Asset Backed Securities and Structured Finance

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Securitization means that a company (both financial and non-financial sponsors):

Separates (pools) an identified (discrete) group of income / cash flow producing assets with similar characteristics (including similar terms, structures and credit characteristics) from its balance sheet. In most cases the assets are financial institution originated, self-liquidating loans (secured and unsecured, fixed or revolving interest rate).

Places the assets under the legal control of a separate entity known as a Special Purpose Vehicle (SPV) or an SPE (Special Purpose Entity), often referred to as the Trustee. The structure of asset-backed securities (ABS) is intended, among other things, to insulate ABS investors from the corporate credit risk of the sponsor that originated or acquired the financial assets.

Creates an interest-bearing, and principal amortizing, bond by essentially selling the combined similar assets to capital markets investors who rely upon the repayment of their principal and interest from the cash flow generated by the underlying pool of assets and the residual (salvage) or market value of the assets. The bond is also tradable.

These investors now essentially finance the assets and the company that securitized the assets off of its balance sheet receives cash in exchange with which it can invest in new assets.

The company (sponsor) may retain some contingent or indirect guarantee or recourse to the assets in the event of non-performance. The transfer of the assets from the sponsor and the rights and responsibilities of participants (Sponsor, Trustee and Servicer) is set out in a “pooling and servicing agreement”.

In offering ABS, there is generally no business or management to describe. Instead, information about the transaction structure and the characteristics and quality of the asset pool and servicing is what is most important to investors.

What is the purpose of asset securitization?

By taking the assets off the balance sheet of a financial instituion and providing them with cash, they now have capital to go out and make new loans (which they would not be able to do as quickly if the assets remained on their balance sheet until maturity).

If the financial institution also charged upfront fees and / or financing points (percentage of the principal) and sold the asset at par value (100%), above par, or below par value but higher than the addional percentage points collected, then not only have they had the principal returned but also earned income without any further credit risk exposure to the specific asset.

This financing technique takes financial assets, which in many cases themselves individually are less liquid, which are pooled and converted into instruments that may be offered and sold in the capital markets.

By securitizing assets into structures with various risk profiles and and various interest rates and repayment schedules (tranches), the risk to finance those assets can be spread across a pool of investors and a corresponding larger amount of investment capital can be obtained.

Who sponsors asset securitizations? Banks, mortgage companies, finance companies, investment banks. It allows financial institutions or finance companies the ability to avoid the necessity of having to issue on-balance sheet debt or obtain a line of credit in order to originate new receivables. Who purchases asset-backed securities? Institutional investors, including financial institutions, pension funds, insurance companies, mutual funds, hedge funds and money managers. Generally, ABS are not marketed to retail investors.

How large is the market? At the end of 2007, there were more than $7.0 trillion of both agency and non-agency mortgage-backed securities and nearly $2.5 trillion of asset-backed securities outstanding.

Asset-Backed Securities (ABS)

Asset Backed Securities (ABS) are securities (notes or bonds) that are issued with a structure that repayment is intended to be obtained from the cash flow generated by an identified, and secured / collateralized, pool of assets. Two types:

Fully-supported: repayment is supported by a financial guarantee (surety bond, letter of credit, third party guarantee or irrevocable liquidity facility). This provides both liquidity and credit protection for investors: the provider of the support has agreed to provide funds to the SPV (Special Purpose Vehicle) to repay investors without regard to the value of assets owned by the SPV.

Partially-supported: repayment primarily depends on the cash flow expected to be realized on the pool of assets, as well as liquidity and credit enhancement from third parties.

The credit enhancement / insurance providing companies are often referred to as Monoline insurers as this is their only business (they also insure other types of debt such as municipal bonds) and this sector is dominated by four companies:

AMBAC (American Municipal Bond Assurance Corporation)

MBIA (Municipal Bond Insurance Association)

FGIC (Financial Guaranty Insurance Company)

FSA (Financial Security Assurance)

The ABS market is so well developed in the United States that assets (primarily bank originated loan receivables; there are some "private label" securitizations in which a bank is not involved) are originated right into an ABS program.

The assets are of all types and are primarily loans (either secured or unsecured):

Credit Card receivables

Automobile loans

Bank loans

Boat loans

Highly-leveraged bank loans

Manufactured home loans

Recreational vehicles

Railroad rolling stock

Aircraft

Single-family residential mortgages

Single-family home equity loans (HEL)

Commercial real estate mortgages

Student loans

Vacation time shares

Some of the less standard securitizations include tobacco settlement fees, music royalties, movie revenues, mutual fund fees

By having a homogenous group of assets with similar terms, structures and credit characteristics, the proven histories of performance facilitates the modeling of future payments and thus analysis of yield and credit risks.

Securitization Process and Structure

1. Similar income producing assets (interest paying loans) are originated and identified. The assets can be originated right into a Conduit Program (in the mortgage industry it is referred to as a single-seller whole-loan mortgage warehouse conduit) managed by a financial institution, which means that there is no intention other than securitizing the loan once it is originated, and may be originated by a third party other than the lender through a conduit program sponsored by the lender. A "dry" loan is one that has been reviewed by the lender and is actually in the lender’s possession at the time the loan is acquired by the lender. A "wet" loan, which is riskier, is a loan provided to a borrower by a third party before the loan note has been received and reviewed by the lender.

2. A True Sale means that the Seller of the asset(s) no longer owns the asset on-balance sheet, and if the Seller declares bankruptcy the asset is not affected by the bankruptcy filing, and the assets are beyond the claims of creditors of the Seller. It also means that the assets can eventually be transferred to a securitization. The Seller may retain some legal recourse such as repurchasing an asset that ceases to perform within a specified date of the original sale to the SPV / SPE. A synthetic securitization means that the credit risk related to a pool of assets may be transferred but not the legal ownership of the assets as transpires in a true sale.

3. The SPV / SPE, whose only function is to purchase and securitize assets, may be set up by the financial institution that originates the assets for securitization. However, it is a bankruptcy-remote entity, which means that it is not a subsidiary of the originator nor would it be affected by a bankruptcy of the originator. Oftem the SPV has a higher credit rating (most secure a AAA rating) than the originator.

