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  1. 1. What is securitisation? <ul><li>In traditional methods of corporate finance, a corporation raises equity/obligations to own assets. </li></ul><ul><li>In securitisation, a corporation creates and ‘securitises’ assets - that is, transfers assets. In form of securities. </li></ul><ul><li>The claim is on assets, and not on the entity </li></ul><ul><li>Hence, asset-based funding </li></ul><ul><li>Securitisation and traditional funding: is the difference skin-deep or superficial? </li></ul><ul><ul><li>All claims are, eventually, claims on assets: question is one of stacking order: securitisation puts investors on the top of the stacking order by isolation </li></ul></ul><ul><ul><li>Broader the periphery of assets backing up the claims, more the volatility, risks </li></ul></ul><ul><ul><li>Asset-backed funding narrows down asset definition and hence reduces volatility </li></ul></ul><ul><ul><li>Hence, reduces credit enhancement </li></ul></ul><ul><ul><li>Crux of asset backed funding lies in reducing the equity, and increasing the leverage </li></ul></ul>Securitisation Masterclass Sept 2006
  2. 2. Securitisation and corporate finance
  3. 3. Basic process of securitisation Originator Obligors SPV special purpose entity 2.Assigns Cash flow Investors 1. Cash flow before securitisation 4. Proceeds of issue of securities 3. Issues securities/ notes 5.Collection and servicing 6.Passes over to SPV, less fees Reinvestment 7. Reinvestment/liquidity buffer 8. Reinvestment proceeds/liquidity facility 9. Payments to investors 10. Originator’s residuary profit 4. Proceeds of sale of receivables Security trustee Class A Class B Class C
  4. 4. Essential securitisation process Bank Bank Mortgages Equity Public Savings Origination Credit enhancement Funding Servicing Bank Bank Mortgages Equity Bank Bank Mortgages Equity Bank Mortgages Equity Debt Mortgages Equity Bank Mortgages Equity Debt Public Savings Origination Credit enhancement Servicing SPVs Mortgage-backed Securities Traditional framework Securitisation framework Class A Class B Retained class Residual interest
  5. 5. The economic substance of securitisation <ul><li>The key economic driver of securitisation is lower cost, resulting out of: </li></ul><ul><ul><li>Lower credit enhancement, due to insulation of the transaction from originator risks </li></ul></ul><ul><ul><li>Higher ratings, due to originator bankruptcy remoteness </li></ul></ul><ul><li>Bankruptcy remoteness: </li></ul><ul><ul><li>The essential premise is that the assets are put beyond the control of the selling entity </li></ul></ul><ul><ul><li>The buying entity is a special purpose entity, unlikely to go into bankruptcy </li></ul></ul><ul><li>Hence, legal structure, that is, achieving a bankruptcy remote transfer, and insulating the transaction from originator risks, is key to every securitisation </li></ul><ul><li>Other spin offs – off balance sheet, capital relief, etc. are consequences, not cause of the isolation process </li></ul>
  6. 6. Key features of securitisation <ul><li>Capital market funding </li></ul><ul><li>Use of special purpose vehicles as a transformation device </li></ul><ul><li>Structured finance </li></ul><ul><ul><li>Meaning of structured financial products: product structured or made-to-needs of the investor </li></ul></ul><ul><ul><li>Key structuring principles: </li></ul></ul><ul><ul><ul><li>What are investors rating needs </li></ul></ul></ul><ul><ul><ul><li>What are investors payback needs/ paydown needs </li></ul></ul></ul><ul><ul><ul><li>What is investors’ appetite for interest rate risk, prepayment risk? </li></ul></ul></ul><ul><ul><li>Securitised instruments reorganise investors’ rights to suit their needs </li></ul></ul>
  7. 7. The economic substance of securitisation <ul><li>The key economic driver of securitisation is lower cost, resulting out of: </li></ul><ul><ul><li>Lower credit enhancement, due to insulation of the transaction from originator risks </li></ul></ul><ul><ul><li>Higher ratings, due to originator bankruptcy remoteness </li></ul></ul><ul><li>Bankruptcy remoteness: </li></ul><ul><ul><li>The essential premise is that the assets are put beyond the control of the selling entity </li></ul></ul><ul><ul><li>The buying entity is a special purpose entity, unlikely to go into bankruptcy </li></ul></ul><ul><li>Hence, legal structure, that is, achieving a bankruptcy remote transfer, and insulating the transaction from originator risks, is key to every securitisation </li></ul><ul><li>Other spin offs – off balance sheet, capital relief, etc. are consequences, not cause of the isolation process </li></ul>
  8. 8. Key features of securitisation <ul><li>Capital market funding </li></ul><ul><li>Use of special purpose vehicles as a transformation device </li></ul><ul><li>Structured finance </li></ul><ul><ul><li>Meaning of structured financial products: product structured or made-to-needs of the investor </li></ul></ul><ul><ul><li>Key structuring principles: </li></ul></ul><ul><ul><ul><li>What are investors rating needs </li></ul></ul></ul><ul><ul><ul><li>What are investors payback needs/ paydown needs </li></ul></ul></ul><ul><ul><ul><li>What is investors’ appetite for interest rate risk, prepayment risk? </li></ul></ul></ul><ul><ul><li>Securitised instruments reorganise investors’ rights to suit their needs </li></ul></ul>
