What is Securitization

1
What is Securitization?

• Transformation of an asset into an investment
• Selling claims on future cash flows
• Any asset with expected future cash flows can be
  securitized
• Mortgages, credit card receivables, song
  portfolios
• The essence of securitization is risk sharing
• Issuer transfers risk to investors
• Investors are willing to bear risk in exchange
  for appropriate expected return

2
Benefits of Securitization

• Issuers get liquidity
• Allows issuers to create more assets
• Make more loans, issue more credit cards, etc.
• Investors get higher returns
• Get access to markets otherwise unavailable
• Allows for diversification as well as higher
  returns

3
Risk in Asset Backed Securities

• Risks for investors in asset backed securities
• Interest rate risk -- Like any debt instrument,
  the value of a ABS will vary with changes in
  interest rates.
• As interest rates increase, the value of the ABS
  will go down, and vice-versa

4
Risk in Asset Backed Securities

• Risks for investors in asset backed securities
• Pre-payment risk
• Borrower may pay loans earlier. Causes return on
  ABS to be lower than expected. Generally,
  prepayment risk is higher when interest rates go
  down. Opposite of interest rate risk
• Estimating prepayments
• Constant prepayment
• Escalating prepayment

5
Risk in Asset Backed Securities

• Risks for investors in mortgage backed securities
• Default risk
• MBS is only as good as the issuer. FNMA and GNMA
  MBSs are guaranteed. Many other asset backed
  securities are not.

6
Risk in Asset Backed Securities

• Risks for issuers
• Warehousing of loans before securitization
• Lack of market for securitized product
• Lack of market for underlying asset

7
Typical Securitization Structure

• Sequential claims form the waterfall.

Senior
Sub 1
Sub 2
8
Typical Securitization Structure

• Sequential claims form the waterfall.
• Size of senior and subordinate classes may be
  altered to affect repayment probability for
  senior securities.
• Underlying pieces are a form of credit
  enhancement, or guarantee.

AAA
AAA
A
A
BBB
BBB