4. The financing of the receivables held in the SPV is usually accomplished by issuing short-term commercial paper to investors (through commercial paper dealers). The funding may also come from an investor(s), which provides a revolving line of credit for the purpose of purchasing loans. The amount of commercial paper issued usually matches the level of assets held by the SPV. The short-term commercial paper needs to constantly be rolled over and the pricing to and acceptance by investors reflects the performance of the underlying receivables, and the availability, performance an yield of alternative short-term investments. A Trustee, Collateral Agent, Custodian, and Depositary Agent, all separate from the SPV, operate the commercial paper program on the behalf of the holders (purchasers) of the commercial paper issued by the SPV.

The Trustee is responsible for the establishment and maintenance of accounts necessary to allocate and distribute interest payable to the commercial paper investors.

The Collateral Agent verifies that is in possession of, and segregated and secured (security interest), a fully-documented and executed loan prior to the SPV issuing commercial paper to finance the purchase of the loan, and verifies that any Borrowing Base condition (sufficient collateral in the form of cash and purchased loans exists in relation to issued commercial paper) has been satisfied. The Collateral Agent also controls the Collateral Account, which will be utilized to either purchase assets or to repay the issued commercial paper.

The Custodian has the responsibility to review loan files before they are purchased by the SPV, and then take possession of the loan documents acquired by SPV and hold them for the benefit of the Collateral Agent.

The Depository Agent is responsible for the roll over of the commercial paper on a monthly basis after verifying with the Collateral Agent that the Borrowing Base condition is satisfied.

5. The SPV performing the asset-backed securitization(s) also usually has a backup liquidity facility in place provided by a stand-by commitment from a syndicate (group) of banks. This facility protects the investors who purchase the commercial paper issued by the SPV as the assets are being purchased and pooled. If for some reason the SPV cannot attract the same or new investors to roll over the commercial paper or there is insufficient cash flow generated by the pool to pay off maturing commercial paper then the SPV draws on the backup liquidity facility to payoff the investors and the bank group then become the owners of the assets held by the SPV (to either wait for the cash flow to improve or to liquidate the portfolio).

6. Once sufficient assets have been assembled a security issued (the SPV is usually only allowed to hold assets for a specific length of time). The proceeds received from the sale of the security to the investors is used to payoff any outstanding commpercial paper issued by the SPV.

7. A Trust is created to own the assets (loans, receivables) and the assets become the Trust Property. An Owner Trustee as appointed as the trustee of the Trust, and manages the Trust on the behalf of investors by dispersing payments and reporting on the status of the underlying assets / loans. The Trustee / Trust issues Certificates (Mortgage Pass-Through Certificates or Asset-Backed Certificates) to the investors in the securitization, which is an undivided interest in the underlying assets. Rather than setting up a new trust for each securitization issued, most companies that generate assets that can be securitized use a single master trust for multiple subsequent issues. A Master Trust is set up to allow for receivables to be added to the trust over time and to issue multiple "series" of certificates identified by specific issue dates (Example: ABC Equipment Financial Receivables 2008-1) all backed by a single pool of credit card receivables in the master trust. The cash flow generated from all of the receivables in the master trust is used to fund debt service payments on each series

8. Credit enhancements are required in order to receive higher debt ratings and thus improve marketability and financing costs. Credit enhancements can be either internal or external or a combination of both. The most common external credit enhancements facilities are cash collateral accounts, collateral invested amounts, third-party letters of credit, and reserve accounts. The most common internal credit enhancements facilities are senior/subordinated certificates, excess finance charges, spread accounts and over collateralization. The NRSRO Credit Rating Agencies (Moody's, S&P, Fitch) determine the amount of credit enhancements required for specific credit ratings, the amount of the retained seller's interest, and account eligibility.

9. The credit enhancement of a securitization can also be achieved by dividing it into tranches and allowing some tranches be exposed first to any loss from defaulting / under-performing indivdual asset or group of assets first. In this manner, these front-line tranches almost function like an equity piece such that the investors in the other tranches (Mezzanine tranches) are satisfied first before the lower tranches. These lower-rated (first loss) tranches usually receive a higher yield (due to their higher risk position) when the security is first structured in order to attract investors when first brought to market.

However, in the above example the only credit support for the senior tranche(s) are the subordinated tranches. One of the key issues of the financial problems related to RMBS during 2007 through 2009 is that a proportion of private-label residential MBS were not structured with subordination levels sufficient enough to absorb the volume of delinquencies and defaults, which effectively eroded the the junior tranches at a much more rapid pace than had been modeled, and then senior, and even super-senior securities, were subject to potential downgrades and writedowns.

There is a second, alternative structure, which is the overcollateralization structure. This means that the dollar amount of the principal balance of the loan collateral exceeds the dollar amount of the notes / tranches being issued / sold to investors.

Asset-backed securitizations usually have a hierarchy / priority (set out in the “pooling and servicing agreement”) of which class of securities receives a payment first from the cash flow generated by the underlying assets and a hierarchy / priority of who receives repayment first in the event of the liquidation of the assets. This hierarchy of descending payments ("flow of funds") from senior to successive subordinated investor class is known as the "waterfall" such that those nearest to the top in the hierarchy are compensated first when assets are "liquefied":

Pay fees first to the Trustee, Servicer / Asset manager

Pay interest due to the most senior notes. If over-collateralization and interest coverage tests are not met, redeem notes until test is in compliance

Pay interest due to the next subordinated tranche. If over-collateralization and interest coverage tests are not met, redeem the most senior notes first and then this subordinated tranche until test is in compliance

Service all subordinate tranches in the hierarchy of investors in the securitization

Satisfy as many tranches according to their priority as is necessary and there are sufficient assets to continue to do so

Satisfy most subordinate equity investors if there are sufficient assets to do so

10. Surety Bonds are issued by third parties, usually a triple-A rated, mono-line insurance company. Surety bond providers guarantee the payment of interest and principal to specified investor certificate holders. The cost of this guarantee is a component of the trust expenses and is taken out of the cash flow generated by the underlying receivables (a component of the excess spread calculation).