  9. 9. ABS types based on collateral Securitisation Existing asset Future asset Risk Mortgage backed Asset backed Credit risk Insurance risk Operating revenues RMBS CMBS Retail assets CDOs
  10. 10. ABS types based on other parameters Securitisation Purpose Nature of asset transfer Term of paper Balance sheet Arbitrage Synthetic structures Commercial paper Cash structures Term paper True sale structure Secured loan structure
  11. 11. Parties to securitisation transaction <ul><li>Originator/ seller </li></ul><ul><li>Obligors </li></ul><ul><li>Special purpose vehicle: single/ multiple </li></ul><ul><li>Servicer </li></ul><ul><li>Back up servicer </li></ul><ul><li>Trustees </li></ul><ul><li>Investors </li></ul><ul><li>Collecting and paying bank </li></ul><ul><li>Depository </li></ul><ul><li>Swap counterparties </li></ul><ul><li>Liquidity provider </li></ul><ul><li>Credit enhancement provider </li></ul>
  12. 12. Typical originators <ul><li>Application of securitisation techniques has greatly expanded recently. </li></ul><ul><li>Typical users of securitisation are: </li></ul><ul><ul><li>Mortgage financiers </li></ul></ul><ul><ul><li>Bank loans </li></ul></ul><ul><ul><li>Finance companies </li></ul></ul><ul><ul><li>Credit card companies </li></ul></ul><ul><ul><li>Hoteliers, rentiers </li></ul></ul><ul><ul><li>Public utilities </li></ul></ul><ul><ul><li>Intellectual property holders </li></ul></ul><ul><ul><li>insurance companies </li></ul></ul><ul><ul><li>aviation companies </li></ul></ul><ul><ul><li>exporters of unprocessed materials </li></ul></ul><ul><ul><li>plantations </li></ul></ul><ul><ul><li>Governments </li></ul></ul><ul><li>Interactive: </li></ul><ul><ul><li>Can you think of other asset classes? </li></ul></ul>
  13. 13. Typical assets securitised <ul><li>Financial assets </li></ul><ul><ul><li>long-term assets </li></ul></ul><ul><ul><li>short term assets </li></ul></ul><ul><ul><li>revolving assets </li></ul></ul><ul><li>Physical assets </li></ul><ul><ul><li>using transformation devices </li></ul></ul><ul><ul><li>using secured loan structures </li></ul></ul><ul><li>Whole business transactions </li></ul><ul><li>Future flow transactions </li></ul><ul><li>Structured investment vehicles: </li></ul><ul><ul><li>CDOs of investment products such as hedge funds, private equity funds, etc. </li></ul></ul>
  14. 14. Trustee <ul><li>A logistic requirement, later made a statutory obligation in public offerings of debt instruments </li></ul><ul><li>Fiduciary for the investors </li></ul><ul><li>Holder and administrator of security interests and safeguarding collateral documents </li></ul><ul><li>Traditional functions: </li></ul><ul><ul><li>Acting as registrar and transfer agent for the securities </li></ul></ul><ul><ul><li>Distribution of principal and interest payments </li></ul></ul><ul><ul><li>oversight of the conduct of the transaction, particularly payments, co - mingling, compliance with respective agreements </li></ul></ul><ul><ul><li>monitoring covenant compliance and reporting - regular loan level and bond level reports </li></ul></ul><ul><ul><li>monitoring principal and interest payments </li></ul></ul><ul><ul><li>Enforcement of seller representations and warranties </li></ul></ul><ul><ul><li>monitoring of triggers and withholding distributions </li></ul></ul><ul><li>Timely, decisive action </li></ul><ul><li>Ability and willingness to act as backup servicer or organise succession </li></ul>
  15. 15. Securitisation and borrowing
  16. 16. Securitisation and borrowing - 2
  17. 17. Why securitisation <ul><li>Lower cost - inherent cost and weighted average cost </li></ul><ul><ul><li>The best example of economics of securitisation is an arbitrage CDO </li></ul></ul><ul><li>Alternative investor base -institutional and retail </li></ul><ul><li>Matching of assets and liabilities </li></ul><ul><li>Issuer rating irrelevant </li></ul><ul><li>Multiplies asset creation ability </li></ul><ul><li>Non-conventional source; may allow higher funding </li></ul><ul><li>Off-balance sheet financing - removal of accounts </li></ul><ul><li>Frees up regulatory capital </li></ul><ul><li>Improves capital structure </li></ul><ul><li>Higher trading on equity with no increased risk </li></ul>
  18. 18. Why securitisation - 2 <ul><li>Extends credit pool </li></ul><ul><li>Not regulated as loan </li></ul><ul><li>Reduces credit concentration </li></ul><ul><li>Risk management by risk transfers </li></ul><ul><li>Arbitraging opportunities - repackaging transactions </li></ul><ul><li>Avoids interest rate risk </li></ul><ul><li>Improves accounting profits </li></ul><ul><li>Interactive: do you think there are other merits? </li></ul>
  19. 19. Lower cost due to securitisation <ul><li>Increased leverage: lower use of equity: leverage arbitrage </li></ul><ul><li>Capital market source – reduces agency costs </li></ul><ul><li>Better rated product: ratings arbitrage </li></ul><ul><li>Aligns investment with investor objective: structural arbitrage </li></ul><ul><li>Studies of whether securitisation has reduced funding costs: </li></ul><ul><ul><li>Mortgage market is cited as an example </li></ul></ul><ul><ul><li>Arbitraging profits in the securitisation market </li></ul></ul>
