Book 2. Credit Risk

FRM Part 2

CR 23. An Introduction to Securitization

Presented by: Sudhanshu

Module 1. Securitization Process

Module 2. Cash Waterfall, SPV Structures, Securitization Benefits and Performance Analysis Tools

Module 3. Securitized Structure Ratios

Module 4. Prepayment Forecasting

Module 1. Securitization Process

Topic 1. Securitization

Topic 2. The Securitization Process

Topic 3. Roles of Participants

Topic 1. Securitization

• Definition: Securitization is the process of transforming the illiquid assets of a financial institution or corporation into a package of tradable securities, known as asset-backed securities (ABSs) or mortgage-backed securities (MBSs).

• The Process: A third party uses careful packaging, credit enhancements, liquidity enhancements, and structuring to issue securities backed by a pool of assets.

• Key Concept: It allows a company to raise capital by selling a pool of cash-flow producing assets to a legally distinct Special Purpose Entity (SPE), also known as an SPV, which in turn issues the securities.

• Off-Balance-Sheet: The transaction removes the assets and their associated risks from the originator's balance sheet, provided the sale is without recourse. For MBSs, the property serves as collateral.

Practice Questions: Q1

Q1. Which of the following statements most accurately describes the effect of selling a loan without recourse?
A. The bank that sells the loan retains a contingent liability.
B. The bank that sells the loan bears a specified percentage of the credit risk.
C. The loan is removed from the balance sheet of the bank that sells the loan.
D. The purchaser has the right to sell the loan back to the bank that originated the loan.

Practice Questions: Q1 Answer

Explanation: C is correct.

When a bank originates a loan and then sells it without recourse, the loan is removed from the bank’s balance sheet, and the purchaser bears all of the credit risk.

Topic 2. The Securitization Process

• Step 1: Origination. The originator (e.g., a bank) creates a pool of credit-sensitive assets, such as residential mortgages, auto loans, or credit card receivables.

• Step 2: True Sale. The assets are sold to a legally distinct SPV to separate them from the originator's financial state. This "true sale" is crucial because it ensures the assets are not considered part of the originator's bankruptcy estate.

• Step 3: Structuring & Issuance. The SPV structures the assets into tranches and issues securities to investors, using careful packaging, credit enhancements, and liquidity enhancements.

• Step 4: Cash Flows. The payments from the underlying assets are collected and distributed to investors in a predetermined order, a process known as the "cash waterfall."

Topic 3. Roles of Participants

• Originator: The entity that creates the assets and sells them. This could be a bank, finance company, or other corporation. Their primary role is to pool the assets and sell them to the SPV.

• Issuer (SPV/SPE): The separate legal entity that buys the assets and issues the securities. The SPV is created solely for this purpose and is designed to be "bankruptcy-remote," meaning its financial condition is separate from the originator.

• Structuring Agent: Typically an investment bank, this agent designs the securities and determines the structure of the deal, including forecasting the cash flows from the underlying assets and arranging the different tranches.

• Trustee: A third party, often a commercial bank, responsible for safeguarding the investors' interests. The trustee ensures the SPV adheres to the terms of the legal agreement and oversees the distribution of cash flows according to the waterfall.

• Financial Guarantor: An insurance company that may provide a financial guarantee against losses, covering the loss of principal in the collateral pool. This reduces the risk for investors and can help the securities achieve a higher credit rating.

• Credit Rating Agencies: Organizations like Moody's or S&P that provide formal credit ratings for the different tranches of the securities to help investors assess the risk and determine the appropriate pricing.

Module 2. Cash Waterfall, SPV Structures, Securitization Benefits and Performance Analysis Tools

Topic 1. Cash Waterfall Process

Topic 2. SPV Structures

Topic 3. Securitization Benefits

Topic 4. Credit Enhancements

Topic 5. Performance Measures for Securitized Structures

Topic 1. Cash Waterfall Process

• Concept: The cash waterfall is a strict, pre-defined order in which all cash flows (principal and interest) from the collateral pool are paid to different parties.

• Priority of Payments: Payments flow "down" the waterfall, with the most senior (least risky) tranches being paid first. The typical payment order is:

  • Senior Debt: Paid principal and interest first.

  • Mezzanine Debt: Paid principal and interest after senior debt is fully paid.