Servicing

In addition, the assets need to "serviced" during the lifetime of the securitizaion: (depending on the asset class) the billing, collection and pass-through to investors of scheduled interest and principal payments, prepayments of principal, taxes, insurance, fees. Sometimes the originator retains the servicing of the assets and sometimes the "servicing rights" are sold to a third party, professional Servicer. The servicing is of value because the servicer is paid a fee to perform the actual function for the securitization and also collects late fees, processing fees, legal fees, etc. Secondly, servicing is very important: the interest and principal payment must correctly be allocated and distributed to the investors to retain their confidence and the individual loans of the underlying assets must be managed actively so that payments are sent as scheduled and in the amount as specified. In 2007, the role of servicing became very important such that servicers of residential mortgages had to determine how to work with subprime and adjustable rate mortgage borrowers in order to control the number of defaults and foreclosures that developed. In all asset classes, servicers are the closest to the individual borrower and are best able to monitor the account and respond quickly to any problems thus an experienced, adequately-staffed servicer is very important in the securitization market.

In 2008 / 2009 as the consensus developed to modify the terms of mortgage loans in foreclosure so the home owner could remain in the property a problem developed for the servicers. For instamce, Bank of America entered into an agreement (July 2008) with several state attorney offices to modify the terms of mortgages originated by Countrywide Financial Corp. (which Bank of America acquired). However, the modification program has been challenged by investors in the securitizations who will be forced to accept the unilateral principal reduction. In December 2008, the investors brought a lawsuit against Countrywide / Bank of America to force them to purchase, at face value, any and all loans that are planned to be modified. The counter argument is that most servicing agreements usually allow the servicer the opportunity to modify a loan in default status.

Mortgage-Backed Securities (MBS)

Please also see the separate page for the Primary Residential Mortgage Market & Underwriting Guidelines

The most well-known asset backed security market is that of the Mortgage Backed Securities (MBS) market, which includes both RMBS (Residential Mortgage Backed Securities) and CMBS (Commercial Mortgage Backed Securities; see below).

The modern MBS market can be traced to 1970 when the Government National Mortgage Association (GNMA / Ginnie Mae), a wholly owned federal government corporation, first guaranteed a pool of mortgage loans. In the United States, the performance of mortgages were anlyzed over time and it was found that U.S. home owners had certain predictable payment and duration of ownership characteristics. Thus, holding a portfolio of mortgages was like holding a debt security that had a predictable yield, maturity and default rate. By packaging enough mortgages into a pool or group, one esentailly had a single security, again with an aggregate interest rate and maturity. The Federal Home Loan Mortgage Corporation (FHLMC / Freddie Mac) issued its first mortgage-backed participation certificates in 1971. For a number of years, mortgage-backed securities were almost exclusively a product of government-sponsored entities (GSE’s), such as Freddie Mac and the Federal National Mortgage Association (FNMA / Fannie Mae), and Ginnie Mae. Immediately after this development Soloman Brothers issued the first private label MBS.

In the RMBS market, companies such as Fannie Mae and Freddie Mac purchase mortgages (individually or in groups) in the primary market from banks (savings and commercial), credit unions, insurance companies, etc., and packages the loans into MBS (which it guarantees for full and timely payment of principal and interest). Underwriting loans for the specific purpose of inclusion in a FNMA or FHLMC securitization are known as agency loans, these were also referred to as conforming loans (prime borrowers, 30-year fixed rate, 80.0% LTV, etc.). FNMA issues various types of debt instruments in the global markets to fund its purchase of mortgages prior to securitization. Mortgage loans in private securitizations or non-conforming loans are referred to as non-agency origination / non-agency issuance.

MBS are sometimes also referred to as Mortgage Pass-Through Certificates as the pro-rata share of the monthly interest, amortized principal payments (net of fees paid to to the issuer, servicer and/or guarantor of the respective security issue) and unscheduled principal pre-payments (many of the individual underlying mortgages have no prepayment penalty features that allow the mortgagee / borrower to make partial or full principal payments) generated by the underlying pool of individual residential mortgages in the securitization are "passed through" to the investors holding an undivided interest in the specific security. Due to the principal pre-payment feature repayment of principal to the holder of a pass-through security may accelerate during times of a declining interest rate environment, thus shortening the life of the security. These types of securities can also be structured in several ways, for instance just interest payments can be stripped out (IO Strip).

Each securitized pool has a Weighted Average Coupon / WAC (all of the mortgages within a specific security must be within 200 bps. of the WAC). The pass-through rate is lower than the WAC / interest rates on the underlying mortgages in the pool. FNMA provides a guarantee for its MBS for the timely payment of principal and interest to the investor, whether or not there is sufficient cash flow from the underlying group of mortgages. As some lenders continue to service the loan on the behalf of FNMA and the investor, part of the interest rate differential is used to compensate the lender for the servicing function. In addition, a portion of the interest rate ditterential is used to compensate FNMA for providing a guarantee of the security. Each security also has a Weighted Average Maturity (WAM), which indicates the average maturity in months of the underlying mortgages in the pool.

Only GNMA is authorized to issue a guarantee with the full faith and credit of the United States government for the timely payment of prinicipal and interest on mortgage-backed securities issued by institutions approved by GNMA and backed by pools of Federal Housing Administration-insured or Veterans Administration-guaranteed mortgages.

FNMA issues both fixed-rate mortgage and adjustable rate mortgage (ARM) securities.

Problems in the U.S. Residential Mortgage Market

The mortgage backed security underwriting business developed problems in 2007 related to the prior growth in sub-prime lending and many of these type of loans being bundled and sold to investors. The decline in value was related to the growth in defaults by the underlying sub-prime mortgage borrowers and the resultant decline in demand by investors for MBS of this type. Many of the MBS had been bundled into tranches of structured Collateralized Debt Obligations (CDO), which received higher credit ratings / valuation by Moody's and S&P then should have warranted considering the characteristics of the underlying borrowers. There was (and is) continued concern that these hard-to-value assets cannot accurately be marked-to-market. There are also some concern that some private hedge funds may have engaged in private, pre-arranged sales to each other of these type of securities in order to establish the price.

From 2007 and into 2010, it became evident that poor regulatory oversight had led to very poor credit origination within the U.S. residential mortgage industry (especially within the 2006 through 2008 private-label / non-agency origination securitizations), and not just within the sub-prime sector of the market. It became obvious that there were some structural problems in the securitization process. The first is between the originator and the aranger of the securitization: the originator has an information advantage over the arranger with regard to the quality of the borrower. Similarly, the arranger of the securitization has more information about the quality of the mortgage loans which creates an adverse selection problem: the arranger can securitize bad loans and keep the good ones. The widespread increase in default rates in securitizations held on the balance sheet of many commercial banks, investment funds, insurance companies, and both FNMA and FHLMC is credited with starting the financial meltdown of 2008 and the subsequent conservatorship of FNMA and FHLMC.