  20. 20. Limitations/ disadvantages of securitisation <ul><li>What are the disadvantages/limitations of securitisation? </li></ul>
  21. 21. Session 2 Principal structures in securitisation
  22. 22. Basic elements of securitisation structures <ul><li>Transfer of assets to bankruptcy-remote entities: </li></ul><ul><ul><li>Cash versus synthetic structures </li></ul></ul><ul><ul><li>secured loan structures </li></ul></ul><ul><ul><li>Two-tier transactions </li></ul></ul><ul><li>Cash inflow and outflows: </li></ul><ul><ul><li>pass-throughs and bond structures </li></ul></ul><ul><li>Determination and form of credit enhancements </li></ul><ul><li>Classes of securities and coupon of each </li></ul><ul><li>Profit extraction devices </li></ul><ul><li>Liquidity enhancements </li></ul><ul><li>Structural protections: early payment or de-leverage triggers </li></ul><ul><li>Pay down methods: </li></ul><ul><ul><li>normal </li></ul></ul><ul><ul><li>abnormal - in case of triggers </li></ul></ul>Securitisation Masterclass Sept 2006
  23. 23. Securitisation structures Securitisation Masterclass Sept 2006 Securitisation structures: Transaction features viewpoint Synthetic structures Cash structures True sale structure Secured loan structure Pass- through structure Collateral structure Simple pass- through Master trust
  24. 24. Cashflow schematics of securitisation <ul><li>We will model the cashflow structure of a dummy securitisation transaction </li></ul><ul><li>And iterate it with respect to: </li></ul><ul><ul><li>Simple pass - through </li></ul></ul><ul><ul><li>Reinvestment of principal into passive financial instruments </li></ul></ul><ul><ul><li>Reinvestment of principal into the original asset </li></ul></ul><ul><li>To see the impact on: </li></ul><ul><ul><li>Residual returns </li></ul></ul><ul><ul><li>Weighted average maturity </li></ul></ul>Securitisation Masterclass Sept 2006
  25. 25. Securitisation Masterclass Sept 2006 Collect Interest (plus other revenue) Collect Actual Principal (Scheduled) Collect all Prepayment Deduct all Senior Expenses Is Actual Principal < Scheduled Principal? Debit Deliqnent Principal Ledger Pay Senior Coupon Excess Spread Principal Waterfall Transfer to Deliqnent Principal Is excess spread >delinquent Principal ? Pay Principal Pay Junior Coupon No Yes No Yes Graphics © Vinod Kothari Cash Flow Scheme of Securitisation
  26. 26. Session 3 Understanding cashflow structure of securitisations
  27. 27. Basic ingredients of securitisation structures <ul><li>Analysis of the collateral pool: </li></ul><ul><ul><li>Retail, equal payment pool </li></ul></ul><ul><ul><li>Retail, revolving payment pool </li></ul></ul><ul><ul><li>Whole-sale pools </li></ul></ul><ul><li>Asset liability mismatches: </li></ul><ul><ul><li>No mismatch – pass-through transactions </li></ul></ul><ul><ul><li>Revolving/reinvesting transactions: </li></ul></ul><ul><ul><ul><li>Revolving cash back into assets </li></ul></ul></ul><ul><ul><ul><li>Reinvesting cash externally </li></ul></ul></ul><ul><li>Nature and form of credit enhancements </li></ul><ul><li>Payback tranching of securities: </li></ul><ul><li>Default allocation </li></ul><ul><li>Special triggers: </li></ul><ul><ul><li>Early amortisation triggers to curtail reinvestment </li></ul></ul><ul><ul><li>Triggers to use over-collateralisation </li></ul></ul><ul><li>Profit extraction devices </li></ul>Securitisation Masterclass Sept 2006
  28. 28. Key features of a securitised asset <ul><li>Typically an equated payment asset amortizing over a period of time </li></ul><ul><li>Full payout structures </li></ul><ul><li>Deviations between scheduled and actual cashflows: </li></ul><ul><ul><li>Delayed payments </li></ul></ul><ul><ul><li>Defaults </li></ul></ul><ul><ul><li>Prepayments </li></ul></ul>Securitisation Masterclass Sept 2006
  29. 29. Understanding the impact of prepayment <ul><li>Prepones principal, reduces interest </li></ul><ul><li>Reduces the weighted average maturity of the pool </li></ul><ul><li>Impacts the quality of the pool? </li></ul><ul><li>Introduces callability risk in asset backed securities </li></ul>Securitisation Masterclass Sept 2006
  30. 30. Default rate or Expected losses <ul><li>Credit enhancement workings for retail portfolios (ABS) and wholesale loans (CDOs) differ: </li></ul><ul><ul><li>The former are based on expected losses, while the latter are typically based on simulation studies. </li></ul></ul><ul><li>Expected loss: </li></ul><ul><ul><li>Dynamic pool: the current loss rate as % of the portfolio outstanding </li></ul></ul><ul><ul><li>Static pool: the cumulative loss rate of a static pool originated at the same time over its life </li></ul></ul><ul><ul><ul><li>Static pool analysis is more representative of asset backed transactions which generally have a static pool </li></ul></ul></ul>Securitisation Masterclass Sept 2006
