Asset Securitization

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Asset Securitization

• Eric J. Higgins Kansas State University

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The Securitization Market
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ABS Outstanding, 2002
Source Bond Market Association
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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

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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

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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

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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

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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.

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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

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Typical Securitization Structure

• Sequential claims form the waterfall.

Senior
Sub 1
Sub 2
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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
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Typical Securitization Structure

• Cash leftover after distributions to investors
  and funding of credit enhancements are called the
  excess spread
• Inadequate excess spread is a sign that the pool
  is not producing expected cash payments
• Excess spread has direct relationship with value
• Higher the excess spread (from zero) ?
• Greater certainty that payments will be made ?
• Lower default risk ?
• Greater value

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ABS Downgrades

• Moodys, SP, and Fitch ratings changes show
  downgrades are rare for credit card ABS

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True Sale Provision

• True sale governed by FASB 140
• Governs sale of loans from originator to SPE
• Reiterated in supervisory treatment

Borrower
Loan Originator
Special Purpose Entity
Rating Agency
Credit Enhancer
Underwriter
Investors
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Types of Support Provided

• Adding higher quality (or discounted) receivables
• Removing early amortization triggers
• Increasing credit enhancement
• Lowering base rate
• Recently done by Chase (April 28, 2003)

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Implications

• True sale is fiction but
• Sponsor is rewarded for providing support though
  may require time to put affairs in order before
  next issuance.
• Sponsor may be acting rationally by violating
  GAAP/RAP.
• Could behavior be harmful to safety net?
• Points out the need to think harder about how
  securitization affects firms and how to establish
  meaningful capital requirements for securitizing
  banks.