A present proposal in the United States and Europe as of part of financial reform in the wake of the financial problems incurred during 2008 / 2009, is that issuers of RMBS should now be required to retain a percentage ownership of an issued security (a pro-rata participation in each class) in order to align the interests of the issuer and the investor(s). However, it is unclear how to define the level of risk that the issuer should retain: how long should it extend after the origination of the mortgage, and how should it be defined in extreme real estate market downturns.

Commercial Mortgage-Backed Securities (CMBS)

Similar to residential mortgage backed securities in form and function, however the mortgages in the pool are on multi-family or commercial real estate (industrial and warehouse properties, office buildings, retail space, shopping malls, cooperative apartments, hotels, motels, nursing homes, hospitals and senior living centers). CMBS are issued in both public and private transactions and are issued in a variety of structures, including multi-class structures featuring senior and subordinated classes. The underlying mortgage loans of the securitization tend to lack standardized terms with regard to rate (fixed and floating), term, amortization and some properties also have comply with certain environmental laws and regulations.

Collateralized Mortgage Obligation (CMO)

A Collateralized Mortgage Obligation (CMO) is a security (debt instrument) that is collateralized by either a pool of whole / individual residential mortgages or pass-through mortgage-backed securities (whose underlying assets are also residential mortgages).

The underlying pools of mortgages of the CMO can consist of both conforming and non-conforming residential mortgages; and can can also be agency (guaranteed or issued by GNMA, FNMA, FHLMC) mortgages or certificate securities (Agency CMO) or private label securities (issued by financial institutions; Non-Agency CMO). Agency CMOs have a lower credit risk due to the government guarantee of the underlying residential mortgages.

This CMO is a special purpose entity (SPE) that owns the underlying whole loans or MBS securities, which is then divided into various securities (bonds) / tranches (classes) of payment streams with varying maturities and payment priority (seniority). The higher the seniority of the tranche the higher the credit rating of the tranche as it receives any scheduled repayment or unscheduled prepayment of principal first. However, the higher rated tranches earn the lowest interest rate return to investors. Thus, the AAA-rated tranche receives its principal repayment before the AA-rated, A-rated or BBB-rated tranche(s) or classes. The AAA-rated tranche may have an average duration of 3 years; the AA-rated tranche may have an average duration of 5 years; the A-rated Tranche may have an average duration of 7 years; and so on (this is often referred to as a sequential payment CMO).

The lower-rated tranches must absorb any loss prior to the higher rated tranches. However, the lower-rated tranches receive the highest interest rate payment due to the higher risk exposure.

In addition, some tranches are purposefully structured to payoff principal more rapidly than other tranches. However, conversely, tranches can also be structured to pay principal on a defined schedule during a low interest rate environment (when prepayments increase as mortgagors refinance to a lower interest rate) as long as prepayments remained within a pre-defined range.

The division of the security in the various tranches increases the different types of investor profiles than a single security could be marketed to (which is the reason why the CMO was created so that prepayment risk could be controlled and marketed to various types of investors). The division can also eliminate prepayment risk from some investor classes. The common CMO structures are: Interest Only, Principal Only, Floater, Inverse Floater, Planned Amortization Class (PAC), Support (to a PAC CMO), Scheduled, Sequential, Targeted Amortization Class (TAC), and Z or Accrual Bond. Unfortunately, due to the uniqueness of many of the multi-class (tranches) CMOs they are less liquid.

Stripped Mortgage-Backed Securities (SMBS)

In an SMBS the interest and principal payments from a standard FNMA MBS are "stripped" out of the original security to create two new classes of security. One class of security receives the interest only (IO strip) and one class receives the principal only (PO strip). While they are exclusive of each other they can still be recombined if necessary at a later date. The pricing on either stripped security is usally at a discount from the par value of the underlying MBS. In a declining interest rate environment when the prepayment of residential mortgages acelerates as home owners refinance to lower rates, the PO strips also experience acelerated principal prepayment which increases the yield of the PO strip discounted security. However, in a declining interest rate environment, the IO strip receives less cash due to less outstanding principal balances on which to clculate interest, thus the yield actually declines on the IO strip.

In a rising interest rate environment, with lower volumes of prepayment of principal, the IO strip yield performs as expected or has an improved yield as there is sufficient prinicipal and maturity of the underlying mortgages to sustain the interest payments (however, the yield may not be as attractive as newly issued MBS with WAC that reflect the recent increase in mortgage interest rates).

REMIC (Real Estate Mortgage Investment Conduit)

A REMIC is a multi-class, investment grade mortgage-backed security created by Fannie Mae, Ginnie Mae, Freddie Mac and other entities. The monthly cashflow from the underlying mortgages are allocated to various tranches, resulting in each tranche having a separate and different maturity, coupon and payment priority compared to the other tranches in the security. The REMIC is not subject to income tax (except on net income from prohibited transactions, net income from foreclosure property, and contributions made after the startup day). In addition, REMICs also produce a residual of paper gains and losses in value ("phantom income" and "phantom loss"). Holders of the REMIC investment are required to pay tax on the phantom income however they actually never receive any actual cash. Phantom losses can by utilized to offset gains from other investments. Thus, investors in REMICs must pay other qualified entities to purchase the residual and the tax liability it generates (pension plans and non-U.S. individuals are barred from owning a residual).

REMICs are governed by sections 860A through 860G of the Internal Revenue Code (IRC).

Real Estate Synthetic Investment Securities (RESI)

A RESI is a security collateralized by a pool of mortgages like many mortgage-backed securities. However, unlike other MBS, a RESI passes along any loss incurred from an underlying mortgage to an investor. Thus, if a property ever goes into foreclosure and there is insufficient value received from the sale of the property to satisfy the outstanding mortgage principal and accrued interest, then that loss is passed on to the investor. The security is divided into several tranches with the lowest rated tranche incurring the first losses and then each successively rated tranche incurring the next losses if the first tranche is liquidated by accumulated losses. In exchange, the lowest rated tranche receives a very high market interest rate in the form of a margin over LIBOR.

Collateralized Bond Obligation (CBO)

CBO (Collateralized Bond Obligations) are securitized pools of high-yielding bonds and leveraged loans, whose purchase is financed by debt.