  31. 31. Analysis of the cumulative loss curve <ul><li>The cumulative loss curve plots the cumulative losses/charge offs to the initial outstanding balance of the pool </li></ul><ul><li>Relation between prepayment and expected loss: </li></ul><ul><ul><li>As obligors prepay, even though the charge off rate rises, the cumulative loss rate slows down </li></ul></ul><ul><ul><li>In such cases, it is important to examine the hazard rate, that is, the rate of charge off relative to the then-outstanding portfolio balance </li></ul></ul><ul><ul><li>To smoothen the impact of periodic ups and downs, a 6-monthly moving average may be used </li></ul></ul><ul><li>For a typical portfolio, the hazard rate ascends as the portfolio seasons; however, the cumulative loss rate tends to flatten as the impact of ascending hazard rate is reduced by reducing pool size </li></ul>Securitisation Masterclass Sept 2006
  32. 32. Risks and risk mitigants in securitisation <ul><li>Sources of risks: </li></ul><ul><ul><li>Prepayment </li></ul></ul><ul><ul><li>Delayed payment </li></ul></ul><ul><ul><li>Losses </li></ul></ul><ul><ul><li>Mismatch in pay-in and pay-out schedule </li></ul></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><ul><li>Exchange rate risk </li></ul></ul><ul><ul><li>Risk on reinvestments </li></ul></ul><ul><li>Risk mitigants: </li></ul><ul><ul><li>Prepayment: </li></ul></ul><ul><ul><ul><li>PO/ IO structures, reinvestment structures </li></ul></ul></ul><ul><ul><li>Delays and losses: </li></ul></ul><ul><ul><ul><li>Credit enhancements </li></ul></ul></ul><ul><ul><li>Cashflow mismatches: </li></ul></ul><ul><ul><ul><li>Liquidity support </li></ul></ul></ul><ul><ul><li>Interest rate and other risks: </li></ul></ul><ul><ul><ul><li>Interest rate derivatives </li></ul></ul></ul><ul><ul><ul><li>Inverse floater </li></ul></ul></ul>Securitisation Masterclass Sept 2006
  33. 33. Concept of credit enhancement <ul><li>Credit enhancement is to securitisation what economic capital is to corporate finance, and loan to value ratio is in lending </li></ul><ul><li>Function of economic capital: protect the enterprise from bankruptcy at a certain “confidence level”: the confidence level itself is a product of target rating for the enterprise </li></ul><ul><ul><li>In securitisation too, credit enhancement is to protect the structure from default at a target rating level </li></ul></ul><ul><li>Need for relatively more careful credit enhancement setting in securitisation: </li></ul><ul><ul><li>Isolation works on a mutually exclusive basis – investors, solely, have a sole claim on the assets isolated </li></ul></ul><ul><ul><li>No scope for inviting fresh equity or support to protect a transaction </li></ul></ul><ul><ul><li>No scope for discretion on the part of the investors </li></ul></ul>Securitisation Masterclass Sept 2006
  34. 34. Credit enhancements <ul><li>The needed enhancement is a product of desired ratings. </li></ul><ul><ul><li>Size of enhancement based on expected losses. </li></ul></ul><ul><ul><li>Expected loss times a multiplier decide the enhancement levels </li></ul></ul><ul><ul><li>The multiplier is related to the target ratings </li></ul></ul><ul><li>Key factors: </li></ul><ul><ul><li>Expected loss/ probability of default/ default severit </li></ul></ul><ul><ul><li>Diversification of the portfolio </li></ul></ul><ul><ul><li>Reliability of data </li></ul></ul><ul><li>Factors affecting the extent of credit enhancement: </li></ul><ul><ul><li>Quality of the collateral </li></ul></ul><ul><ul><li>Diversification of the portfolio </li></ul></ul><ul><ul><li>Historical performance </li></ul></ul><ul><ul><li>LTV ratio </li></ul></ul><ul><ul><li>Seasoning: for example, in mortgages, S&P says 90% of all defaults occur up to the 10th year. </li></ul></ul><ul><ul><li>Originator/ third-party enhancement - domestic investors normally content with originator enhancement, but international investors prefer third party enhancements </li></ul></ul>Securitisation Masterclass Sept 2006
  35. 35. Originator credit enhancement <ul><li>Originator credit support: </li></ul><ul><ul><li>Direct recourse or repurchase agreement: </li></ul></ul><ul><ul><ul><li>Legal issues </li></ul></ul></ul><ul><ul><ul><li>Credit rating </li></ul></ul></ul><ul><ul><ul><li>Problems in bankruptcy </li></ul></ul></ul><ul><ul><li>Retained profit - most common in cases of high spread, as auto loans: </li></ul></ul><ul><ul><li>Over-collateralisation – in-kind reserve </li></ul></ul><ul><ul><li>Cash reserve </li></ul></ul><ul><ul><li>Loan from a bank repaid by excess servicing fees </li></ul></ul><ul><ul><li>Full or partial recourse </li></ul></ul><ul><ul><li>Substitution </li></ul></ul><ul><ul><li>Representation/warranties : current quality/ subsequent quality </li></ul></ul><ul><ul><li>Advancing mechanism - advances against delinquent pmts </li></ul></ul>Securitisation Masterclass Sept 2006
  36. 36. Structural credit support <ul><li>Structural credit enhancement: stratified structure </li></ul><ul><ul><li>Senior/ junior structure: the inferior bonds provide protection to superior bonds </li></ul></ul><ul><li>Third party credit support </li></ul><ul><ul><li>Direct recourse or Guarantees </li></ul></ul><ul><ul><li>letters of credit </li></ul></ul><ul><ul><li>Insurance </li></ul></ul><ul><ul><ul><li>Mono - line insurers </li></ul></ul></ul><ul><ul><ul><li>Multi - line insurers </li></ul></ul></ul><ul><ul><ul><li>political risk insurance </li></ul></ul></ul><ul><ul><li>Credit derivatives </li></ul></ul>Securitisation Masterclass Sept 2006
