Chapter 2: Fundamentals of Structuring

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Chapter 2 Fundamentals of Structuring

• Andrew Davidson
• Anthony B. Sanders
• Lan-Ling Wolff
• Anne Ching

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Issuers motivations legal, accounting and tax
Considerations

• From the point of view of the issuer,
  securitization may be viewed as a sale or a
  financing, and in many ways securitization has
  features of both.
• Because of this dual nature, securitization
  reflects many motivations of the issuer including
  financial, regulatory, tax, accounting and
  strategic considerations.

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Selling assets versus securitizing assets

• Financial (economic) motivations for selling
  assets rather than securitizing them
• risks are transferred to the buyer (with the
  seller retaining responsibility for the
  representations and warranties)
• costs of the transactions are generally lower
  than securitization
• the issuer must determine whether the proceeds
  from the securitization, after taking into
  account the value and risk of the retained
  classes, represents greater value than an
  outright sale of the loans.

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Balance sheet analysis an example

• XYZ has total assets of 300 million, of which,
  200 million are a loan portfolio that they seek
  to sell or securitize.
• XYZ has equity equal to 10 percent of its assets.
• XYZ estimates its cost of capital by taking the
  weighted average of the components of their
  liabilities.
• On this basis, XYZ might be encouraged to sell or
  securitize whenever the cost of securitization is
  less than the cost of capital

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Example (continued)
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Example (continued)
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Results of securitization

• After the securitization, the size of XYZs
  balance sheet is greatly reduced as proceeds from
  the securitization are used to pay down debt (see
  Table 2.2).
• The securitization of 200 million in loans will
  result in cash proceeds of 190 million.
• The bonds issued had an all-in cost of 6.5
  percent (based on the yields of the bonds and
  expenses).
• XYZ will retain a residual (equity-like
  component) interest in the securitization.
• XYZ values that component at 15 million.
• This results in a gain-on-sale of 5 million. The
  resulting balance sheet is shown in Table 2.3.

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Example (continued)
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Profitability of securitization

• XYZ sees the securitization as being profitable
  using two separate analyses.
• First, the securitization resulted in a profit of
  5 million.
• Second, the all-in cost of the bonds of 6.5
  percent was less than XYZs cost of capital of
  8.35 percent as calculated in Table 2.2.
• Even if XYZ blends in the cost of equity of 25
  percent on the 10 million not received as cash
  in the securitization, the blended cost of
  securitization is 7.43 percent.

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The impact of the retained residual

• The XYZ analysis is too simplistic, however,
  because it fails to take into account the risk of
  the retained residual.
• The residual bears much of the credit risk of the
  original loan portfolio, and may even have
  substantial interest-rate and prepayment risk.
• Investors in the companys debt may require
  higher yields or a higher amount of capital to
  maintain the same yield.
• Moreover, given the illiquid nature of the market
  for residuals, it may be difficult for the firm
  to verify the value of the residual. If the
  appropriate value of the residual should have
  been 9 million rather than 15 million, then the
  firm actually lost money on the securitization
  transaction.

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The structuring process

• Tax issues
• Asset-backed securities and mortgage-backed
  securities are generally issued by trusts because
  income is not generally subject to taxation at
  the trust level.
• Bankruptcy issues
• The trust establishes a legal separation between
  the issuer and the pool of assets deposited into
  the trust.
• In the case of a corporate bankruptcy, the
  bankruptcy-remote trust cannot be consolidated
  with the other assets of the insolvent company.
• This allows investors to continue to receive
  proceeds without interruption from the underlying
  loan pool.

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Issuing vehicles

• Grantor trusts
• Owner trust
• REMICs
• FASITs

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Issuing vehicles grantor trusts

• A grantor trust is the simplest type of trust
  because principal and interest from the
  underlying loan pool is simply passed through
  to investors.
• Investors, commonly referred to as certificate
  holders, are treated as owners of the underlying
  collateral and are entitled to a pro rata share
  of cash flow generated from the underlying loan
  pool.

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Issuing vehicles owner trusts

• Owner trusts are more flexible structures because
  they allow for the creation of multiple-class
  securities with varying maturities, which appeal
  to a broader range of investors.
• Unlike grantor trusts, principal payments can be
  accelerated or delayed with respect to specific
  classes and do not have to mirror the underlying
  cash-flow patterns of the collateral. In the case
  of a fast-pay class, principal payments are
  made until the class with the earliest stated
  maturity is fully retired, even though the
  underlying collateral may have loan terms of up
  to thirty years.
• Owner trusts tend to be used most commonly for
  auto, student, home equity, and equipment loans.

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Issuing vehicles REMICs

• A REMIC or real estate mortgage investment
  conduit is another important vehicle used for
  securitizations.
• REMICs were created primarily as a means of
  issuing multiple-class securities backed by
  mortgages or real property not subject to tax at
  the trust or entity level as long as they are in
  compliance with REMIC requirements as stated in
  the Tax Reform Act of 1986.
• REMICs can take many legal forms including
  corporations, partnerships, and trusts, or as a
  segregated pool of assets.
• REMICs are the vehicle of choice for
  multiple-class, sequential-pay mortgage-backed
  securities.

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Issuing vehicles FASITs

• FASITs or financial asset securitization
  investment trusts were created in 1996 at the
  request of credit card sponsors to provide
  similar tax relief as REMICs for revolving
  non-mortgage assets.
• To date, FASITs have not been widely used even by
  the groups that sponsored the legislation in 1996.

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Types of securities issued

• Type of securities issued depends on the issuing
  vehicle.
• The main features of the issuing vehicles are
  summarized in Table 2.4 and brief descriptions of
  the various types of securities are contained in
  Table 2.5.