The issuer, normally a bankruptcy-remote special purpose vehicle (SPV), buys a pool of assets (public bonds) which it then uses to collateralize a series of securities.

By subordinating or ranking each series or tranche in terms of seniority, the issuer effectively protects the most senior tranches against potential losses by forcing the junior classes to accept the risk of first loss.

The bottom tranche rarely carries a coupon or attracts a rating thus it function similar to equity.

To obtain a Triple-A rating, the senior securities must typically be over collateralized one-and-a-half times.

Thus, $500 million in assets assembled, no more than $330 million in senior securities ($500 million divided by 1.5), and would have to place $170 million in junior subordinated securities to close the transaction.

Collateralized Loan Obligation (CLO)

CLO (Collateralized Loan Obligations) allows a bank/issuer to bundle low-margin corporate loans into a new type of bond sold in the ABS market.

To the purchaser they offer higher yields than typical credit card and auto loan ABS.

However, purchasers take on new types of downgrade and default risks, combined with the novelty of the CLO may make it difficult to trade.

Sometimes it is not evident what corporate credits the CLO wrapper is hiding: the pooled loans meet only certain criteria of the rating agencies. In some issues the loans are not fully isolated from the bank such that if the bank's debt rating were to be downgraded, so would the rating on the CLO itself.

For the banks, selling a CLO frees up capital tied up in low margin loans (the bank must set aside capital even for blue-chip issuers, however, it cannot charge a higher interest rate due to the low default profile for the blue-chip corporations. Banks that have securitized their loan portfolios can lower their overall regulatory capital requirement.

The collateral in a CLO consists of investment grade and non-investment grade corporate loans, with several tranches of rated securities issued based on the prioritization of cash flows, with the most subordinate tranche (or an equity tranche retained by the bank) absorbing the first launches from default. The most senior tranche holds the lowest credit risk and receives the higher rating compared to the other tranches.

Credit enhancement is provided by the prioritization of cash flows, cash reserve accounts, letters of credit or guarantees.

Ratings are also based on historical default and recovery information for underlying assets, industry and obligor diversity, minimum interest coverage ratios, minimum collateral ratings tests and hedging transactions (to hedge against currency and/or interest rate related risk).

The structure is that the bank assigns the loans to a Seller/Servicer/Asset Manager; who in turn sells the loans to the Issuer Trust (a bankruptcy remote special purpose vehicle that is limited to the acquisition and managment of the collateral and the issuance of ABS); the Trust issues ABS to invesotrs and uses the proceeds to purchase the loans; a Trustee protects investor's security in the collateral; the bank may act (or a third party) as a swap counter-party for currency/interest rate hedging.

If the transfer of the loan is done by participation without the knowledge of the Obligor, then the default of the originating bank could result in the Trust being the unsecured creditor of the bank/seller without recourse to the Obligor.

Assignments represent a more complete transfer.

CLN (Credit Linked Note) are debt instruments backed by the full credit of the selling institution but whose performance is based on the reference loan(s).

Synthetic CLO

In a synthetic CLO The assets remain on the balance sheet of the sponsor. Instead, the credit risk of the collateral pool of loans is transferred to the SPV by means of a credit derivative (portfolio default swap).

Collateralized Debt Obligation (CDO)

Standard & Poor's CDO credit actions:   www2.standardandpoors.com/spf/xls/media/Cash_Hybrid_CDO_Actions.xls   (.xls file)

Refers to multi-class structures containing diversified, investment-grade bonds, loans and ABS securitizations, or all or portions of CMOs, CBOs and CLOs, held by an SPV or an SIV (Structured Investment Vehicle) or an SPE (Special Purpose Entity). The SPV or SIV can divide a portfolio of securities into various tranches with various maturities, interest rates, seniority, credit enhancement and external credit rating in order to market the securitixation to several investor profiles.

Individual loans or debt issues are bundled into a single security. Groups of securities are then bundled into a CDO. There is usually a separate Collateral Manager who manages the CDO assets and is paid an asset management fee. The CDO usually have different tranches representing risk (one group of investors absorbs the first losses) and retrun (the lower risk tranche receives a lower interest rate). The highest credit rated tranches are Super Senior / Senior (rated AAA), followed by Mezzanine (rated AA to BB) and the lowest rated tranches are often referred to as the Equity level (which are unrated and incur the first losses but receive the highest interest rate). Portions of the CDO can also be placed into a new CDO with its own specific structure. The structure may include the lower rated tranches of the first CDO that are then structured in a new CDO with a higher credit rating although the undelying securities / CDO are still the BBB to B rated tranches. When a CDO is created from other CDOs it is referred to as CDO² or CDO-Squared, and taken even one step further they are referred to as CDO³ or CDO-Cubed.

In 2007, CDOs consisting of subprime U.S. residential mortgage-backed securities caused a serious problem within the banking and financial markets when it was determined that the stress modeling conducted by the credit rating agencies in analyzing these securities did not really equate the actual performance of these assets. The number of defaulted real estate loans in the subprime market was so numerous that even the super senior tranches of CDOs (senior-most positions of the capital structure) were of doubtful value. This led to a substantial revision (downgrade) of the credit ratings that Moody's and S&P had originally assigned to these assets.

The rapid deterioration of these assets and the credit downgrades resulted in a situation where investors were not willing to purchase the Commercial Paper of the SIVs because it was unclear whether there would be further deterioration in the subprime residential mortgage market. In addition, it also became known in the marketplace that some of the more complex CDOs and/or subprime MBS could not adequately or accurately be valued, and that some valuations had actually been conducted by the owner/manager of the CDO (Level 3 securities) or had been established through a coordinated, non-arms length sale. Thus, there was an extreme lack of liquidity in the Asset-Backed Commercial Paper (ABCP) market and a resulting slowdown of the Commercial Paper market for SIV-issued CP, which placed significant pressure on the ability of all SIVs to refinance maturing Commercial Paper regardless of what assets they were holding.

Why weren't even the super senior tranches of U.S. residential mortgage-backed securities CDOs regarded safe? Some of these super senior tranches are not subject to valuation based on observable market transactions. Accordingly, fair value of these super senior exposures was based on estimates about, among other things, future housing prices to predict estimated cash flows, which are then discounted to a present value. The rating agency downgrades and market developments referred to above have led to changes in the appropriate discount rates applicable to these super senior tranches, which have resulted in significant declines in the estimates of the fair value of the super senior tranches.