  37. 37. Excess spread and credit enhancement <ul><li>Excess spread provides the most basic, natural credit enhancement to a transaction </li></ul><ul><li>The economic substance of excess spread is the same as debt/income in traditional lending </li></ul><ul><li>Due to static pool nature, excess spread comes down as pool factor reduces: </li></ul><ul><ul><li>Tendency towards prepayment is higher in pools with higher excess spread: </li></ul></ul><ul><ul><ul><li>Within the pool, loans with higher interest rates may prepay faster, thus reducing the average APR as well </li></ul></ul></ul><ul><ul><li>Further reduces due to charge offs </li></ul></ul><ul><ul><li>Combined effect may sharply reduce the excess spread </li></ul></ul><ul><li>Uses of excess spread in securitisation transactions: </li></ul><ul><ul><li>Returned periodically as service fees/junior coupon </li></ul></ul><ul><ul><li>Used to meet defaults on assets and paid to investors </li></ul></ul><ul><ul><li>Used to create reserves for defaulted assets; retained by the SPV </li></ul></ul>Securitisation Masterclass Sept 2006
  38. 38. Profit extraction devices and excess spread <ul><li>Whether and to what extent will a transaction be benefited by excess spread depends on profit extraction devices </li></ul><ul><li>Certain transactions strip the profits upfront and do not allow excess spread to go to the SPV: </li></ul><ul><ul><li>Excess spread serves as a credit enhancement only if it is routed through the SPV; AND </li></ul></ul><ul><ul><li>Its payout is subordinated to the claims of investors </li></ul></ul><ul><li>If excess spread is retained, it becomes a cash reserve </li></ul>Securitisation Masterclass Sept 2006
  39. 39. Over collateralisation <ul><li>Over - collateralisation is similar to LTV ratio in traditional lending </li></ul><ul><li>Substantively similar to excess spread or subordinated investment by the originator </li></ul><ul><li>Differences: </li></ul><ul><ul><li>Unlike excess spread, not subject to distinctive prepayment risk </li></ul></ul><ul><ul><li>Unlike excess spread, may not be returned to the originator until after some time </li></ul></ul><ul><ul><li>Unlike subordinated investment, may be held by the originator as originated loan and not investment </li></ul></ul>Securitisation Masterclass Sept 2006
  40. 40. Cash reserve <ul><li>Strongest form of credit enhancement </li></ul><ul><li>Unlike excess spread and over-collateralisation, cash reserve is both credit and liquidity enhancer </li></ul><ul><li>Available upfront and not over period of time </li></ul><ul><li>Reduces economic efficiency: reinvestment has negative carry </li></ul><ul><li>Among other things, cash reserve also ensures performance when servicing is suspended for any reason: </li></ul><ul><ul><li>The extent of cash reserve, among other things, is impacted by the transition from servicer to backup servicer </li></ul></ul>Securitisation Masterclass Sept 2006
  41. 41. Liquidity support <ul><li>Liquidity support is to cover temporary mismatches in cash flows </li></ul><ul><li>Sources of liquidity support: </li></ul><ul><ul><li>Servicer advances </li></ul></ul><ul><ul><li>Third party liquidity facility </li></ul></ul><ul><ul><li>Zero coupon bond </li></ul></ul><ul><ul><li>Cash reserve </li></ul></ul>Securitisation Masterclass Sept 2006
  42. 42. Paydown structure <ul><li>Paydown structure is an important feature of seniority: </li></ul><ul><ul><li>seniority in bankruptcy can lose its meaning if the junior security retires faster </li></ul></ul><ul><li>Sequential paydown structure: </li></ul><ul><ul><li>senior tranches retired first before junior ones; </li></ul></ul><ul><ul><li>increasing proportion of junior tranches over time; therefore, increasing credit enhancement </li></ul></ul><ul><ul><li>Increases weighted average cost of funding </li></ul></ul><ul><li>Pro rata allocation </li></ul><ul><ul><li>All classes retired in proportion to their outstanding balances </li></ul></ul><ul><ul><li>Maintains credit enhancement levels </li></ul></ul><ul><ul><li>Maintains weighted average cost of the transaction </li></ul></ul><ul><li>Fast pay/ slow pay structure: </li></ul><ul><ul><li>principal is distributed for fast pay for senior tranches, slow pay for junior tranches </li></ul></ul><ul><li>Paydown by collateral coverage tests: </li></ul><ul><ul><li>Over - collateralisation test </li></ul></ul><ul><ul><li>Interest coverage test </li></ul></ul>Securitisation Masterclass Sept 2006
  43. 43. Fixing paydown structure <ul><li>Ideally, except in abnormal circumstances, a transaction should provide for a pro-rata repayment: </li></ul><ul><ul><li>However, the paydown structure is related to the shape of the cumulative loss curve </li></ul></ul><ul><ul><li>If the loss curve has a tendency of increasing slope, it is necessary to increase the level of enhancement over time </li></ul></ul><ul><li>This is answered by increasing the CE to a target level by sequential payout </li></ul><ul><ul><li>thereafter, the structure pay provide for a pro-rata payout </li></ul></ul><ul><ul><li>Also called shifting interest structure </li></ul></ul><ul><li>When the structure returns to pro-rata, it would still provide for sequential payment in the event of certain triggers </li></ul>Securitisation Masterclass Sept 2006