  • Junior Debt: Paid principal and interest after mezzanine debt.

  • Equity: The most junior position, which receives any remaining cash flows after all other parties are paid.

• Loss Absorption: In the event of defaults, the junior tranches absorb losses first, protecting the senior tranches. This subordination of tranches is a form of credit enhancement. The most junior tranche is often referred to as the "first-loss piece" or "equity piece" because it is the first to suffer losses.

• Application: All securitization structures, including master trusts and pass-throughs, use a cash waterfall to define the payment hierarchy.

Topic 2. SPV Structures

• Amortizing Structure: Used for assets with a fixed amortization schedule (e.g., mortgages, auto loans), where principal and interest are passed through to investors. The securities issued have a fixed term, and the investor receives a portion of the principal and interest from the underlying assets on a regular basis.

• Revolving Structure: Used for assets with no fixed term (e.g., credit card debt), where principal payments are not paid to investors but are instead used to purchase new receivables to maintain the pool's size and collateral value. This structure is also called a "revolving period" and can be followed by a "scheduled amortization" or "rapid amortization" period.

• Master Trust: A specific type of revolving structure that allows for multiple, frequent securitization issues from a single, continuously changing pool of assets. This is common for credit card debt, as it provides a flexible way to issue new securities as new receivables are generated without having to create a new SPV each time.

Practice Questions: Q1

Q1. A major benefit of securitization for a financial institution is the ability to remove assets from the balance sheet, which lowers risk and the required regulatory capital. While a large portion of the risk is removed from the balance sheet the originating financial institution often maintains a portion of the risk. Which of the following terms best identifies the risk that is maintained by the originator?
A. Correlation.
B. Excess spread.
C. First-loss piece.
D. Guarantor of collateral value.

Practice Questions: Q1 Answer

Explanation: C is correct.

The originator often maintains ownership of the first-loss piece, which is the class of assets with the lowest credit quality and is the most junior level where losses are first absorbed in the event of a default.

Topic 3. Securitization Benefits

• For Financial Institutions:

  • Source of Funding: Provides a new, efficient way to raise capital by selling assets from their balance sheet.

  • Balance Sheet Management: Allows institutions to remove assets and associated risks from their balance sheets, which can improve key financial ratios.

  • Regulatory Relief: For banks, securitization can help reduce capital requirements under regulations like Basel I by removing risk-weighted assets from their books.

  • Risk Transfer: Transfers the credit risk of the underlying assets from the originator to the investors.

• For Investors:

  • New Asset Classes: Provides access to a wide range of new liquid asset classes, such as mortgage-backed or auto loan-backed securities.

  • Diversification: Allows investors to diversify their portfolios with assets that may have different risk-return characteristics than traditional stocks and bonds.

  • Higher Yields: Can offer higher yields than similarly-rated corporate bonds, as investors are compensated for the unique risks associated with the underlying asset pool.

Topic 4. Credit Enhancements

• Overview: Credit enhancements are techniques used to increase the credit quality of a securitization. They provide a buffer against potential losses from the underlying assets, making the securities more attractive to investors and potentially achieving a higher credit rating.

• Overcollateralization: This is a form of internal credit enhancement where the principal value of the assets in the pool is greater than the principal value of the notes issued. This provides a cushion to absorb losses on a portion of the collateral.

• Subordinating Note Classes: The deal is structured into a hierarchy of tranches (e.g., senior, mezzanine, junior). The most junior tranche, often called the "first-loss piece," is the first to absorb losses from the collateral pool. This subordination protects the more senior tranches.

• Third-Party Guarantee: This is a form of external credit enhancement. A third-party, such as a financial guarantor or insurance company, provides a guarantee against losses. This can cover both principal and interest payments, helping the securitized notes achieve a higher credit rating.

Practice Questions: Q2

Q2. Securitized products are often customized to meet the needs of the investor as well as the originator. What type of asset-backed securities (ABSs) typically uses a revolving structure?
A. Residential mortgage.
B. Credit card debt.
C. Commercial mortgage.
D. Commercial paper.

Practice Questions: Q2 Answer

Explanation: B is correct.

Revolving structures are used with products that are paid back on a revolving basis, such as credit card debt or auto loans. Credit card debt does not have a pre specified amortization schedule; therefore the principal paid back to investors is in large lump sums rather than amortizing schedules.