In November 2007, the Trustees of Carina CDO Ltd., indicated that they would liquidate the assets of the CDO. The Triple-A ratings of senior Tranche, Tranche A-1, were downgraded by S&P to junk bond status. It is anticipated that the sale of the CDO's assets may provide the market with an indication of where distressed asset values may be.

An Arbitrage CDO is an investment vehicle designed to take advantage of the difference between the yield on a portfolio of selected assets and the cost of funding the CDO through the sale of notes to investors. Arbitrage CDOs are classified as either “cash flow” CDOs, in which the vehicle passes on cash flows from a relatively static pool of assets, or “market value” CDOs, where the pool of assets is actively managed by a third party.

In a Synthetic CDO, the entity enters into derivative transactions which provide a return similar to a cash instrument to the entity, rather than the entity’s actually purchasing the cash instrument. Typically these instruments diversify investors’ risk to a pool of assets as compared with investments in individual assets.

A Constant Proportion Debt Obligation (CPDO) utilizes a cash account as collateral for issuing credit default swaps. In October 2007, a specific CPDO, the UBS Tyger Series 103 notes, which had issued credit default swaps on financial institutions (banks and insurance companies) experienced a 10% decline in value (when index spreads increased) and a substantial downgrade from the ratings agencies. On November 13, 2007, Moody’s placed eight additional CPDOs under review for possible downgrade due to continuing spread widening in the "financials" sector.

FASIT (Financial Asset Securitization Investment Trust)

A FASIT is a tax structure established by U.S. Legislation for the purpose of attracting investment business to the United States and away from offshore tax havens. As long as a FASIT has a particular capital structure and adheres to certain investment regulations, then the FASIT can accumulate and distribute its gross earnings without incurring U.S. taxation. CDOs may be issued in the form of "regular interests" in a FASIT. For information on FASITs, see sections 860H through 860L of the Internal Revenue Code (IRC).

Special Purpose Vehicle (SPV) Structure

SPV: Special Purpose vehicle; a bankruptcy remote corporation that issues rated securities/commercial paper and uses the proceeds to purchase assets (usually trade and term receivables) from a seller (in a single seller program) or multiple sellers (in a multi-seller program). The bankruptcy remote aspect is important as this way the SPV is not caught up in any problems or failings of the parent organization and the receivables in the securitization pool cannot be claimed by creditors of the parent.

Multi-seller programs are typically established by a bank known as a sponsor. The entities who sell assets to the SPV are often customers of the sponsoring bank. Because the SPV really does not have any active or functional employees, the bank is usually engaged as "administrator" of the SPV to perform all of its operational functions.

For a single seller program, the SPV purchases assets from one seller. The seller often takes on the role of administrator/servicer for the SPV (similar to the bank in the multi-seller). Although the SPV is established for the benefit of the single seller, it is maintained as a separate entity.

The SPV issuer of notes backed by the receivables is usually known as the Owner Trust.

The notes are issued subject to an indenture between the Owner Trust and in many instances, the asset may be held by a third party, bankruptcy remote special purpose corporation solely for the purpose of managing, leasing or servicing the assets.

The Owner Trust still maintains an interest in the underlying collateral by exchanging the proceeds from the CP issuance to the third party and receiving funding notes or certificates (with a specified beneficial interest in certain specified collateral designated for the securitization) from the third party entity.

The Owner Trust issues CP or medium term notes to investors backed by its own assets which include the securitization entity's certificates or notes of beneficial interest in the asset.

Issuance of the Commercial Paper will be backed up by a Liquidity Facility made up of banks that are committed to paying off maturing commercial paper, and perhaps, a credit derivative structure that protects investors, and/or a Credit Facility such as a Letter of Credit Facility that would provide additional over-collateralization of the assets.

Over-collateralization is based on the historical performance/default rate, and/or the estimated residual value of the asset.

The scheduled payment stream from the asset is passed through to a collateral account which is then used to pay-off maturing commercial paper/medium term notes.

When a company pledges away its income to asset-backed investors, it effectively places corporate bondholders in a second position claim on the assets of the company / financial institution. If the company goes bankrupt, then the corporate bond holders would not be allowed to go after the assets previously promised to the asset-backed trust, at least not until the asset-backed investors were paid off.

Gain on sale accounting: earnings are only as good as the company's assumptions on performance of each securitization. If the pool of loans does not perform as well then the company has overstated its earnings.

The triple-A rating that the ratings agencies confer upon these deals is based on various types of credit enhancement built in that make loss of principal highly unlikely. But the triple-A ratings do not address the risk that high losses within the securitized trust will force the deal to pay off early leaving bondholder's with reinvestment risk. Nor does the initial rating suggest how the bond may perform in the secondary market.

Deposit Trust: conveys a participation interest to the owner trust, which then issues notes and certificates to investors.

QSPE (Qualified Special Purpose Entity)

A QPSE is described in FASB Statement of Standards No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", which includes conditions to limit the permissible activities of the QSPE, what the QSPE can hold, and when the QSPE can sell or dispose of non cash financial assets.
72.3.243.42/st/summary/stsum140.shtml

SIV (Structured Investment Vehicle)

SIV (Structured Investment Vehicle) are credit arbitrage vehicles: the SIV borrows in the lower interest rate short-term, commercial paper market to fund the purchase of higher interest rate, long-term assets. They issue debt in the U.S. and Euro medium-term note and commercial paper markets, and with the proceeds, purchase assets of varying maturities. These assets consist of traditional classes of debt, ABS, and CDOs. Derivatives transactions are used to eliminate both interest-rate and foreign-exchange risk. Since the SIVs are funding at the inexpensive AAA levels (commercial paper, junior notes and medium-term notes) but can purchase securities/assets at varying investment-grade rating levels, they can pick up credit spread over the life of that asset. Some SIVs are bank sponsored and some are privately sponsored. In either case, the SIV and its assets are usually off the balance sheet of the sponsor. However, during 2007 and 2008, when there was the disruption in the short-term commercial paper market, many SIVs could not roll over their debt. The situation forced several large, international financial institutions to announce that they would place some, if not all, of their sponsored SIVs back on balance sheet of the financial institution and provide them with additional funding in order to restore investor confidence. Thus, the financial institutions had to set aside additional capital for taking the assets back onto the balance sheet at the same time they were experiencing a liquidity problem.