  44. 44. Waterfall structure <ul><li>Basic fees and expenses including trustee, custodian, paying agent fees </li></ul><ul><li>Net periodic coupon to any swap counterparty </li></ul><ul><li>Servicer fee ?? </li></ul><ul><li>Interest on class A </li></ul><ul><li>Paydown of class A as per paydown structure </li></ul><ul><li>Interest on class B </li></ul><ul><li>Paydown of class B as per paydown structure </li></ul><ul><li>so on </li></ul><ul><li>Any excess service fee </li></ul><ul><li>retained interest </li></ul>Securitisation Masterclass Sept 2006 Where appropriate, there may be separate waterfalls for interest and principal inflows
  45. 45. Computation of credit enhancement <ul><li>Rating agencies construct a benchmark pool to test: </li></ul><ul><ul><li>Weighted average default frequency or default probability </li></ul></ul><ul><ul><li>Default correlation </li></ul></ul><ul><ul><li>Weighted average loss severity </li></ul></ul><ul><li>The methods to use for computing credit enhancement depend on </li></ul><ul><ul><li>diversity of the portfolio </li></ul></ul><ul><ul><li>availability of the data </li></ul></ul><ul><li>For diversified portfolios with established history, statistical methods such as standard deviation are often used. </li></ul><ul><li>For concentric portfolios, highest loss over last 5 years, or other subjective yardsticks are used. </li></ul>Securitisation Masterclass Sept 2006
  46. 46. Covering other risks: Interest rate, exchange risks etc <ul><li>Asset pool may have an actual or embedded interest rate risk </li></ul><ul><li>Necessary to convert a fixed rate collateral into floating rate notes or vice versa </li></ul><ul><li>Originator swap in the most convenient way, but </li></ul><ul><ul><li>originator rating may be a constraint </li></ul></ul><ul><ul><li>rating agencies go by the “weak link” theory and give rating based on the rating of the weakest of all connected parties </li></ul></ul><ul><li>Other swaps </li></ul><ul><li>Inverse floating securities </li></ul>Securitisation Masterclass Sept 2006
  47. 47. Credit enhancements and the cost of the transaction <ul><li>All credit enhancements carry a cost: </li></ul><ul><ul><li>External credit enhancements: explicit cost </li></ul></ul><ul><ul><li>Structural enhancement: spreads on junior classes </li></ul></ul><ul><ul><li>Originator enhancement: higher cost of originator support : </li></ul></ul><ul><ul><ul><li>Equity type treatment for regulatory/analytical purposes </li></ul></ul></ul><ul><li>Credit enhancements and resulting ratings have mutually conflicting impact on the weighted average cost of the transaction </li></ul><ul><li>Objective is to reach an equilibrium where economic waste is avoided, and transaction becomes protected. </li></ul>Securitisation Masterclass Sept 2006
  48. 48. Session 4 Prepayment and default risks in ABS
  49. 49. Risk attributes of asset backed securities <ul><li>Prepayment sensitive: </li></ul><ul><ul><li>Principal payout risk in case of pools subject to high degree of prepayment risk, such as mortgages and home equity </li></ul></ul><ul><ul><li>Early amortization risk </li></ul></ul><ul><ul><li>Differential prepayment sensitivity: </li></ul></ul><ul><ul><ul><li>Due to structuring, as in case of IO/POs, PACs/TACs and support classes </li></ul></ul></ul><ul><ul><ul><li>Due to sequential payment structures </li></ul></ul></ul><ul><li>Credit sensitive: </li></ul><ul><ul><li>High degree of leverage built on determinate credit support </li></ul></ul><ul><ul><li>Default allocation risk: </li></ul></ul><ul><ul><ul><li>Differential allocation due to subordination structures </li></ul></ul></ul><ul><li>Correlation sensitive: </li></ul><ul><ul><li>Correlation products, such as CDOs, are highly correlation sensitive </li></ul></ul>Securitisation Masterclass Sept 2006
  50. 50. Prepayment as a risk <ul><li>Prepayment is not a credit risk: </li></ul><ul><ul><li>It is risk of callability; similar to a callable bond </li></ul></ul><ul><li>Impact of prepayment: </li></ul><ul><ul><li>Interest rate risk: </li></ul></ul><ul><ul><ul><li>You have less money to reinvest when you can reinvest at better rates; more money to reinvest when you can reinvest at lower rates </li></ul></ul></ul><ul><ul><li>Yield: </li></ul></ul><ul><ul><ul><li>Affects yields when investors’ yield < coupon rate </li></ul></ul></ul><ul><ul><li>Duration: </li></ul></ul><ul><ul><ul><li>Introduces contraction/extension risk </li></ul></ul></ul><ul><ul><li>Negative convexity: </li></ul></ul><ul><ul><ul><li>Introduces negative convexity on price/rate relationship </li></ul></ul></ul><ul><ul><li>Investors NPV: </li></ul></ul><ul><ul><ul><li>Reduces investors’ NPV </li></ul></ul></ul><ul><ul><ul><li>Introduces negative convexity </li></ul></ul></ul><ul><ul><li>Impact on interest-rate sensitive products: </li></ul></ul><ul><ul><ul><li>Prices of IOs, support classes crash when prepayments rise </li></ul></ul></ul><ul><li>Impact of prepayment on the pool: </li></ul><ul><ul><li>Reduces excess spread </li></ul></ul><ul><ul><li>Adversely affects quality of the pool; increases default rate </li></ul></ul><ul><ul><li>Introduces risk of over-hedging </li></ul></ul>Securitisation Masterclass Sept 2006
