The Mechanics of Securitization

A Practical Guide to Structuring and Closing Asset-Backed Security Transactions

Suleman Baig, Moorad Choudhry

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118234549
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Finanzwesen

A step-by-step guide to implementing and closing securitization transactions

Securitization is still in wide use despite the reduction in transactions. The reality is that investors and institutions continue to use this vehicle for raising funds and the demand for their use will continue to rise as the world's capital needs increase.

The Mechanics of Securitization specifically analyzes and describes the process by which a bank successfully implements and closes a securitization transaction in the post subprime era. This book begins with an introduction to asset-backed securities and takes you through the historical impact of these transactions including the implications of the recent credit crisis and how the market has changed.

• Discusses, in great detail, rating agency reviews, liaising with third parties, marketing the deals, and securing investors
• Reviews due diligence and cash flow analysis techniques
• Examines credit and cash considerations as well as how to list and close deals
• Describes the process by which a bank will structure and implement the deal, and how the process is project managed and tested across internal bank departments

While securitization transactions have been taking place for over twenty-five years, there is still a lack of information on exactly how they are processed successfully. This book will put you in a better position to understand how it all happens, and show you how to effectively implement an ABS transaction yourself.

Part One
Introduction to Securitization

The purpose of this book is essentially to act as a guide, and checklist, for bankers wishing to originate and close a securitization transaction, either in-house or on behalf of a third-party client bank. Before that, however, we wish to place this template in context by beginning with some descriptive background on the market and its products.

To that end, Part One is an introduction to the concept of securitization, and would be of value to newcomers to the market and graduate students in finance. It defines the key elements behind the technique, and also illustrates the principles of securitization as a generic concept. Chapter 2 looks at some examples of the impact of the 2008 financial crash on the market.

Chapter 1
Introduction to Securitization and Asset-Backed Securities

Perhaps the best illustration of the flexibility, innovation, and user-friendliness of the debt capital markets is the rise in the use and importance of securitization. As defined in Sundaresan (1997, page 359), securitization is “a framework in which some illiquid assets of a corporation or a financial institution are transformed into a package of securities backed by these assets, through careful packaging, credit enhancements, liquidity enhancements, and structuring.”

The flexibility of securitization is a key advantage for both issuers and investors. Financial engineering techniques employed by investment banks today enable bonds to be created from any type of cash flow. The most typical such flows are those generated by high-volume loans such as residential mortgages and car and credit card loans, which are recorded as assets on bank or financial house balance sheets. In a securitization, the loan assets are packaged together, and their interest payments are used to service the new bond issue.

In addition to the more traditional cash flows from mortgages and loan assets, investment banks underwrite bonds secured with flows received by leisure and recreational facilities, such as health clubs, and other entities, such as nursing homes. Bonds securitizing mortgages are usually treated as a separate class, termed mortgage-backed securities, or MBSs. Those with other underlying assets are known as asset-backed securities, or ABSs. The type of asset class backing a securitized bond issue determines the method used to analyze and value it.

The asset-backed market represents a large and diverse group of securities suited to a varied group of investors. Often these instruments are the only way for institutional investors to pick up yield while retaining assets with high credit ratings. They are considered by issuers because they represent a cost-effective means of removing assets from their balance sheets, thus freeing up lines of credit and enabling them to access lower-cost funding.

Instruments are available backed by a variety of assets covering the entire yield curve, with either fixed or floating coupons. In the United Kingdom, for example, it is common for mortgage-backed bonds to have floating coupons, mirroring the interest basis of the country's mortgages. To suit investor requirements, however, some of these structures have been modified, through swap arrangements, to pay fixed coupons.

The market in structured finance securities was hit hard in the wake of the 2007–2008 financial crisis. Investors shunned asset-backed securities in a mass flight to quality. As the global economy recovered from recession, interest in securitization resumed. We examine the fallout in the market later in this chapter. First we discuss the principal concepts that drive the desire to undertake securitization.

The Concept of Securitization

Securitization is a well-established practice in the global debt capital markets. It refers to the sale of assets, which generate cash flows, from the institution that owns them, to another company that has been specifically set up for the purpose, and the issuing of notes by this second company. These notes are backed by the cash flows from the original assets. The technique was introduced first as a means of funding for mortgage banks in the United States, with the first such transaction generally recognized as having been undertaken by Salomon Brothers in 1979. Subsequently, the technique was applied to other assets such as credit card payments and leasing receivables, and has been employed worldwide. It has also been employed as part of asset-liability management, as a means of managing balance sheet risk.

Reasons for Undertaking Securitization

The driving force behind securitization has been the need for banks to realize value from the assets on their balance sheet. Typically these assets are residential mortgages, corporate loans, and retail loans such as credit card debt. The following are factors that might lead a financial institution to securitize a part of its balance sheet:

1. 
   If revenues received from assets remain roughly unchanged but the size of assets has decreased, this will lead to an increase in the return on equity ratio.
2. 
   The level of capital required to support the balance sheet will be reduced, which again can lead to cost savings or allow the institution to allocate the capital to other, perhaps more profitable, business.
3. 
   The financial institution can obtain cheaper funding: Frequently the interest payable on ABS securities is considerably below the level payable on the underlying loans. This creates a cash surplus for the originating entity.

In other words, a bank will securitize part of its balance sheet for one or all of the following reasons:

1. 
   Funding the assets it owns
2. 
   Balance sheet capital management
3. 
   Risk management and credit risk transfer.

We consider each of these in turn.

Funding

Banks can use securitization to (1) support rapid asset growth, (2) diversify their funding mix and reduce cost of funding, and (3) reduce maturity mismatches. All banks will not wish to be reliant on only a single or a few sources of funding, as this can be risky in times of market liquidity difficulty. Banks aim to optimize their funding between a mix of retail, interbank, and wholesale sources. S...