SIVs include:

III Offshore Advisors (Abacas Investments)
AIG (Nightingale Finance)
Axon Financial (Axon)
Bank of Montreal (Links Finance, Parkland Finance)
Cheyne Capital (Cheyne Finance)
Citigroup (Beta Finance, Centauri, Dorada, Five Finance, Sedna Finance, Zela, Vetra)
Dresdner Kleinwort Wasserstein (K2 Corp)
Eaton Vance (EV Variable Leveraged Fund)
Eiger Capital (Orion Finance)
Gordian Knot (Sigma Finance, Theta Finance)
HSBC (Asscher Finance, Ltd., Cullinan Finance, Ltd.)
HSH Nordbank (Carrera Capital Finance)
IKB KG (Rhinebridge)
IXIS/Ontario Teachers (Cortland Capital)
MBIA (Hudson-Thames Capital)
Rabobank International (Tango Finance, in association with Citigroup)
Societe Generale (Premier Asset Collateralized Entity / PACE)
Standard Chartered Bank (White Pine Corp., Whistlejacket Capital)
Stanfield Global Strategies (Stanfield Victoria Finance)
West LB (Harrier Finance Funding Ltd., Kestrel Funding PLC and Kestrel Funding US LLC in association with Brightwater Capital Management)

SNAP (Structured Note Asset Packaging)

SNAP (Structured Note Asset Packaging) are repackaged notes, which includes a trust structure that allows it to ring-fence a pool of underlying assets into separate new issues.

Credit Card Receivables

The discussion covers the receivables securitization of the credit card industry. To see the operational side of credit card issuance and usage please see the Cash / eCash Page. To see the consumer side of credit card issuance and usage please see the Consumer Banking Products Page.

With regard to credit cards, the issuer sells receivables (not the actual accounts) to a trust while retaining an interest in a portion of the pool. Certificates representing the vast majority of the pool, usually 80% to 90%, are then sold to investors as asset-backed securities (ABS).

Credit card debt is unsecured. If the borrower defaults then the bank has no opportunity for recovery from the sale of an asset or collateral. A bank can pursue legal claims against the borrower but it is expensive, time consuming and unclear how much can be collected (as of 2005, credit card debt cannot be entirely discharged in a personal bankruptcy filing). If enough credit card holders defaulted within a given pool of receivables in a securitization, and the reserve account and/or over-collateralization was exhausted, then an investor could incur a loss.

In addition to credit risk posed by individual borrowers, credit risk also exists in the overall credit card portfolio. Relaxed underwriting standards, aggressive solicitation programs, inadequate account management, as well as a deterioration of general economic conditions, can increase credit risk. Changes in product mix, and the degree to which the portfolio has concentrations, geographic or otherwise, can also impact a portfolio’s risk profile. The portfolio has to be analyzed in terms of portfolio performance (percentage of non-performing receivables in relation to the total portfolio), profitability, and customer profiles by business lines, products, and markets. One must also consider changes in underwriting standards, account acquisition channels, credit scoring systems, and marketing plans. Some securitizations are structured such that the failure to adequately underwrite or collect loans also may trigger early amortization of the securitization.

Poorly underwritten or performing receivables can affect a bank’s reputation as an underwriter of credit card securitizations. This creates a risk that future credit enhancements for securitizing credit card receivables may be available at an increased cost or not available at all. Future accessibility to financial markets may be limited or cost more.

Automobile / Motor Vehicle Receivables

In the United States, motor vehicle / automobile loans and leases are an important and active asset class that is securitized, and motor vehicle receivables are purchased by commercial paper conduits on a steady basis and there are a number of originators that have sponsored several receivable securitizations.

The automobile receivables can be loan contracts with both "Prime" ("A" Borrowers) and "Sub-prime" ("B & C" Borrowers) borrowers.

The Sponsor can also be the Servicer of the contracts.

The Prospectus may over several classes of Notes to investors and include subordinated notes that are privately placed with institutional investors.

The pool of automobile loan contracts will be secured individually by a corresponding motor vehicle and related property, such as insurance policies (covering collision and damage, loss, theft). The make-up of the contracts and corresponding vehicle may be mixed: new vehicles, used vehicles, light duty trucks and vans (but all are non-commercial passenger vehicles).

Credit enhancement may be in the form of:

excess collected cash flow

overcollateralization in the form of an excess amount of loan contracts over the aggregate principal amount of the notes

the subordination of each class of note to those senior to it (including any subordinate private placement)

a reserve account (established with an initial deposit at the securitization and increased by the excess cash flow) that can be drawn upon to insure the timely payment of interest and principal.

The portfolio of underlying receivables can be diversified across several states however, most securitizations have some sort of receivables concentration from Texas, New York, New Jersey, Florida and California as these are the states with the largest level of residents with automobiles on the road.

Student Loans

Student loans for higher education purposes at the 2-year college, 4-year college, gradute degree programs and trade schools are securitized in the United States. In the past 10 years, approximately $350 billion in student loans have been securitized. The student loan market has its own unique characteristics:

Originally, student loans made under the Federal Family Education Loan Program (FFELP) were guaranteed up to 98.0% of the outstanding principal by a guarantee agency reinsured by the Department of Education. As a result, if the borrower under a student loan were to default then the issuer of a student loan-backed security would only experience a loss of 2.0% of the outstanding principal and accrued interest on the defaulted loan. However, under the terms of the Higher Education Reconciliation Act of 2005 (signed into law February 8, 2006), the guarantee was reduced to 97.0% for all student loans first disbursed on or after July 1, 2006. The issuer has no right to pursue the borrower for the remaining 3.0% unguaranteed portion of the defaulted student loan. (If the issuer suffers a loss of the 3.0% of the outstanding principal balance of an individual loan as the result of a default, and the amounts in either a capitalized interest fund or reserve fund were insufficient to cover the loss then the investor in the securitization would either suffer a delay in payment or loss on the investment).

The Student Loan Marketing Association (SLMA or Sallie Mae), was the only Government Sponsored Enterprise (GSE) that purchased these loans from financial institutions and specialized lending programs, and then securitized a pool of student loans that are in turn sold to investors. SLMA also guaranteed individual issued securitizations (although many of the loans securitized already had a FFELP / Federal Guaranteed Student Loan Program federal government guarantee).