  51. 51. Quantifying and pricing prepayment risk <ul><li>The standard industry measure of knocking-off the prepayment impact is the computation of option-adjusted spread that values the contingent, path-dependent cashflows </li></ul><ul><li>The classical approach includes: </li></ul><ul><ul><li>Simulating term structure behavior: </li></ul></ul><ul><ul><ul><li>Interest rate process models </li></ul></ul></ul><ul><ul><li>Relating interest rates to prepayment rates: </li></ul></ul><ul><ul><ul><li>Dynamic Prepayment models </li></ul></ul></ul><ul><ul><li>Simulating prepayment paths: </li></ul></ul><ul><ul><ul><li>If number of periods be m, and the simulated yield curves be n, we have mXn paths </li></ul></ul></ul><ul><ul><li>Feed these paths into a transaction cashflow model to get the interest and principal cashflows under each path </li></ul></ul><ul><ul><li>Discount these cashflows with a fixed z spread over the yield curve </li></ul></ul><ul><ul><li>This volatility-adjusted z spread is the option-adjusted spread </li></ul></ul>Securitisation Masterclass Sept 2006
  52. 52. Prepayment behavior <ul><li>Reasons for prepayment: </li></ul><ul><ul><li>Economic: refinancings </li></ul></ul><ul><ul><li>Non-economic: simple factors such as homeowner shifting, unemployment, etc </li></ul></ul><ul><li>Accordingly, prepayment may be classed into: </li></ul><ul><ul><li>Turnover, that is, prepayment taking place for non-economic reasons: </li></ul></ul><ul><ul><ul><li>Turnover is taken as close to 75 to 100 PSA </li></ul></ul></ul><ul><ul><ul><li>As turnover is not necessarily detrimental to investors (it can happen as much during periods of high interest rates as during low interest rates), it is not a risk </li></ul></ul></ul><ul><ul><li>Refinancings, which is function of interest rates </li></ul></ul><ul><ul><ul><li>Detriment investors to the benefit of the homeowners: </li></ul></ul></ul><ul><ul><ul><ul><li>Comparable to a typical option – homeowners have bought a put option written by the mortgage investors </li></ul></ul></ul></ul><ul><li>What complicates prepayment models: </li></ul><ul><ul><li>Rational behavior: the mortgagor will prepay the loan when it is cheaper to refinance </li></ul></ul><ul><ul><li>Irrational behavior: not all mortgagors act rationally </li></ul></ul><ul><ul><li>Prepayment rates have a geographical variation – in mortgage pools, it becomes difficult to aggregate different geographic sensitivities </li></ul></ul>Securitisation Masterclass Sept 2006
  53. 53. Interest rate risk and prepayment behavior <ul><li>As one of the prime causative factors in prepayment is refinancing motive, there is an adverse relation between prepayment rates and interest rates: </li></ul><ul><ul><li>Borne out by empirical evidence: prepayment rates shot through the roof in 2002 and 2003 </li></ul></ul><ul><li>Like other interest-rate sensitive products, it is necessary to take into account the interest rate risk: </li></ul><ul><ul><li>Swap options, callable bonds, structured notes, MBS have common features </li></ul></ul><ul><li>Interest rate modeling is a key part of understanding MBS/ABS risks </li></ul>Securitisation Masterclass Sept 2006
  54. 54. Bond Market Association forecast of prepayment rates Securitisation Masterclass Sept 2006
  55. 55. Prepayment models – commonly static models <ul><li>Commonly used static models: </li></ul><ul><ul><li>PSA: </li></ul></ul><ul><ul><ul><li>Linear increase in prepayment rate over 30 months of origination </li></ul></ul></ul><ul><ul><li>CPR: </li></ul></ul><ul><ul><ul><li>Constant prepayment rate. Typically used for HELs and student loans </li></ul></ul></ul><ul><ul><li>MPR: </li></ul></ul><ul><ul><ul><li>Monthly payment rate used for non amortizing pools such as credit cards. A payment rate, not prepayment rate </li></ul></ul></ul><ul><ul><li>ABS: </li></ul></ul><ul><ul><ul><li>Absolute prepayment speed, which is commonly used for auto loans, etc. The rate is applied on the original pool balance. </li></ul></ul></ul><ul><ul><li>HEP: </li></ul></ul><ul><ul><ul><li>Home equity prepayment curve – 10-step linear increase culminating at 20% </li></ul></ul></ul><ul><ul><li>MHP: </li></ul></ul><ul><ul><ul><li>Manufactured housing prepayment speed. 24-month ramp up starting from 3.7% and reaching 6% in the 24 th month </li></ul></ul></ul>Securitisation Masterclass Sept 2006
  56. 56. Prepayment Dynamic models <ul><li>Econometric models: </li></ul><ul><ul><li>OLS regression methods, where the CPR takes the following form: </li></ul></ul><ul><ul><ul><li>CPR =  +  1 x 1 +  2 x 2 +  3 x 3 +  </li></ul></ul></ul><ul><li>Option-theoretic models, based on option pricing or contingent claims approach </li></ul><ul><li>May also be classified as structural and reduced form models </li></ul><ul><ul><li>The Schwartz Torous model is an example of the reduced form approach </li></ul></ul><ul><li>Studies in prepayment behavior vis-à-vis interest rates: </li></ul><ul><ul><li>Scores of models, such as: </li></ul></ul><ul><ul><ul><li>Asay, Guillaume and Mattu model (1987) </li></ul></ul></ul><ul><ul><ul><ul><li>CPR= .3 -.16 arctan (123.11*(spread +.02)) </li></ul></ul></ul></ul><ul><ul><ul><li>Chinloy Model: </li></ul></ul></ul><ul><ul><ul><ul><li>.0813+-1.7951(0.6735)r +.9063 (.0688)  +.0012 (.0024) t </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Where r is the current rate for fixed rate mortgages,  is the rate at which the mortgage was originated, and t is the seasoning term (parantheses are standard error terms) </li></ul></ul></ul></ul></ul>Securitisation Masterclass Sept 2006