Topic 5. Performance Measures for Securitized Structures

• Overview: These are tools used to analyze the performance of the collateral pool and monitor its health. They are vital for assessing the credit risk of the underlying assets.

• Triggers: The performance measures can serve as triggers to signal early amortization of the receivable pool if the collateral's quality deteriorates. This means principal payments are returned to investors earlier than scheduled to mitigate risk.

• Credit Card ABS Performance Tools: For securitized credit card receivables, key performance tools include:

  • Delinquency Ratio: Measures the percentage of receivables that are 90 days past due. It provides an early indication of the overall quality of the pool.

  • Default Ratio: Measures the amount of written-off receivables divided by the total receivables pool. It quantifies the actual credit losses.

  • Monthly Payment Rate (MPR): The percentage of monthly principal and interest payments divided by the total receivables pool. This indicates the speed at which the receivables are being paid.

Practice Questions: Q3

Q3. Which of the following statements regarding credit enhancements in the process of structuring a securitization through a special purpose vehicle (SPV) is correct?
A. The securitization process is structured such that the asset side of the SPV has a lower cost than the liability side of the SPV.
B. Credit enhancements are typically only associated with mortgage-backed securities (MBSs) and are not used in other types of asset-backed securities (ABSs).
C. The most senior class of notes is often overcollateralized in order to reduce the risk of the asset backed security (ABS).
D. A margin step-up is sometimes used by an asset-backed securities (ABSs) where the coupon structure increases after a call date.

Practice Questions: Q3 Answer

Explanation: D is correct.

ABS issues may use a margin step-up that increases the coupon structure after a call date. Credit enhancements play an important role in the securitization process for both the asset-backed security (ABS) and mortgage-backed security (MBS) issues. The liability side of the SPV has a lower cost than the asset side of the SPV to create an excess spread prior to administration costs. The lowest class of notes are often overcollateralized where the principal value of the notes issued are valued less than the principal value of the original underlying assets.

Module 3. Securitized Structure Ratios

Topic 1. MBS Performance Tools

Topic 2. Weighted Average Coupon (WAC)

Topic 3. Weighted Average Maturity (WAM)

Topic 4. Weighted Average Life (WAL)

Topic 1. MBS Performance Tools

• Overview: These are specific metrics used to analyze the performance of mortgage-backed securities, which are heavily influenced by prepayment risk. Prepayment risk is the risk that a mortgage borrower will pay off their loan before the scheduled maturity date, typically when interest rates fall.

• Importance: MBS investors rely on the steady stream of cash flows from the underlying mortgages. Prepayments disrupt these cash flows and can reduce the investor's return. These performance tools are essential for forecasting cash flows and managing investor expectations by providing a standardized way to measure prepayment speeds and other key characteristics of the collateral pool.

Topic 2. Weighted Average Coupon (WAC)

• Definition: The weighted average of the interest rates (coupons) of all the individual loans in the mortgage-backed security (MBS) pool. It is a key metric for investors as it gives them a single number to represent the overall interest rate of the underlying assets.

• Calculation: The WAC is calculated by multiplying the coupon of each mortgage by its outstanding principal balance, summing those products, and then dividing that sum by the total outstanding principal balance of all mortgages in the pool.

• Purpose: The WAC provides a summary measure of the yield of the underlying assets. It is used in forecasting the cash flows of the MBS and is a critical input for valuing the security. A higher WAC generally indicates a higher potential interest payment to investors, assuming no prepayments.

Topic 3. Weighted Average Maturity (WAM)

• Definition: The weighted average of the time to maturity of all the loans in the MBS pool.

• Calculation: Each mortgage's time to maturity is weighted by its outstanding principal balance.

• Limitation: A key limitation of WAM is that it does not account for prepayments. It assumes all mortgages in the pool will be paid off at their scheduled maturity date. This makes it a less accurate measure of a security's expected life.

• Purpose: Provides an average of the remaining term of the mortgages in the pool, without considering prepayments.

Topic 4. Weighted Average Life (WAL)

• Definition: The weighted average of the time until each dollar of principal is repaid, taking into account expected prepayments.

• Relationship to WAM: Unlike WAM, which only considers the stated maturity of the loans, the WAL is a more accurate measure because it accounts for the impact of both scheduled amortization and prepayments.