In September 2006, the SLMA terminated its GSE designation and became a privatized concern. The successor entity is SLM Corp., continues to use the Sallie Mae name. All existing securitizations funded by debt incurred by SLMA (a AAA rated entity) had to be refinanced as part of the privatization completion, as the successor entity, SLM Corp. is only a single-A+ rated issuer. In 2007, SLM Corp., was set to be acquired by a private investor group. However, after problems in the ABS market for all assets, increasing defaults in the student loan securitizations, a $344 million loss in the third quarter of 2007 and legislation that revised student loan lending procedures, the investor group claimed that a "material adverse effect" had occurred and terminated the offer.

Some of the largest originators of student loans include: Astrive Student Loans, Bank of America, Citigroup, Inc., College Loan Corp., Comerica Bank, Discover Financial Services, Fifth Third Bank, GCO Education Loan Funding Corp., JP Morgan Chase, Key Bank, National Education, Nelnet Inc., NorthStar Capital Markets Services, Inc., SLM Corp. / Nellie Mae, Student Loan Network, SunTrust Bank, Wells Fargo, Wachovia.

Some of the largest instituions securitizing student loans include First Marblehead Corp., SLM Trusts / SMS Trusts (SLM Corp.)

In 2007 it was exposed that there was a conflict of interest between some universities and some participants in the student loan industry. Some of the loan originators were offering revenue-sharing plans to college financial aid officers and university alumni associations in exchange for the officer or association to steer the potential student borrower to the company. In addition, during 2007 the The Senate Banking Committee and New York States Attorney General's Office looked into how student lenders were pricing loan interest rates (which appeared to be on a school by school basis rather than a standard).

In December 2007, legislation was passed that reduced federal subsidies on federally guaranteed student loans paid to student loan originators.

As indicated above, the default rate on student loans has increased during 2007. Many students had to take on a substantial amount of debt to pay for a college education. Secondly, as young students have no credit background or assets, parents had to be co-signers on the student loans. In order to have sufficient funds some families had to refinance their residential property to convert equity into cash. If these borrowers took out adjustable-rate mortgages and the loans are now resetting the rate then these families have insufficient cash flow to remain current on the new mortgage payment and assisting the child on the student loan payment.

One of the largest student loan securitizers, First Marblehead Corp., indicated in December 2007 that the company would curtail new securitizations in response to disruption in the ABS markets. In addition, Education Resources Institute Inc. (TERI), which guarantees nearly all the student loans in First Marblehead securitizations, had its credit rating placed under review for possible downgrade.

Additional student loan guarantors include:

American Student Assistance (Massachusetts Higher Education Assistance Corporation)
California Student Aid Commission (CSAC)
College Access Network (formerly Colorado Student Loan Program)
Connecticut Student Loan Foundation (CSLF)
Education Credit Management Corporation (ECMC)
Finance Authority of Maine (FAME)
Florida Office of Student Financial Assistance
Georgia Higher Education Services Corporation
Great Lakes Higher Education Guaranty Corporation
Illinois Student Assistance Commission (ISAC)
Kentucky Higher Education Assistance Authority (KHEAA)
Louisiana Student Financial Assistance Commisssion (LOSFA)
Michigan Higher Education Assistance Agency
Missouri Student Loan Program
Montana Guaranteed Student Loan Program
National Student Loan Program (NSLP)
New Jersey Higher Education Student Assistance Authority
New York State Higher Education Services Corporation
Northwest Education Loan Assistance (NELA)
Office of Student Financial Assistance (OSFA)
Oklahoma Guaranteed Student Loan Program
Pennsylvania Higher Education Assistance Agency (PHEAA)
Rhode Island Higher Education Assistance Authority
State Higher Education Services Corporation (SHESC)
Student Loan Guarantee Foundation of Arkansas
Tennessee Student Assistance Corporation
Texas Guaranteed Student Loan Corporation (TGSLC)
United Student Aid Funds, Inc. (USAF)

Student loans are also funded short-term in the aution rate securities market. This specific asset class is known as the Student Loan-Backed Auction Rate Securities / Notes (SLARS) and are auctioned periodically to money market investors.

Equipment Leases

Please also see   Leases and Leasing Company Credit Analysis

Leased equipment receivables are generated from telecommunications equipment, copiers, fax machines, general business equipment, computers, medical / dental diagnostic and surgical equipment, restaurant equipment, printing and graphics equipment, agricultural equipment, and treansportation-related equipment. The leases can be either and operating lease or a finance lease.

Equipment lease obligors are primarily commercial entities (not consumers). The leases also have lower prepayment risk than consumer receivables due to contractual provisions that discourage prepayment. In addition, residual value performance / realization has been quite adequate.

Equipment lease-backed securitizations are both publicly issued and privately placed.

Similar to other securitizations, equipment lease-backed securitizations usually have senior, investment grade tranches and subordinated, non-investment grade tranches. In addition to the subordinated tranches, credit enhancement is also increased in the form of cash reserve accounts and equipment residual valuation.

The credit analysis of equipment lease-backed securitizations requires the review of the:

underwriting standards of the lessor

details and structure of the lease(s)

historical portfolio performance (of the securitization or similar equipment securitizations) with regard to losses and delinquencies, and recovery rate on defaults (cash flow is used to offset losses)

portfolio characteristics (equipment type, equipment manufacturer)

concentrations of equipment type, industries / companies (lessee / obligor) and/or geographic location (look for industry and geographic diversification of lessees; look for several different manufacturers of equipment so that no single model is obsolete or will be over-represented in the secondary market; avoid multiple leases with a single large company)

legal structure of the securitization

projected cash flows

historical performance of the lessor with regard to the realization of residual value

servicing and collection procedures

Regulation of ABS

The registration, disclosure and reporting requirements for asset-backed securities under the Securities Act of 1933 and the Securities Exchange Act of 1934 is addressed under 17 CFR Parts 210, 228, 229, 230, 232, 239, 240, 242, 245 and 249. The SEC revised the regulations in 2005 because many of the Commission’s existing disclosure and reporting requirements, which were designed primarily for corporate issuers and their securities, did not elicit relevant information for most asset-backed securities transactions. The new rules and amendments that have been adopted are designed to address the four primary regulatory areas affecting asset-backed securities: Securities Act registration; disclosure; communications during the offering process; and ongoing reporting under the Exchange Act.

Information Resources

American Securitization Forum   www.americansecuritization.com/