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Types of securities issued
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Table 2.5 Securities descriptions

• Pass-through certificates
• Pass-through certificates are treated as owners
  of the trust and entitle holders to a pro rata
  share of principal and interest payments.
• The composition of the asset pool cannot change
  over time and the trust cannot reinvest any
  payments received from the asset pool.

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Table 2.5 Securities descriptions

• Stripped pass-through certficates
• Interest-only (IO) and principal-only (PO) strips
  are examples of stripped pass-through
  certificates in which ownership rights to
  interest and principal are completely separated.
• IO and PO strips entitle investors to 100 percent
  ownership of either interest or principal,
  respectively.
• POs are similar to zero-coupon bonds because they
  are purchased at substantial discounts and repay
  principal in one bullet payment.
• Investors typically purchase POs because they
  either expect a high rate of prepayments or wish
  to hedge against declining interest rates.
• IOs, on the other hand, are purchased by
  investors who expect low prepayments and who want
  to hedge against losses resulting from rising
  interest rates.

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Table 2.5 Securities descriptions

• Senior/subordinated pass-through certificates
• Passthrough certificates can have both senior and
  junior classes, in which the rights of the junior
  classes to receive principal is subordinated to
  senior classes.
• Callable pass-through certificates
• Pass-through certificates can also have an
  embedded call option, which entitles the holder
  to purchase the trust assets for cash.
• Pay-through bonds
• Pay-through bonds represent debt obligations of a
  legal entity rather than ownership interests and
  are mostly commonly issued by owner trusts.

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Table 2.5 Securities descriptions

• REMIC interests
• Regular interests are treated as ownership
  interests in the underlying mortgages.
• Only one residual interest allowed per REMIC.
• FASIT interests
• Single class of ownership interest and one or
  more class of regular interests.

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Credit enhancement and the role of rating agencies

• Once the type of issuing vehicle has been
  established, the issuer will face the decision of
  how to structure the resulting class of
  securities.
• A driving force behind this decision will be the
  level of credit enhancement necessary to achieve
  a given credit rating (AAA, AA, A, BBB, etc.) for
  each of the various classes of the security.
• The basis for the required credit enhancement is
  the estimated losses for each of the classes
  under a range of modeling assumptions.
• This is the point at which the credit rating
  agencies (e.g., SP, Moodys, Fitch) enter into
  the process.

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Foreclosure frequency and loss severity

• The rating agencies will forecast loss coverage
  amount as a product of foreclosure frequency and
  loss severity.
• Foreclosure frequency represents the percentage
  of the loans that will default over the life of
  the transaction.
• Loss severity represents the losses experienced
  by the transaction and consists of any loan
  amounts not recovered as a result of foreclosure
  or other sale of the loan.
• Severity includes all costs of liquidation as
  well as any accrued interest not paid by the
  borrower.
• The rating agencies will establish different
  levels of foreclosure frequency and loss severity
  for the various rating levels.

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Credit enhancement

• Rating agencies will conduct a careful weighting
  of each of these loan characteristics for the
  overall pool in order to determine the ultimate
  credit enhancement level.
• Excess interest, subordination,
  over-collateralization, and spread accounts are
  all examples of internal credit enhancement.
• Corporate guarantees, bond insurance, and letters
  of credit (LOC) are all examples of external
  credit enhancement.

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Excess interest

• Excess interest represents the difference between
  the coupon or interest rate paid by the borrowers
  and the coupon or interest rate paid to the
  certificate holders.
• Generally the interest rate paid by borrowers is
  higher than the interest rate paid to the
  certificate holders.
• This difference, called the excess interest, is
  available to cover any losses that occur during
  that period.
• Thus, if a loan defaults, the excess interest
  could be used to make payments to the certificate
  holders.

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Subordination

• In a typical subordinated transaction, the rights
  of junior classes of investors to receive
  principal and interest are subordinated to the
  rights of the senior classes.
• More importantly, the junior classes are in a
  first-loss position and shield senior classes
  from potential principal and interest shortfalls
  resulting from defaults or credit losses.

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Over-collateralization

• Over-collateralization (OC) is a form of
  subordination and represents the difference
  between the certificate balance (sometimes
  referred to as bond balance) and the underlying
  loan balance.
• An original OC amount is established when the
  transaction is issued.
• For example, if 100 million of bonds were
  secured by 102 million of collateral, the OC
  amount would be equal to 2 million (102 million
  minus 100 million equals 2 million).
• Another way of stating this is that the
  transaction is over-collateralized by 2 percent.
• What this means is that this transaction can
  withstand losses equal to the OC, plus any excess
  spread available before senior certificate
  holders incur any losses.

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Spread accounts

• In contrast to OC, excess interest/spread is
  deposited into an account that accumulates over
  time to cover any current losses of the
  underlying pool.
• Once a deal has reached its target level, any
  remaining excess spread is distributed to the
  residual holders.

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External credit enhancement.

• Credit enhancement can also be provided by an
  external guarantor.
• The primary sources of external credit
  enhancement are corporate guarantees or monoline
  insurers.
• A corporation can guaranty full and timely
  payment of interest and principal on a
  transaction, regardless of the performance of the
  collateral.
• While this is generally viewed as atypical, it is
  actually the most prevalent form of credit
  enhancement
• The Federal Home Loan Mortgage Corporation
  (Freddie Mac) and the Federal National Mortgage
  Association (Fannie Mae), which are
  government-sponsored enterprises (GSEs), issue
  corporate guarantees for the timely payment of
  interest and ultimate repayment of principal for
  all of the mortgages and CMOs they issue.