  57. 57. More prepayment models <ul><li>Schwartz and Torous model: </li></ul><ul><ul><li>CPR = {lp (lt)^(p-1)/ (1+lt)^p }* exp(S 1to 4 bh *vh) </li></ul></ul><ul><ul><li>where </li></ul></ul><ul><ul><li>l=0.01496 </li></ul></ul><ul><ul><li>p=2.31217 </li></ul></ul><ul><ul><li>b1 = .38089 </li></ul></ul><ul><ul><li>b2=.00333 </li></ul></ul><ul><ul><li>b3=3.57673 </li></ul></ul><ul><ul><li>b4=.26570 </li></ul></ul><ul><ul><li>v1 = c - 1(t -s ), where c is the contracted mortgage rate, t is the current long term treasury rate with a lag of s (standard taken as 3) </li></ul></ul><ul><ul><li>v2- v1^3 </li></ul></ul><ul><ul><li>v 3 Is the ln of the actual mortgage pool outstanding, divided by the outstanding that would have been there had there been no prepayments (tracks the history of prepayments in the pool) </li></ul></ul><ul><li>Goldman Sachs model: </li></ul><ul><ul><li>RI (refinancing related prepayment rate) = .31234 - .20252*atn (8.157* { - (c+s)/(p+f) +1.20761} </li></ul></ul><ul><ul><li>where c is average MBS coupon rate and S is the servicing fee taken out (which means C + S is the weighted average rate for the loans in the pool </li></ul></ul><ul><ul><li>p is the refinancing rate and F is the additional refinancing cost associated with refinancing </li></ul></ul><ul><li>Stanton’s model is an example of the structural approach </li></ul>Securitisation Masterclass Sept 2006
  58. 58. Structural approach to defaults and prepayments <ul><li>The structural approach takes its basic inspiration from the seminal work of Merton on default being seen as an option of the equity holders to put the assets on debt </li></ul><ul><li>Likewise, a mortgagor has the option to either default or prepay a loan. </li></ul><ul><li>Thus, the value of the mortgage liability is: </li></ul><ul><ul><li>PV of mortgage cashflows – value of default option – value of prepayment option </li></ul></ul><ul><li>Default option: </li></ul><ul><ul><li>The option to default will arise if the house price is less than the PV of Mortgage payments </li></ul></ul><ul><li>Prepayment option: </li></ul><ul><ul><li>Will arise where the refinancing cost is less than the mortgage cost </li></ul></ul>Securitisation Masterclass Sept 2006
  59. 59. Default risk in MBS <ul><li>Prepayment and defaults: competing or compounding risks: </li></ul><ul><ul><li>Both are dependent on common factors: </li></ul></ul><ul><ul><ul><li>Interest rates </li></ul></ul></ul><ul><ul><ul><li>House prices </li></ul></ul></ul><ul><ul><ul><li>General economic conditions </li></ul></ul></ul><ul><li>Static default model: </li></ul><ul><ul><li>The SDA model: </li></ul></ul><ul><ul><ul><li>Linear increase in default rates upto the 30 th month, staying flat for the next 30 months, and then declines until maturity </li></ul></ul></ul>Securitisation Masterclass Sept 2006
  60. 60. Default models <ul><li>Scoring models: </li></ul><ul><ul><li>FICO scores: </li></ul></ul><ul><ul><ul><li>NextGen FICO scores </li></ul></ul></ul><ul><li>Option theoretic models: </li></ul><ul><ul><li>Kau etc (1985) proposed a model that looks at default as an option to default if the LTV exceeds 100% </li></ul></ul><ul><ul><ul><li>However, no empirical evidence as default rates for LTV<100% are still low </li></ul></ul></ul><ul><ul><ul><li>However, there is an evidence that default rates are high where LTV ratios are high </li></ul></ul></ul><ul><ul><ul><ul><li>The model should, in fact, look at not only LTV but also debt coverage ratio </li></ul></ul></ul></ul><ul><li>Intensity approach: </li></ul><ul><ul><li>Looks at default as a hazard rate function </li></ul></ul>Securitisation Masterclass Sept 2006
  61. 61. Default risk in retail loan pools <ul><li>Default risk in non-mortgage pools is dependant on: </li></ul><ul><ul><li>Collateralised loans, such as auto loans </li></ul></ul><ul><ul><li>Non-collateralised loans, such as credit cards </li></ul></ul><ul><li>In the former, the LTV ratio is still an important guide </li></ul><ul><li>In the latter, default is driven by non-economic factors: </li></ul><ul><ul><li>Systemic factors, such as economic cycle, unemployment, etc </li></ul></ul><ul><ul><li>Adversities faced on account of bad credit history </li></ul></ul><ul><ul><li>Legal hassles of defaulting, etc </li></ul></ul>Securitisation Masterclass Sept 2006
  62. 62. Computation of default-adjusted spread <ul><li>Like OAS, one may compute default adjusted spread by computing the expected value of losses on account of default: </li></ul><ul><ul><li>Computed PV of mortgage payments under different scenarios of defaults (a) </li></ul></ul><ul><ul><li>Assign probability to each scenario (b) </li></ul></ul><ul><ul><li>The expected value of the payments is (ab) </li></ul></ul><ul><ul><li>The difference between the expected value at no defaults and ab is the cost of the default option (d) </li></ul></ul><ul><ul><li>The market price + the cost of the default option is the default-adjusted price </li></ul></ul><ul><ul><li>The yield computed on the default adjusted price is the default adjusted yield; likewise, default adjusted spread may be computed </li></ul></ul>Securitisation Masterclass Sept 2006