital one.
This process consists of three stages:
Identification of the assets to be securitized
Transfer of the assets to the Special Purpose Vehicle
Issue and placement of the transferred assets.
The main point to be clearly understood is that ABS differ from any other type of bonds or financial instruments because of the strong correlation between the payment of coupons and the transferred credits they present in their processes. In fact the transferred credits are totally in the hands of the SPV, which is a business making of one or more transactions. The sums received are then exclusively used to pay the rights incorporated in the bonds and the securitization costs. Because of the close linkage between the interest and the capital, there are many connected risks. In particular, the repayment of an ABS may fail, partially or in whole, in the event of the failure of the securitization credits collection. In order to limit the risks, the amount of the transferred credits is usually higher than the face value of the issued bonds.
For example it is taken in consideration the case of a bank having a portfolio of various kind of loans and in need of liquidity. The bank will demobilize such credits, creating a SPV for this purpose, which will give credits and guarantees. The SPV will issue bonds with a face value lower than the guarantees and will pay the coupons with the mortgage coupons it will receive.
The main aspect of the ABS process is the division of the assets. All over the world, it has been realized in two different way: mutual funds and specialised companies.
The first type is mainly used in France (Fonds communs de créance) and in Spain (Fondos de transaction Hipotecario) for mortgage loans. The second type of players can realize the process of securitization through two distinct way: pay-through and pass-through. This distinction and a deeper explanation of the securitization process will be given in the next pages.
According the activity which requires a securitization operation, the ABS can be named differently
Mortgage Backed Securities (MBS), Collateralized Bond Oblibation (CBO), Credit Loan Obligation (CLO), Collateralized Debt Obligation (CDO), Certificates for Automobile Receveible (CAR). No further details will be given, as this will lie too much outside the point of our research.
Advantages
Firstly the process of securitization greatly improve the liquidity of the financial intermediaries involved into the process, eliminating the eventuality that the resources remain stuck into the long-term credits, as for the loans. An ABS incorporates several different credits, thus the chance of a simultaneous failure of all the debtors is really difficult, and so it is the global risk. However it has to be remarked that the payment of the coupons and the repayment of the bond value face is closely connected to the collection of the securitized credits. With an ABS the investor has a great diversification of the investment, as he has a security which represents a big credits portfolio. Usually, moreover, even in case of default of more than one debtors, the SPV can easily recover the major part of the investment. The financial institutes see the securitization as the method for a better financing and less expensive than the other methods; in fact the securitization methods uses instruments which have a high rating and low risk levels for the final investor, thus the coupons to be issued can be lower than the one issue through traditional bond.
Securitization helps financial institute in getting better their balance sheets.
Disadvantages
The only disadvantage hits the ABS subscribers, if compared to government issues of the same level of risk: liquidity is much lower. Despite the fact that the coupons are usually more generous that the equivalent issued by the States, It may be sometimes difficult for the investor to sell shares of his ABS. That is the main problem and is however often resolved with the presence of a specialist who guarantee a fixed price for the sell and buy.
Different structures of securitisation
Previously it has been shown the standard structure of a securitisation operation. However, over the years, different operating structure were born. These structures can be grouped in three main categories:
The pass-through structure
The asset-backed bond structure
The pay-through structure
These three structures mainly differ from each other for their securitised assets features and for the level of correlation between the cash flows of those assets and the payments due to the final investor.
Pass-through structure
This structure requires the originator to place the pass-through securities, which represents a pool of assets, on the market, through a special purpose vehicle in the form of a Grantor trust. Those securities are certificates representing a property right on the securitized assets and, thus, the investor are the true and lawful owners of those assets. This particular feature allows the originator to release its budget from the pool of assets sold.
Moreover it is important to underline that there is a very tight and biunique correlation between the payments from the pool and those ones from the final investors, since the cash flors of the assets are turned directly to the Trust, as the net of the servicing fee and without any modification to their structures. This means that the securities which were sold to the final investors have the same financial configuration of the pool of the transferred assets, and so there is a correlation between these two types of cash flows. However this correlation represents the main limitation of this structure, as the final investors are subject to the prepayment risk, which, other things being equal, decreases the attractiveness of the ABS on the market.
Asset-backed bond structure
The securities issued under an asset-backed bond structure do not incorporate a property right of the underlying assets, but they represent a bond of the SPV to the final investors. In that way, the securitised assets remain owned by the SPV, which can be a society of people, capital or owner trust. About the correlation between the cash flows of the underlying assets and the payments to the final investors, it is clear the independence of the two flows in terms of maturity. Since the ABS represent the SPV liabilities, the cash flows arising from the original pool can be structured in securities, whose maturities are able to meet the different needs of the final investors.
Pay-through structure
The pay-through structure can be thought as an intermediate structure between the other two previously discussed. In fact, the underlying assets remain owned by the issuing company, as in the pass-through structure, while the cash flows from the assets are related to the outflows of the ABS investors, as it happens in the asset-backed bond structure. Therefore, the final investors are no longer direct creditors of the transferred pools of assets, but the credits of the company issuing the securities.
Collateralised Debt Obbligation CDO
The collateralised debt obligation are a branch of structured ABS, whose goal is to release the performance and the maturities structure of the ABS from the features of the assigns receivables.
The date of birth of the CDO dates as far back as the 1988, and they consist in obligations arasing from the aggregation of different assets subject to credit risks, in other words private loans, derivates, bonds, mutual funds. CDOs were originally used to make liquid those assets that were not liquid at their birth. However during the Nineties this technique was studied and improved, thanks to the possibility of building operations for the originators’ needs.
As said before, the CDOs are created through the securitisation process and present similar features to ABS ones. In fact, in both the cases, the investors bear the collateral credit risk and bonds are issued in several tranches, offering different maturity times, performances and risks. If a default or an underperformance occurs, the payments for the senior tranches come before the other subordinates. Typically, the final tranche of the loan is signed by the originator itself in order to increase the rating score assigned to the operation.
However the key distinction between ABS and CDOs lies in different way of dealing with the securitised assets, while the similarities are about the interests payment (the waterfall method), the actors involved and the ability to buy coverage.
On a structural point of view, the CDOs can be divided in some different categories: balance sheet and arbitrage transactions. The following table shows those categories.
The balance sheet CDOs are securities issued against commercial and industrial loans granted by banks to borrowers with high credit ratings. Issuers do that for purely regulatory reasons: it is known that banks balance sheets must meet a minimum capital ratio set by the supervisory regulations. Each state has an own regulation, but still a securitisation transaction helps improving the capital , as the transfer of loans reduces the amount of credits in the budget. In a balance sheet CDO the originator sells a pool of loans to a special purpose vehicle, which is financed by issuing a CDO. The source to pay the holders of a CDO is represented by various payments made by the borrower: they continue to repay share capital and share interest directly to the originator, who then transfer them to the investors.
On the other hand the arbitrage CDOs are transactions whose aim is the gain from the differential between the return on the securitised portfolio and the cost thereof. Usually, this type of transaction includes the transfer of a pool of high-yield assets from the originator to a company specifically established. Thus the assets of that SPV are extremely various and this helps to create a positive differential between the coupons of the issued bond and the interests of its assets: the investors will be paid less than the cash flow arising from the titles.
In order to understand the concepts explained in that paragraph we suggest the reader to move to the appendix for a practical example.
CDOs’ five reason for global spreading:
Facilities in terms of regulatory capital, opportunity to arbitrage spreads, good for funding, transfer of risk.