• Influencing Factors: The WAL is highly sensitive to the level of prepayments. If prepayment speeds increase, the WAL will decrease because the principal is being returned to investors more quickly. Conversely, if prepayments slow down, the WAL will lengthen.

• Importance: This metric is crucial for bond investors as it helps them estimate the true expected term of the investment and understand the impact of prepayment risk. A shorter WAL can be a negative for investors who desire a longer-term, predictable income stream.

Practice Questions: Q1

Q1. Assume an MBS is composed of the following four different pools of mortgages:

• $2 million of mortgages that have a maturity of 90 days.
• $3 million of mortgages that have a maturity of 180 days.
• $5 million of mortgages that have a maturity of 270 days.
• $10 million of mortgages that have a maturity of 360 days.

What is the weighted average maturity (WAM) of these mortgage pools?
A. 167 days.
B. 225 days.
C. 252 days.
D. 284 days.

Practice Questions: Q1 Answer

Explanation: D is correct.

The WAM is calculated as follows:

WAC= [90(2 million)+180(3 million)+270(5 million)+360(10 million)/(2 million+3 million+5 million+10 million)
= (180 million +540 million +1,350 million+3,600 million)/20 million
= 5,670 million/20 million
= 284 days

Module 4. Prepayment Forecasting

Topic 1. Constant Prepayment Rate (CPR)

Topic 2. Public Securities Association (PSA)

Topic 3. Single Monthly Mortality (SMM)

Topic 1. Constant Prepayment Rate (CPR)

• Definition: An annual rate that assumes a certain percentage of the outstanding principal balance will be prepaid each year. The CPR assumes a constant rate of prepayment over the life of the mortgage pool.

• Purpose: It is a key assumption used in cash flow modeling for MBS to forecast prepayments. Since it is a simplistic assumption, it is often used in combination with other models, such as PSA, to get a more realistic picture of future prepayments.

• Calculation: Can be calculated from SMM as                                     .

• This formula shows the direct relationship between the annual CPR and the single monthly mortality rate (SMM).

Topic 2. Public Securities Association (PSA)

• Definition: A benchmark for prepayment speeds developed by the Public Securities Association. It provides a standardized framework for analyzing and comparing the prepayment behavior of MBS.

• The PSA Curve: The PSA model is represented as a curve, with a 100% PSA being the standard benchmark.

• Standard Assumptions (100% PSA): A 100% PSA assumes a Constant Prepayment Rate (CPR) of:

  • 0.2% in the first month.

  • This rate increases linearly by 0.2% each month until month 30.

  • From month 30 onwards, the CPR remains constant at 6%.

• PSA Multiples: Prepayment speeds are often quoted as multiples of this standard PSA curve (e.g., 50% PSA, 200% PSA). A 50% PSA means the prepayment speed is half the standard rate, while a 200% PSA means the speed is twice the standard rate.

• Purpose: The PSA model is used to compare the actual prepayment speed of an MBS pool against a standard benchmark, allowing investors to better assess the potential impact of prepayment risk.

Topic 3. Single Monthly Mortality (SMM)

• Definition: The monthly prepayment rate. It is a more precise measure of prepayment than CPR because it is applied to the remaining principal balance of the mortgage pool on a month-by-month basis.

• Calculation: It is derived from the CPR using the formula:

•  
•  This formula allows for the conversion of an annual CPR into a monthly rate.
• Purpose: Represents the percentage of the remaining mortgage pool principal that is expected to be prepaid in a single month. SMM is a fundamental building block for cash flow models, as it can be used to forecast the monthly principal repayments and therefore the cash flow from an MBS. It is often used in conjunction with other metrics to provide a more accurate and detailed prepayment analysis.

Practice Questions: Q1

Q1. Which of the following measures are most likely to be used by a securitized product backed by student loans?
A. Single monthly mortality (SMM), constant prepayment rate (CPR), and Public Securities Association (PSA).
B. Loss curves and absolute prepayment speed (APS).
C. Weighted average life (WAL), weighted average maturity (WAM), and weighted average coupon (WAC).
D. Debt service coverage ratio (DSCR) and monthly payment rate (MPR).

Explanation: A is correct.

The constant prepayment rate (CPR) and the Public Securities Association (PSA) method are common methodologies used to estimate prepayments for student loans and mortgages.